Significant Cost Increase
You signed a 10-year lease 7 years ago. Since then, the market value of your space has more than doubled. At this pace, you’re looking at a huge price increase in 3 years. What should you do? Today in the San Francisco Bay Area marketplace, this is the single most common discussion we have with tenants. Since our approach to this question is always the same, we thought it made sense to describe it here today. The question “What should we do?”, is really comprised of 3 questions:
1. How will the market perform between now and our lease expiration?
2. How should we be thinking about time relative to activating our process?
3. What actions should we take now, if any?
Of course, no one can predict the future. But it is possible to provide reasonable forecasts of potential leasing outcomes which will inform and support strategy. With TenantSee, we provide a highly specific approach to monitoring the market, which commences 3 years prior to lease expiration and involves the provision of Market Diagnostics, twice annually. Our Market Diagnostics analyze data associated with the specific asset (landlord motivation, lease rollover, cost basis, financing, etc.), the broader market dynamic/trajectory and financial modeling to ascertain whether action is warranted (compare early extension to normalized extension to relocations with landlord indifference sensitivities and projected market sensitivities).
4X Comparison
If you know you will seek to stay in a market, require relatively the same amount of space in a similar building and location, there are 4 transactions you must analyze before making any decisions (a less common 5th and 6th would be purchasing a building and coworking, both of which can be included in our model):
1. Early lease extension
2. Disposal of existing space and early relocation
3. Normalized lease extension
4. Normalized relocation
We begin the diagnostics phase 3 years out because, for many clients, we will look to activate process about 2 years ahead of expiration. This is because if your lease has a renewal option, it very likely calls for a written exercise to be delivered to the landlord between 18 and 12 months prior to lease expiration. This is known as the renewal option notice window. Knowing whether the renewal scenario is appropriate or attractive necessitates that you know the cost/benefit of all alternative leasing scenarios to the renewal (which also requires analysis since most renewals are tied to fair market value and the true cost is only known once you exercise). Over my 30-year career, I’ve never had a client exercise a renewal option. The primary purpose of the option is to protect you in a market environment in which supply is so constrained that other users, either from within the project or outside, put you at risk of losing your space. This dynamic is mostly associated with very tight market conditions such as we are experiencing now in San Francisco.
The Model
The math associated with analyzing options 1-4 is straight forward, excepting unique corporate finance objectives. These would include, for example, strategies that are highly sensitive to EBITDA. This is not uncommon since many companies are valued on a multiple to EBITDA. It’s important to know this up front because EBITDA sensitive companies may choose a higher cost relocation over a lower cost lease extension due to the specific impact on EBITDA, particularly the scale of tenant improvements.
Accounting nuances aside, the framework for our comparison model is as follows:
1. Select analysis comparison period. This is the time remaining on the existing lease + the new term. For example, if you have 3 years remaining on the lease you probably want to select a 10-year comparison period to account for a new 7-year term at expiration of the existing lease.
2. Select 2 future market sensitivities for the model: 1) appreciating and 2) depreciating. These should not be wild swings in either direction; but, rather, percentage increases and decreases that would be within the realm of 10%-15%. It’s best that you plan to high probability outcomes, not black swan events.
3. Frame out assumptions:
a. Early Extension: existing obligation + lease extension value at current market
b. Early Relocation: disposition value (positive or negative after all costs) + relocation transaction value (including all associated costs)
c. Normalized Extension: existing obligation + lease extension value at projected market pricing (appreciating and depreciating)
d. Normalized Relocation: existing obligation + relocation transaction value at projected pricing (appreciating and depreciating)
With this approach, TenantSee clients always know how they should be thinking about the market – they have total awareness. You can learn more about TenantSee and about our team, by visiting www.lowfogg.com or www.tenantsee.co. If you’d like to visit with us about our diagnostic approach, please contact us to schedule an appointment.