Over the past decade as demand surged and supply became increasingly limited, office rents rose uniformly across the bay area. But now that demand is waning and supply rising, don’t expect landlords to make downward price adjustments in unison. Landlord behavior varies by type of landlord (private capital, REIT, institutional fund), debt and equity, stability of tenancy and cost basis. While product type may be comparable (e.g., class A office buildings in the San Francisco financial district), individual owner motivations reflect the highly differentiated interplay of these variables.
Type of Landlord
There are 3 basic types of landlord:·
Private Capital·
REIT·
Institutional Fund
Private Capital owners are generally motivated by cash flow. They favor limiting capital spending, minimizing risk and maintaining continuity of tenancy.
The REIT, or real estate investment trust, is a publicly traded entity which owns assets typically focused by asset class. A good example is Boston Properties (BXP), a large office REIT owning assets across the US. REITs favor occupancy and maximization of rental income in order to achieve highest possible levels of Funds from Operations (“FFO”), which is the measure by which REIT stocks are valued.
Institutional Fund landlords are comprised of investments from endowments, pensions and insurance companies, to name a few. These funds are typically run by operating entities that also have a small amount of equity in the investment. Each fund has an investment thesis and targeted returns over a defined period.
Debt and Equity
In past downturns, debt to equity ratios were significantly higher than those typically seen today. In fact, debt levels were so high in the early 2000s that a good number of assets became known as “zombie assets" where the operator was effectively unable to transact because it (and in many cases some percentage of the debt holders) had lost all equity. Large office buildings can have complex ownership structures involving multiple equity partners and multiple layers of debt. As the market declined in the early 2000s asset values fell through the equity and debt stack, at times leaving only debt holders down the stack with enough incentive to “own” the asset.
Stability of Tenancy
Multi-tenant office buildings can have dramatically different circumstances when it comes to stability of tenancy. Assets having significant lease rollover in the near-term will be more inclined to transact in a declining market since the alternative is more vacancy, taking longer to lease; whereas, landlords of assets that are highly occupied over the mid-term and long-term may choose to sustain modest levels of vacancy through the downturn in order to avoid transacting at discounted rental economics, thereby preserving future target valuations.
Cost Basis
Ultimately, landlords are people. People who convince their investment committee to buy at a certain price. People who secure investors with target returns. People who have compensation tied to the performance of the asset. No one wants to tell the partners/investors the bad news. When it is revealed, it often comes in stages as the operator remains overly optimistic despite clear signs of a deeper downturn. This is simply human nature. It’s noteworthy that in San Francisco where investment volume has been record-high over the past 10 years, asset values have appreciated significantly. In fact, numerous assets have traded multiple times during the cycle at increasingly high values. For many San Francisco landlords cost basis is at an all-time high. There’s a high degree of reluctance to accept reality built into the current market.
Summary
Achieving market-favorable leasing outcomes in a declining market requires a thoughtful negotiating strategy that includes understanding unique landlord motivation profiles. Negotiating strategies must be sensitive to factors influencing landlord motivation. Occupiers must have access to critical data and advisory teams that understand how to analyze this data to inform strategy. While the pace of decline will be erratic, the balance of leverage has shifted to the tenant and this trend will accelerate over the next 12+ months. TenantSee, powered by Cushman & Wakefield, combines data and teams of subject matter experts with powerful technology to create total transparency for office tenants. TenantSee Market Diagnostics illuminate and analyze critical data to provide actionable insights. Contact us to learn more about our complimentary diagnostic resource. ~