Dual Agency Brokerage Under Attack in California

Mary Smith, a salesperson at ABC Brokerage Company, is the listing agent for space in a building owned by Big Owner. In the marketing flyer for the space, Mary states that the space is 20,500 sf even though she knows it is not that large.  XYZ Company, a tenant, hires Bob Jones, also an agent at ABC Brokerage Company, to represent it in its search for space.  After a lease is signed for the subject premises, it turns out that, unbeknownst to Bob Jones and the XYZ Company, the space is only 16,000sf.  Does XYZ Company have a claim against its brokerage firm, ABC Brokerage Company, based on the actions of its agent, Mary Smith?  It might depend on what state you are in.

A recent California Supreme Court case held that, in a dual agency situation (i.e., where the same brokerage firm represents both the seller and buyer or landlord and tenant in the same transaction), the agents of the brokerage firm owe fiduciary responsibilities to both of the firm’s clients in the transaction and not just to the client they are specifically representing.  The case, Horiike v. Coldwell Banker, involved the purchase and sale of a mansion in Malibu.  However, the holding has important precedential value for commercial real estate transactions in California as well.

In Horiike, the home seller’s agent, Chris Cortazzo of Coldwell Banker, failed to warn the buyer that the square footage of a home identified in a sales brochure was incorrect.  The buyer purchased the home based on the erroneous information.  At the trial, the buyer sued both Mr. Cortazzo and Coldwell Banker.  The trail court threw out the suit against Mr. Cortazzo because it determined that Mr. Cortazzo was exclusively representing the seller and, therefore, had no fiduciary duty to the buyer to warn him of the inaccuracy in the sales flyer.  The court then instructed the jury that, to find Coldwell Banker liable to the buyer, it would have to determine that the agent at Coldwell Banker representing the interests of the buyer in the transaction acted wrongly.  Because the buyer’s agent, Chizuka Namba, also of Coldwell Banker, was not aware that the square footage reference in the brochure was incorrect (and the buyer did not even name Ms. Namba in the suit), the jury found in favor of the defendant.  The buyer appealed the case.

The California Court of Appeals reversed the lower court’s findings and held that Mr. Cortazzo, as a salesperson working under Coldwell Banker’s license, owed a duty to the buyer “equivalent” to the duty owed to him by Coldwell Banker.  The obligations and fiduciary responsibilities of the individual sales agents of the Coldwell Banker were found to be derivative of the obligations and responsibilities of the firm they worked for and under whose license and direction they operated.  Thus, because the buyer was a client of Coldwell Banker, all of its agents had the same fiduciary responsibility to that client regardless of who they were representing in that transaction.  This responsibility included the requirement that Mr. Cortazzo “disclose known facts materially affecting the value or desirability of the property to both parties.”  This duty to warn was expressly contained in the “Disclosure and Consent to Representation of More Than One Buyer or Seller” which the parties signed as required under California law because Coldwell Banker was representing both the buyer and seller in the transaction.

Coldwell Banker felt it was entitled to retain the two significant commissions it made on this transaction even though (1) the buyer had relied to his detriment on the firm’s misleading marketing brochure and (2) the firm’s employee (Mr. Cortazzo) knew the square footage was overstated. It argued, in effect, that the home buyer did not truly hire Coldwell Banker; he only hired the broker at Coldwell Banker who was working with him.  Thus, it was Coldwell Banker’s position that the only person at the company who was obligated to protect the buyer was Ms. Namba, the agent working for him, even though its other agent, Mr. Cortazzo, knew the sales brochure he had prepared was inaccurate.  The holding in the Horiike case is largely dependent on the statutorily required disclosure form that all of the  parties were required to sign under California law because Coldwell Banker was acting as a dual agent in the transaction.

Needless to say, this case is causing considerable distress in the brokerage community for firms who typically act as dual agents in the market.  If in fact a landlord broker has a fiduciary duty to warn a tenant about problems with a given property or the creditworthiness of the landlord, it could be difficult for him to aggressively market the building and advance the landlord’s interests.  Likewise, would a tenant broker whose firm also represents the landlord be required to inform the landlord that the tenant is having financial difficulties?

The Horiike case is specific to California.  What would the outcome of the case be in Pennsylvania?

Pennsylvania contemplates two types of dual agency situations. The first, involving a “dual agent” is where the very same agent represents both the landlord and tenant (or buyer and seller) in the transaction. The second, involving a “designated agent”, is where, though the same brokerage firm represents both parties to a transaction, the firm designates different agents within the firm to represent the interests of each party.

Section 35.314 of the Pennsylvania Code (Duties of Dual Agent) addresses the first scenario.  In this instance, the dual agent in Pennsylvania may take “no action that is adverse or detrimental to either party’s interests in the transaction.”  Because any negotiation is a zero sum game where a dollar earned by one party is a dollar taken from the other party, a dual agent would be hard pressed to do anything in a transaction other than introduce the parties and then let them hash out their own deal. Clearly he could not advocate for the financial interests of one client without necessarily being adverse to the interests of the other client.

Section 35.315 of the Pennsylvania Code (Duties of a Designated Agent) deals with the second scenario where the brokerage firm designates one agent to represent one party (i.e., the seller or landlord) and another of its agents to represent the other party (i.e., buyer or tenant).  Subsection 35.315(e)(1) states that each designated agent owes: “Loyalty to the principal with whom the designated agent is acting by working in that principal’s best interests.”  Thus, if the Horiike case were tried in Pennsylvania, it is likely that Coldwell Banker would have prevailed because Mr. Cortazzo would be statutorily required to act solely in the best interests of the seller.  He would have no fiduciary duty to the buyer and arguably, by informing the buyer of the incorrect square footage, would be breaching his fiduciary obligation to act in the seller’s best interests.  Thus, unlike in California, where all the brokers in your firm have duties to protect your interests, in Pennsylvania, only the agent working for you has your back.

Conclusion

In Philadelphia where two or three firms dominate the landlord listings, dual agency scenarios have become more and more common leading to more frequent opportunities for conflicting loyalties within a firm.  In these instances, the tenant needs to understand that it isn’t hiring a brokerage firm; it is only really hiring the agent working on its deal.  In fact, there may be situations where some of the agents at the tenant’s brokerage firm could be obligated to act against the tenant’s interests.

For more information contact Glenn Blumenfeld http://www.tactix.com/team.php#Glenn

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Office Market: Why Philadelphia’s West Market Corridor Will Stay Strong

A few years ago, a lot of people were pointing to 2017-18 as the time when the Central Business District (CBD) office market might start to soften up, providing relief to tenants who might be looking for space. A “perfect storm” of factors all indicated that vacancy should be picking up this year and into 2018. That really hasn’t happened. We’ll explain why.

First let’s summarize the tenant friendly future we were contemplating back in 2014-2015; then we’ll discuss how five unexpected things helped change the market we were expecting.

What we were expecting and why

New Inventory. The pending development of FMC Tower and Comcast Innovation and Technology Center, together with the redevelopment of 2400 Market Street was scaring a lot of Center City landlords. With approximately 2,000,000sf of new office space coming onto the market, they understandably worried how this was all going to be absorbed. Certainly, Comcast was going to take most (and, as it turned out, all) of the new Innovation Center but most people expected that, in doing so, they would vacate the approximately 600,000sf of space they were currently leasing at Two and Three Logan and other buildings. FMC would soak up a large part of the new FMC Tower but there was still 200,000sf of space to fill in the new building. FMC’s departure from Mellon Bank Center would also create a 200,000sf vacancy there.

Center City landlords had already dodged (at least temporarily) a major bullet when GlaxoSmithKline vacated approximately 800,000sf of CBD office space in 2013 to relocate to the Navy Yard. To their relief, none of this vacated office space came back on the market as Three Franklin Plaza was sold to a charter music school and One Franklin Plaza was mothballed (it’s currently in redevelopment and ultimately 200,000sf of office space will soon add to available inventory). Could they dodge another bullet of excess inventory in 2017-18?

Significant Center City departures and downsizings. Some major corporations and space occupiers had announced they were leaving the City or were at least going to be downsizing significantly. Among the big users that left the City were Sunoco and Dow. Those significantly downsizing their Center City presence included BNY Mellon and Cigna. Landlords were justifiably concerned that these pending vacancies would put further downward pressure on rents.

More efficient space trends. It’s well recognized across the industry that companies are consuming much less space per employee as they move to new, more efficient utilization concepts such as open plan environments, smaller offices, hoteling and telecommuting. Law firms, for example, who used to plan for 750-850sf/attorney in the early 2000s are now down to 600-650sf/attorney in many cases. Large corporations who used to have a ratio of offices to open seating of 3 or 4 to 1 are now flipping the paradigm to 1 to 3 or 4. When companies use less space, it drives down demand putting even more downward pressure on rents. This trend is probably not going to change any time soon and, as existing leases continue to expire, more and more firms will be implementing these space saving programs. Landlords had more reason to worry.

Well, they shouldn’t have worried. 

What changed?

Here are five unexpected events that helped save the CBD office market for landlords.

  1. Comcast grew faster than expected.While nothing definitive has been decided, it does NOT look like Comcast will be vacating most of the office space it currently occupies outside of their two-building urban campus. The 500,000-600,000sf of space that many landlords feared would open in Two Logan and Three Logan may only be a fraction of that now. Comcast will not only fill up it’s beautiful new Innovation and Technology Center, but it appears they will also still need several hundred thousand of square feet of overflow space on top of that. Even if Comcast goes ahead with their third tower currently on the drawing board, that will be at least four or five years down the road and Comcast will need interim space to house their growth while that building gets developed.
  2. Aramark moved west.Facing a 500,000-square-foot office development down the street at 2400 Market, West Market Street landlords were praying that an out of town tenant would come along and soak that up before their own tenants defected there. They got the next best thing. Aramark surprisingly announced that it would be relocating its headquarters from Aramark Tower at 11th and Market into approximately 300,000 square feet at 2400. While this move was clearly a blow to the East Market Street sub-market, it was a Godsend to the landlords on West Market Street. Though there’s still close to 200,000 square feet of office space available at 2400 Market, this big office project won’t have the negative impact on West Market Street that many initially feared.
  3. WeWork loves Philadelphia.If corporate tenants were taking less office space and no big, new companies were moving into town, landlords needed some sort of miracle to absorb the pending vacancies. Enter WeWork. They have quietly leased close to 100,000sf of space between 1900 Market Street and 1601 Market Street that won’t be occupied by their own employees. It will ultimately be occupied by lots of entrepreneurs, small businesses and even large companies with temporary staffing needs. In many cases, these occupants would never have ended up in these buildings because they are too small, don’t have the credit or wouldn’t commit to long enough lease terms. By packaging up all of these types of users under one roof, they have increased demand for Class A office space across the country. With WeWork, the whole is more than the sum of its parts.
  4. Spark Therapeutics came out of nowhere.Remember all that new space in FMC Tower that was going to draw existing tenants from the trophy towers along West Market Street? Well, a firm very few people had ever heard of, Spark Therapeutics, who has been quietly knocking the cover off the ball in University City, just leased 75,000 square feet of space at FMC Tower and are rumored to be taking a bunch more at Schuylkill Yards. They are a Philadelphia success story that landlords around town should be lining up to thank.
  5. Two distinguished law firms finally join their friends along West Market.Back in the late 1980s and early 1990s, the center of the universe for Philadelphia’s law firms moved from South Broad Street to the shiny new, trophy towers being built along West Market Street and north 18th Street. There had been some holdout firms in non-mainstream locations including Montgomery McCracken at 123 South Broad Street and Berger Montague at 1622 Locust Street. Well, they are now unexpectedly joining their friends on West Market and soaking up another 100,000 square feet of space in the process.

Predicting markets, or anything for that matter, is an inexact science. We all assess the facts, weigh the probabilities and make an educated guess about the future. Sometimes, however, unexpected variables enter the equation and change everything. Real estate markets rise and fall as ours has and will continue to do in the future. We’re in a tight market that will eventually turn. Maybe just not as fast as we all thought.

This article was published in the Philadelphia Business Journal on February 23, 2017.

For more information contact Glenn Blumenfeld http://www.tactix.com/team.php#Glenn

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The Sins of Our Past May Be Coming Back to Haunt Us

The Great Recession of 2008 seems like a distant memory to many of us.  The Dow Jones is flirting at 20,000 up from a low of 6,300 and the real estate market, which many blame for the demise of the global economy back then, has been humming along for five years.  What could possibly go wrong?  Apparently, a lot.

Commercial mortgage backed securities (“CMBS”) were all the rage back in the early 2000s and represented a significant portion of all commercial real estate loans in the United States.  Because it was incredibly easy for lenders to get the loans they originated off their books by securitizing them, money was flowing freely back in 2006 through 2008 and underwriting standards became somewhat lax.  Guess what?  All those 10 year loans that were originated during the boom years of 2006-2008 are starting to come due and the lending environment isn’t going to be as generous when it comes time to refinance.  Stricter loan underwriting requirements post-2008, new CMBS risk retention regulations under Dodd Frank which come into effect later this month, and the specter of rising interest rates announced by the Fed earlier this week all may make life very interesting to property owners.

A Wall Street Journal (WSJ) article, Trouble Brewing in Commercial Real Estate, published on November 15, 2016, reveals that we are starting to see the first signs of trouble on the horizon.  According to the article, commercial property sales volume was down 8.6% in the first nine months of 2016 as compared to 2015.  Another alarming statistic is the significant increase in the rate of delinquencies on commercial mortgage loans.  Close to 5.6% of the almost $400 billion of commercial mortgage loans packaged into securities were more than 60 days late in payment as of September 2016 as compared to 4.6% earlier in the year. That’s close to $25 billion of debt that could be on the brink of foreclosure.

Again, per the WSJ article, Morning Star Credit Ratings LLC predicts that “borrowers won’t be able to pay off roughly 40% of the commercial mortgage-backed securities loans coming due next year.”  Much of the increase in property values over the past 10 years has been driven not by rent growth, but by record low interest rates which have enabled owners to pay more for assets.  Think of a $1,000 government bond that pays $40 in annual interest when issued (4%).  When interest rates fall to 3%, that same bond may sell for $1,333.  It’s the same thing with real estate.  A Class A office building that throws off $500,000 in net operating income may be worth $6,250,000 when cap rates are 8%; however, if cap rates for that type of asset drop to 7% due to declining treasury rates, that same asset may be worth $7,142,857.

Just as property values steadily rose as market interest rates fell over the past eight years, they are likely to fall should interest rates rise in the months ahead as has been signaled by the Fed.  Simply put, many buildings have changed hands over the past five years at prices that, all else being equal, wouldn’t make sense if interest rates were 200 basis points higher.  Absent improvements in the asset fundamentals such as increased occupancy and/or rental rates, the assets won’t be worth as much in a higher interest rate environment as they were before and will not be able to service the debt on higher interest rate loans. Making matters worse, the net available loan proceeds from CMBS transactions won’t be as plentiful going forward if Dodd-Frank is not repealed.  Issuers of CMBS will now be required to retain 5% of the securities they create.  With less available loan proceeds and declining market values for properties, many property owners may find that they have trouble raising the loan proceeds necessary to refinance their existing loans.  Stricter loan reserve requirements and tighter loan to value ratios will further burden owners looking to refinance their properties.

What does this mean for tenants?  Their lease could become a very valuable piece in their landlord’s attempt to reposition the asset.  The difference between a vacancy and a long-term lease could translate into significant differences in the building’s valuation by lenders and potential buyers.  That means the tenant could have significant leverage when it comes time to renew its lease or cut a deal for a new lease.  A pending loan maturity for the landlord may also provide an opportunity for a tenant to restructure its lease in advance of the natural expiration on favorable terms.

The problem of course is that some landlords may not have the ability or incentive to strike very aggressive rental deals.  While the landlord may recognize that a material vacancy could cause it to lose the building to its lender, striking too aggressive a deal with a tenant on a new or extended lease may reduce the building’s value to less than the underlying debt resulting in the same outcome.  Any deal that doesn’t maintain an asset value in excess of the underlying debt isn’t worth doing if the loan is non-recourse.  This is especially true if, as is typically the case, the lease deal requires the landlord to come up with additional capital for tenant improvement allowances, building improvements and transaction costs.

Tenants not only need to understand how their landlord’s loan situation will affect their bargaining leverage when it comes time to negotiate a new lease or renewal, they need to make sure that the landlord can carry out the financial obligations it commits to in its lease.  We all know that a key issue in most lease negotiations in lease security for the tenant’s obligations including letters of credit or cash security deposits.  However, with mortgage loan defaults steadily rising and storm clouds forming in the distance, it may be time for tenants to start focusing more on the landlord’s credit; especially when the landlord is a single purpose entity whose only asset is the building.  Should the loan go into default or the landlord lose its equity in the building, the tenant may find that, absent a good non-disturbance agreement with the lender, it is out of luck.

Conclusion

Everything has been going gangbusters for the real estate market the past five or six years.  Unfortunately, a sleeping giant is starting to awake from a ten-year nap and it may cause major problems for landlords across the country.  Real estate goes in cycles and we have been riding a long upturn.  If and when things turn, and there are indications that it will, tenants need to be prepared to both take advantage of the opportunity and protect themselves from the risks.

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How Do You Feel Now?

Your broker just helped you find terrific space in a new building and you’re feeling great about the whole transaction.  He has assured you that he pushed the landlord to the limit and got everything he could have out of the deal; taking full advantage of the leverage you had as a large tenant.  However, a month after you move into your new space, you find out the landlord has now hired your broker to represent them in the sale of the building.  What are you thinking now?

In many professional service businesses, the ultimate compliment is when the other side hires you based on your performance in a transaction.  Many attorneys have built significant books of business by outperforming their counterpart in the courtroom or at the negotiating table.  Sometimes it’s only by seeing your advisor’s work in the context of a competing advisor that you can put their relative performance in perspective.

The problem is that law is very different from brokerage in two key respects.  First, in law, a client can prevent its attorney from representing an adverse party. Before an attorney can represent a new client whose interests are adverse or potentially adverse to an existing client, the existing client must sign a formal conflicts waiver consenting to the new representation.  The legal profession abhors conflicts of interest, actual or perceived, and, therefore, has strict safeguards to ensure that a client never has to worry about the loyalties of its counsel.  In brokerage, however, a client is only entitled to notice of a conflicting representation; it cannot prevent it.  Second, when one party loses a major lawsuit and then decides to hire the opposing attorney who beat them in the courtroom, there is no question as to their motivation.  They simply want to retain the best advocate so they don’t lose the next time.  Motive is not always so clear when your landlord hires your brokerage firm after your lease deal is completed.

Example: An example will help illustrate this problem.  Let’s present two different hypotheticals.  In the first, ABC Company is suing XYZ Company for breach of contract and seeking $100M in damages.  ABC Company hires Sarah Smith, Esq., as its attorney and she wins the case by securing a plaintiff’s verdict for $75M.  In the second hypothetical, ABC Company agrees to settle the above lawsuit for $75M based on the strong recommendation and counsel of attorney Smith.  In both hypotheticals, following resolution of the case, XYZ Company approaches attorney Smith and asks her to represent them in future cases not involving ABC Company. 

If you are the General Counsel of ABC Company, do you feel differently under scenario 1 and 2 when told by Smith that she will now be representing XYZ Company?  In scenario 1, it’s clear that you won the case and the only reasonable explanation for why XYZ Company would be hiring Smith is because she got a better outcome than their attorney did.  However, in scenario 2, it’s not so clear.  Is Smith’s emphatic recommendation that you settle the case now called into question by the fact that the other side is hiring her?  Even if it was the right risk assessment and Smith’s legal judgment was unassailable, wouldn’t the General Counsel now have no choice but to wonder about the objectivity of the advice?  Is Smith being rewarded by XYZ Company for engineering the settlement?  Certainly, XYZ Company had to shell out $75M; however, maybe they were very worried that it could have been a lot worse.

Brokerage is a lot more like hypothetical 2 in the foregoing paragraph.  Assume a broker negotiates a 100,000sf lease on behalf of a tenant to take half of a building. Two months later the landlord engages the tenant’s broker to be the listing agent on this Tenant’s building as well as two of its other properties.  Even if the tenant’s broker negotiated a very strong deal for its client, the lease created significant value for the landlord and may have turned a distressed investment into a viable one.  Like with the hypothetical involving the litigation settlement, it’s not clear that there was a winner or a loser in this lease transaction, therefore, it’s not entirely clear why the landlord engaged the broker after the fact.  Was the engagement an acknowledgement that the landlord was very impressed by the performance of the tenant’s broker or firm or is it a reward for bringing the landlord a very valuable deal that still had some fat in it?

When the landlord hires the tenant’s broker after they conclude a lease deal, it creates two major problems for the tenant.  First, it raises doubt about the broker’s objectivity and loyalty during the transaction and, therefore, creates questions about whether the lease deal was really as good as the tenant thought it was.  Second, the tenant’s broker now works for the landlord. That means when it comes time to renew its lease, its broker is completely conflicted and can no longer, credibly, represent the tenant.

Most tenants hire a broker because they want to make sure they are getting the most aggressive economic terms on their lease deal.  For many companies, real estate can represent one of its largest line item expenses.  Thus, lease negotiations can have a major impact on a company’s bottom line.  Because leasing is a zero-sum game between the respective economic interests of the landlord and tenant, the tenant needs to know that its broker’s loyalties are not compromised.

Unfortunately, in full service brokerage (where a firm represents both landlords and tenants), every tenant transaction represents an opportunity for the broker to impress the landlord or curry favor with them for future business.  Even if the broker does not currently represent that landlord, you can be 100% sure that it would love nothing more than to represent the landlord in the future because that’s where the real money is. Whereas most tenants only need a broker’s services once every five or 10 years, landlords need their services every day.  This inherent tension between what is best for the tenant and what is best for the broker’s long term financial interests creates problems for the tenant client regardless of how the broker resolves the internal conflict.  Once the tenant’s broker is hired by the landlord—regardless of the reason– the tenant is left to wonder.

Conclusion

Following a major lease transaction, it is not uncommon to see the landlord engage the tenant’s broker (or brokerage firm) as a listing agent, sales agent or managing agent either on the building in question or some other assets in the landlord’s portfolio.  The problem for a tenant in these situations, just as it was for the General Counsel in our above example, is that it may now be left to wonder about the objectivity of the advice it received and the merits of the deal it agreed to.  The legal profession prohibits conflicts of interest (unless expressly authorized by the parties) so that clients never have to second guess their decisions.  Unfortunately, because no such protections exist in brokerage, tenants are too often left wondering and with a bad feeling.

For more information contact Glenn Blumenfeld http://www.tactix.com/team.php#Glenn

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What a Beer Run Means to the Future of Real Estate

Early in the morning of Oct. 25th, a truck pulled out of the Anheuser-Busch facility in Loveland, Colorado with 2,000 cases of Budweiser. Nothing seemed unusual, but this trip was anything but routine. This trip was Uber’s first real traffic test of a fully self-driving truck. The truck would make its 120-mile journey through Denver without incident – and without a driver.

otto-truck

Just last September Uber deployed a fleet of autonomous cars on the streets of downtown Pittsburgh as part of their goal to eventually replace Uber’s 1.5 million drivers. We all know that Google has had self driving cars on the road for years. The Google cars have logged 2 million miles with a safety record far better than any flesh and blood driver.

But neither Uber nor Google wants to sell you a car. They have much bigger plans. They want to rent you a car by the trip, and they see self driving technology as a means to get you to car share. Car sharing is the goal.

It’s hard to say when you will take your first drive in an autonomous car. Many technical challenges remain. One of the reasons Uber selected Pittsburgh as their test city was because it has more than the occasional snowy day. Snow is the Achilles’ heel of autonomous vehicles since something as simple as a light layer of snow dramatically reduces the effectiveness of the car’s sensors.

Legal issues loom as well. An autonomous car can be programmed when faced with an unavoidable accident to impact with, say, the bicycle or the dump truck. In one instance the bicyclist is severely injured and the passenger in the autonomous vehicle is not. In the other instance the dump truck driver is unhurt but the automobile passenger is on the way to the hospital. Besides the moral conundrum, this presents a legal liability Catch-22 for any autonomous vehicle manufacturer. The developers of self driving cars have asked Congress to decide how the cars should the programmed.

There is no doubt that the technical and legal obstacles will eventually be resolved. There’s also little doubt that self driving cars will lead to an explosion in car sharing. One study by Barclay’s Bank predicts that the technology will cut car ownership in half in 25 years. The catalyst for this shift will be the dramatically lower cost of car sharing which will have been made convenient by self driving technology. The last chapter in America’s love affair with car ownership is about to be written. But how will sharing self driving cars affect real estate?

Real estate has historically been highly resistant to technological change. The big inventions of the last 30 years were the personal computer and the cell phone. Those changed how we work, but not so much the buildings where we work.

You have to go back over 100 years to find a technology that transformed real estate. In the early 1900’s three new technologies coalesced to create the large scale, high density commercial real estate that we take for granted today: (1) the development of low-cost load bearing steel by Henry Bessemer; (2) the development of electric powered air conditioning by Willis Carrier; and (3) the invention by Elisha Otis of an elevator that someone of sound mind would actually use.

Will shared self driving cars be more like the personal computer and cell phone, greatly impacting our lives but having no impact on real estate? Or will they change the real estate paradigm?

Probably somewhere in between.  Let’s break it down:

Urban commercial districts. All people who commute to work in an urban center want to reduce that tortuous twice a day ritual.  Autonomous cars promise to do just that by not only doing the driving but by coordinating movement among vehicles to make those inexplicable slowdowns on the highway a thing of the past. It’s not a leap to say that an easier and quicker commute is likely to increase the demand for office space in urban areas.

There is another impact to consider. When you get to work your shared self driving car will not park itself but will go off to shuttle other people and goods until you’re ready to head home. Demand for parking will plummet freeing up additional land for development.

Suburban office. One of the results of the recent trend of “densifying” office space is that many suburban office parks now have inadequate parking. A design that provided 3.5 parking spaces for every 1000 square feet of office space worked perfectly for years, until we started putting five or six employees in that same 1000 square feet. Many suburban buildings will ultimately be saved from the brink of obsolescence by car sharing. Some suburban office parks in high demand areas will even flourish as they are able to convert now unneeded seas of asphalt into more office buildings.

Retail. The Internet has savaged traditional retail. And the self driving car will likely make it worse. Amazon, Google and Uber all envision a world where autonomous vehicles will provide you with near instant gratification right to your door. “Two day shipping” will be a hardship you tell your grandchildren about. If you can get your purchase delivered to you in a self driving car in under an hour, why have bricks and mortar retail?

Industrial/warehouse. The trucking industry is expected to be an earlier adopter of autonomous vehicle technology. An autonomous truck can drive 24 hours a day with no labor costs and far fewer accidents. Lower freight cost will allow the industrial and warehouse industries to locate further away from the customers they serve. That means a single location can economically serve a larger area with resulting consolidation. Further, with lower transportation costs, locations next to major highways may not be able to charge the premiums they have historically demanded.

Housing. If you had a safe, inexpensive chauffeur at your disposal 24 hours a day, where would you live? Would you finally get that hobby farm? Maybe you love living in the city, but with shared self driving cars, how much of a premium would you be willing to pay for a home that has off street parking?

Coupling self driving technologies with car sharing will dramatically increase the convenience of travel and slash the cost of getting there. Imagine a world where as soon as you step into a car you can start your workday, read a book or catch up on the latest episode of your favorite TV show. Imagine a world where computer guided cars communicate with each other to eliminate congestion and traffic jams.

The “rules of the road” are about to be rewritten. The popularization of the automobile in the early 1920s, and the expansion of the interstate highway system in the 1960s each effectively shrunk time and space, and as a result each changed the American landscape. Get ready for another paradigm shift brought to you by the shared self-driving vehicle. Please fasten your safety belts.

This article was written by Judson Wambold and published in the November 21, 2016 Philadelphia Business Journal.

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Why a Cable Company and Apartment Developer Hold the Keys to the Center City Office Market

Given that we are the fifth largest city in the United States, it is surprising that the near term future of our office market actually hinges on the decisions and success of two entities; neither of whom is an office developer.  Because our core Central Business District is so small and geographically concentrated, and availabilities are currently at historic lows, it won’t require a lot of new vacancy to turn the tide in favor of tenants.  Luckily for them, help may be on the way thanks to two unlikely players.

PMC Property Group (“PMC”), one of the region’s most successful multi-family developers, is diversifying into office product in Philadelphia and is jumping in with both feet.  It’s first project is the redevelopment of the former Design Center at 2400 Market Street which, when completed in 2018, will deliver over 500,000sf of new Class A office space into the market.  In addition, PMC, which acquired One Franklin Plaza, a 600,000sf building at 16th and Race in 2015, is planning a mixed use redevelopment of that building that is targeted to include approximately 200,000sf of Class A office space.

One Franklin Plaza was previously occupied by Glaxo SmithKline before it relocated to the Navy Yard in 2013.  This building has essentially been mothballed since then which elated anxious Center City landlords who were petrified about the gaping hole that GSK’s departure/vacancy would create in the Center City office market.  As Three Franklin Plaza (GSK’s other vacated building) was converted into a charter school shortly after their departure, none of the GSK 750,000sf of vacancy has hit the office market to date.

Because the Center City Class A office market is only about 39 million sf (excluding owner occupied or single tenant buildings like Comcast Tower), the creation of approximately 800,000sf of new class A inventory will have a significant impact on the market. Unless a new company is coming into town to take a big chunk of this new space, PMC’s new projects are creating approximately 25% more vacancy in the market.  In fact, by creating viable new move options, this space could actually facilitate even more effective vacancy in the market.  Most companies today that relocate are achieving material efficiency gains as compared to what they occupied in their old space due to the implementation of space programs with higher densities.  Thus, if a 300,000sf tenant moves into one of these new projects, there is a good chance they are vacating more than that.

The creation of new office inventory is not the only good news for tenants who, for the past year or so, have been struggling to find good move options.  The biggest space user in the City, Comcast, may be freeing up close to 500,000sf of office space that it currently occupies in various Center City buildings once its new Innovation and Technology Center opens in 2018.  To date, Comcast has not publicly stated whether its new tower will accommodate all of its immediate and near term space needs or whether it will continue to need overflow space outside of its growing urban campus between JFK Boulevard and Arch Street.  Given the exponential growth of Comcast and the fact that its planned third office tower on Arch Street could take another four years to build, Comcast may ultimately decide it will always need transition space in the market while its next project is in development.  Thus, the path Comcast ultimately takes with regard to its 500,000sf of overflow space could have a material impact on the market.

In the event Comcast elects to vacate all or a material portion of its overflow space when the Innovation and Technology Center comes on line, it will represent a major opportunity for other tenants in the market–especially those looking for larger blocks of space.  Right now, tenants looking for 50,000sf of Class A office space have few options.  That could change quickly.

The office rental market, like all markets, is simply a reflection relative supply and demand.  While many people would have us believe that the recent rise in Center City office rents is a sign of new prosperity, it is really the result of shrinking supply as millions of square feet of office inventory has been converted into apartments over the past 10 years.  More than twice the amount of current vacancy in the market has been converted into apartments.  Think of what the market would look like today if that space were still available to office tenants.  Yes, we’ve had some new businesses relocate into the City but it hasn’t been material enough to move the needle on demand especially since we’ve also had our share of major losses with companies like Sunoco, Dow and Lincoln Financial picking up and leaving.    In a truly healthy office market, rents go up because of significant increases in demand due to job growth not because we decommission existing inventory and shrink supply.

Given the tight market over the past year or so, many tenants have been frustrated by both the lack of viable move alternatives and the increasing rents that their landlords have been demanding for the same product.  Luckily, in a relatively small market like Philadelphia, one or two events can quickly change market dynamics.  An apartment developer and a communications company may very well prove to be the knights in shining armor for office tenants as they potentially create significant new vacancy in the market by 2018.  It would be a welcome change for a market that needs more options and certainly needs more competition. Sometimes relief comes from the most unlikely sources.

For more information contact Glenn Blumenfeld http://www.tactix.com/team.php#Glenn

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Bullet Holes and Vacancy

In prior blogs we have discussed the high profit margins that landlords receive on renewal leases. The greater profit is due to the lower costs a landlord incurs in renewing a tenant compared with having to find a new one. The savings a landlord realizes in renewing a tenant fall into three main categories:

  1. Rent Abatements. Renewing tenants typically get little or no free rent; whereas new tenants can get as much as one month for every year of their term.
  2. TI Allowance. Renewing tenants typically get less than half the tenant improvement allowance offered to new tenants.
  3. No Rent Interruption. But by far the biggest savings to landlords in doing a renewal deal is avoiding the rent interruption caused by the time it will take to find a new tenant – in the industry the concept is referred to as “time on market”.

Before we can really understand the landlord’s exposure to “time on market”, we need to understand statistical biases. A great example can be found in World War II.

World War II was fought on many fronts, including the mathematical front. Unknown to most people even today was the super secret Statistical Research Group which included some of the best mathematical minds of the time. Their job was to use their brains, not their brawn, to win the war.

One of the greatest challenges of the war was to keep the Allies planes in the air. The attrition of planes and crew was appalling. During some campaigns, the chances of the plane and its crew returning were about the same as flipping a coin and calling heads.

Planes needed armament to survive, but where was the most effective place to put your limited armor? If you were given the statistics below on bullet holes in fighter planes returning from battle (these are actual numbers) where would you put the armor?

Section of Plane_001

Based on this data, the US Army reinforced the areas denominated “Fuselage” and “Rest of the Plane”, because that’s where the most bullet holes were. But losses increased. So the problem was sent to the Statistical Research Group, specifically Abraham Wald, a brilliant mathematician who had fled Austria shortly before the Nazi occupation.

Wald observed that holes in the returning aircraft actually represented areas where a plane could sustain damage and still return home safely. Areas that were relatively unscathed, on the other hand, represented critical portions of the aircraft which, if hit, would cause the plane to be lost.

Wald’s solution was the opposite of the U.S. Army’s original gambit. Wald said to put the armor where the bullet holes were not. This strategy was successful and more planes returned from battle.

Wald’s insight was so profound that it was given the name “Survivorship Bias”. In the case of the aircraft, only the survivors were in the sample.  No one saw where the lost planes had been hit. Survivorship bias is one of the many types of sampling biases found in analyzing statistical data.

Survivorship biases are around us every day, and they are particularly alive and well on Wall Street. For example, when looking at the historic performance of mutual funds investing in any segment of the market compared with the direct performance of that same market segment, the average performance of the funds is inflated by the survivorship bias. Mutual funds which failed or became so small as to be statistically insignificant are not reflected in the numbers. A comprehensive 2011 study published in Review of Finance examined the 10 year trailing returns of nearly 5,000 mutual funds. The study determined that survivorship bias increased the average mutual fund performance by nearly 20%.  The funds that failed during the 10-year study period were the planes that were lost on the way back.

So what does survivorship bias tell us about the “time on market” risk that landlords face if they cannot renew a tenant?

Data on time on market is even easier to get than counting bullet holes in a plane. Costar Group, headquartered in Washington DC, is the source that all commercial brokers turn to for market data. With the press of a few buttons I can tell you the distribution of Time on Market for the any submarket in the country. Let’s look at the 42 “Class A” buildings in the West Market Street submarket of Philadelphia:

Graph for blog_001

The Costar database can slice data every which way. So how much time would it likely take a landlord to re-tenant a space in the West Market Street Submarket?  The weighted average time for the above data is 28.4 months – a pretty remarkable number. But that number is wrong, materially wrong.

“Time on market” data suffers from a substantial survivorship bias. But fortunately, once recognized, it’s easy to correct for.  Let’s look at a hypothetical, overly simplified real estate market to illustrate the point. Assume that:

  1. exactly one space becomes available on the first of every month, and
  2. it always takes exactly 12 months to find a tenant for any space.

What would the distribution of “time on market” look like in this hypothetical market if you ran your Costar report on December 31? Well, there would be one space that had been on the market for 1 month (the space that was listed for rent on December 1st); there would be one space that had been on the market for 2 months (the space that was listed for rent on November 1st); there would be one space that had been on the market for three months (the space that was listed for rent on October 1st); and so on. The distribution would look like this:

hypo_001

In other words, the data would be evenly distributed. The weighted average of the above data is 6 months (1+2+3…+12 divided by 12). But wait, we specified in the hypothetical that it always takes 12 months to lease space. Why are we off by a factor of two?

The problem with the above data is obvious: the spaces haven’t been leased, they are in the process of being leased. It’s like counting bullet holes before the battle is over.

From the simplified model we can see that “time on market” statistics underreport the actual vacancy threat by a factor of two.  Landlords have more to lose if they lose you as a tenant than the data would suggest. The 28-month number for West Market Street that we discussed above – as surprising as that number may be – is in reality probably closer to 50 months. Of course more desirable spaces would generally be below that average and less desirable spaces generally above the average. But good, bad or ugly, the statistics grossly understate the landlord’s probable vacancy if they lose a tenant.

When negotiating a renewal with your landlord it’s important to understand the landlord’s expected costs if you move. Lost rent is one of the major costs a landlord incurs in losing a tenant and having to find a new one. Any broker can produce reams of data from CoStar about average “time on market”, just like any buck private can count bullet holes in a plane. What you need is somebody who cannot just report what the data is, but can tell you what the data means.

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Why 95% Can Be a Failing Grade in Real Estate

When I was in school and the teacher handed back a test on which I’d received a 95% grade, I felt pretty good. If you have kids who bring home papers with grades of 95%, I bet you feel pretty good too.  But in real estate leasing, 95% is usually a failing grade. Let’s see why.

Most leases contain an option for the tenant to renew at the end of the term at a market rate. Some leases allow the tenant to renew at 95% of market – and tenants typically feel pretty good about getting that 5% discount.

Implicit in a discounted renewal rate is the acknowledgment that the landlord avoids all the costs of finding a new tenant for the space. The idea is that the landlord and tenant should share in these savings. However, a 5% or even 10% discount off of market often leaves the landlord with a windfall.

Let’s assume that we are in a $30 per rentable square foot market. A renewal at 95% of market would give the tenant a deal at $28.50/rsf. That’s a savings of $7.50/rsf over the typical five-year renewal term (i.e., $1.50/rsf times five years). It sounds good for the tenant until you look at the landlord’s ledger.

The face rate of the lease is only a small part of the picture. The dirty little secret in lease renewals is that it costs the landlord less, much less, to renew a tenant than to find a new one. Let’s look at three of the main savings a landlord pockets when a tenant renews:

  1. Tenant Improvement Allowance. In a typical renewal, the landlord will provide the tenant with a very modest improvement allowance to refresh the space (fix the carpeting, repainting and moving a wall or two). In most cases this is because the space generally “works” for the tenant who has been there for years. However if the current tenant leaves, the landlord will have to offer a significantly larger tenant improvement allowance in order to attract a new tenant, often more than double. Because it is an extremely rare occurrence to find a tenant that can “glove fit” into second-generation space, the landlord typically has to budget for an additional $15-30/rsf in tenant improvement allowance for a new tenant.  We recently met with a tenant who raved to us about the great renewal deal they got which included “Almost $1Million to fix up our space!”  Well, this tenant was leasing over 300,000sf of space so the cash concession amounted only to about $3/sf for the five year renewal.  Had the tenant left, the landlord would have had to shell out between $12M and $15M. Once we walked the tenant through the numbers, they realized it was the landlord who got the great deal, not them.
  1. Free Rent. Renewing tenants are rarely offered free rent as an inducement to renew and when they are, it’s often a modest amount. But it’s common for a new tenant to receive substantial free rent – as much as 3/4 to one month of free rent for each year of the lease term. In our above example for a five-year lease renewal, that’s between four and five months of free rent that the landlord would save on the renewal as compared to a five-year deal with a completely new tenant. In our example this translates into between $9.00 and $12.50 per square foot of additional benefit to the landlord from the renewal deal.
  1. Even in a robust market, landlords anticipate a one-year vacancy when tenants turn over. But it’s not just vacancy that’s important, it’s the total rent interruption period. The landlord doesn’t start collecting rent as soon as he finds a tenant. Let’s look at the math: it usually takes at least twelve months to find a tenant, then sixty days to negotiate the lease, then ninety days to design the space and draw the permits, then 120 days or more to build the space. That’s a total of at least 21 months without rent compared with a renewal where the rent typically continues uninterrupted. The value of the avoided rent loss in our example would be a whopping $52 per square foot. And that’s if everything goes smoothly for the landlord. With a little slippage in the schedule, rent interruption can easily cost the landlord in our example $70 per square foot or more. Note also that there is also considerable risk to the landlord as to what the space will ultimately rent for when he finally finds a tenant.

So what’s the score?

chart_001

So of the $76 likely minimum that the landlord saves in renewing a tenant, only $7.50, or little less than 10% is passed along to the tenant. Compounding the inequity is that the tenant’s 10% is dribbled out over the five year lease term whereas the landlord’s savings were all realized up front.  Fair? Not remotely. Common? Unfortunately yes.

So you now know that a renewal at 95% of market leaves the landlord with 90% of the savings.  How can you to avoid this “failing grade”?

  1. Never rely on your contractual renewal right in order to renew. Contractual renewal rights a worst case scenario, and almost always leaves the tenant with:
  • lousy economics
  • no flexibility in the length of the renewal term
  • no ability to contract or expand your space in connection with the renewal given to you
  1. Start your “renewal” process well before the notice of renewal date in your lease.
  • Notice dates in leases are designed to give landlord additional marketing time, they rarely give the tenant sufficient time to effect a move should you decide that is your best course of action. Don’t fall into the “time trap”.
  1. Keep an open mind. Even if you think that a renewal makes sense, you can’t be sure until you put that renewal into a market context. Make sure that you and your broker put in the work to compete your requirement in the open market and create viable move alternatives well before the notice date in your lease. Your landlord will only equitably share the savings of your renewal with you if he truly believes there is a risk of losing you and, therefore, they may incur the huge expenses and losses of a replacement tenant.

Landlords enjoy a much greater profit margin on renewals than on new leases, even when granting a renewing tenant the right to renew at 95% of market. But landlords won’t price renewal deals at the narrower margins they are willing to accept from a new tenant unless their existing tenant has (1) a viable move alternative and (2) the time to execute that move.

Our advice – if you want a great renewal deal, get a great move deal first.

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We Need a Brand

A French, an American and an Israeli architect are bragging about the architectural accomplishments of their respective countries. To prove whose construction feats are the most impressive, they agree to give each other a tour of their most iconic works.  The French architect takes them to the Eiffel Tower in Paris and says “We are very proud that in 1889 we built this world famous structure in a mere two years and 65 days.”  They then travel to the United States where the American architect brings them to the Empire State Building in New York City.  “When we built this building in 1931, it took us a mere one year and 45 days to complete and it was the tallest building in the world.” Finally, they accompany their Israeli friend to Tel Aviv.  On the drive into the city, the French architect points to a cluster of gleaming new office buildings and asked his host “What are those new buildings over there?”   “I don’t know” replied the Israeli architect, “they weren’t there when I went to pick you up at the airport this morning.”

It’s not far from the truth.  New office buildings are popping up all over the City of Tel Aviv. What makes this remarkable is that Israel is a country where taxes, on an aggregate basis, are almost 70% of income when you include federal taxes, health care taxes, social security and VAT.  Nevertheless, businesses from around the world are flocking to this city.  Why is that relevant to Philadelphia? Well, while people claim that our City’s tax structure is what’s keeping businesses from coming here, the number of new office buildings in Tel Aviv is proof that high taxes don’t have to be an obstacle to meaningful job growth.  Tel Aviv is proving that businesses will go where the talent is.  While the Israeli government certainly provides tax incentives for companies to locate there, it’s still an expensive place for people to work.  Closer to home, the taxes in New York City are much higher than they are here in Philadelphia.  Nevertheless, companies are there because, once again, that’s where the talent is.  Young workers want to be there even if the cost of living is higher and their tax bills are much higher.

What makes young people want to be in Tel Aviv?  It doesn’t hurt that they have great weather, beautiful beaches and allegedly one bar or restaurant for every 230 people. Oh yeah, they also have great universities.  With so many young, highly educated workers, it’s no wonder employers are flocking there.  In addition, because many young people there have served two years in the military, the younger workforce is perceived by employers as disciplined, more mature and tech savvy.  While we obviously lack beautiful beaches, the fact that we have more universities than any region of the country other than Boston, should make us much more successful in attracting new businesses than we have been to date.  The key is getting more young people to want to stay here after they graduate from our colleges and universities and establishing ourselves as a destination city for young workers across the country who otherwise have no ties to the Delaware Valley. Of course this creates the classic chicken and egg problem.  The young people will stay or come here if there are good jobs for them, and the employers will come if there are lots of young, talented workers living here.

The best way to solve a chicken and egg problem is to address both of them at the same time.  We have come a long way in the past 10 years creating great lifestyle amenities that young people are looking for. We have scores of great, affordable new apartment and condominium projects, loads of new, exciting restaurants and dozens of new attractions including pop up parks, beer gardens, walking/biking trails and even a new boardwalk on the river.  People are taking notice as the City continues to be recognized as a tourist destination and a great place to live.  Even the Pope and the Democratic party think Philadelphia is a great place to visit and spend time.  With perhaps the exception of Sam Bradford, most young people who are working here also seem to like living here.  Now we just need to convince the rest of the country that Philadelphia is not just a great place to live, it’s also a great place to work.

Surely our tax system, school system and local government need reform and, thanks to some creative initiatives from some of our business leaders, help may be on the way.  However, we can make a lot of progress even while these long term goals are in progress.  A lot of our problem is actually tied to simple branding; specifically, what do we want to be known for and who do we want to be the face of our city?  While we all think we know Philadelphia very well, what do people outside the City think?

The following exercise helps illustrate our problem.  Ask an average person on the street anywhere in the United States what industry comes to mind when they hear certain cities.  For those cities experiencing high job growth, the answers are almost uniform.  Here’s what you’re likely to hear for some of these successful cities: Washington, D.C. (government or defense), New York City (finance/Wall Street), Los Angeles (Hollywood/entertainment), San Francisco/Silicon Valley (tech and venture capital), and Boston (tech/finance).  In sum, these cities have effectively branded themselves as the center of the universe for these exciting industries.  As a result, when a Millennial interested in any of these industries thinks of the ideal place to be, they see themselves in those cities. Further, even if a young person isn’t interested in these specific industries, they understand that because the local economy is thriving as a destination center, other interesting job prospects will be available to them.

We’re not getting the new jobs and it’s partly because we aren’t really known for anything.  What industry comes to mind when you say “Philadelphia” to the average American?  While some folks who have spent time here may say “Eds and Meds”, it will by no means be a universal answer and a lot of the other possible responses clearly lack the pizzazz of Wall Street, politics, Hollywood or high tech.  When it comes to business, we don’t have a well-established brand or at least an exciting one. That makes it a lot harder to sell Philadelphia to workers and employers.  Being “conveniently located between New York and Washington, D.C.” is hardly a compelling pitch.  Likewise, the face of Philadelphia is not Bill Gates, Michael Dell, Steven Spielberg or Steven Jobs, it’s still Ben Franklin and he died over 225 years ago.  We desperately need an updating.

The good news is that things may be changing and, not surprisingly, our hopes and aspirations lay squarely at the feet of Comcast.  Our leading industry used to be law (15% of all office space was occupied by law firms) but now, as the changing skyline clearly attests, our future is communications and entertainment.  We, as a city, need to sell that hard because, frankly, it’s cool, it pays well and it can become a magnet for other industries that support communications and entertainment or that require related skill sets (i.e., tech and innovation).  What Millennial wouldn’t want to work for Dreamworks or NBC Universal?  We could become the east coast version of Hollywood and Silicon Valley all wrapped up in one place and on everyone’s short list for those industries.  Our face could become someone from the 21st century.

Many people don’t realize it but we are now well positioned for success despite our burdensome tax system.  We have the colleges and universities, the amenities and housing, and, with the Navy Yard and Schuylkill Yards, we even have the cool, hip environments that today’s cutting edge businesses are looking for.  Maybe all we really needed was a compelling face—our own Microsoft, Dell or Sony Pictures that we could build around and help define us to the young workforce and employers around the country. We clearly have that now.  Let’s go sell it.  Brand it and they will come.

This article appeared in the Philadelphia Business Journal May 18, 2016.

For more information contact Glenn Blumenfeld http://www.tactix.com/team.php#Glenn

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Broker Marketing 101: “Don’t Worry, I’ll Sublet Your Space for You”

Getting new clients in real estate brokerage is a very difficult part of the profession.  Because most companies only need a broker once every five or 10 years, most brokers spend a good portion of their day pounding the phones trying to find out when leases are expiring.   With everyone canvassing the market for this critical information, it’s not surprising that companies get inundated with cold calls from brokers on almost a daily basis once they get within a year or two from their lease expiration date (and even earlier for larger leases).  Savvy brokers know that this is about the time their competition starts to pursue these lease opportunities. So what do they do to get a leg up? They start earlier by coming up with premature real estate strategies that, while often not viable or in the client’s best interest, at least gets the broker in the client’s door before the competition shows up.  The newest scheme is the pre-emptive sublet.

During the Great Recession when the market was very soft, brokers tried to get their foot in the door ahead of their competition by promising tenants that if they renewed their leases well in advance of their lease expiration date, they could take advantage of the weak market conditions and secure immediate savings. While it was true that savings were often available, they were typically only a fraction of what the tenant could have realized had it waited a year or two and competed its requirement in the open market.  The broker was able to swoop in well before his competition but the tenant lost out.  Today the market is stronger so clever brokers are using a different approach to get ahead of their competition.

Since it’s hard to generate immediate savings in a strong market, a new ploy was needed to get into the client ahead of the competition. Today brokers are promising they can sublet the tenants current space thereby enabling them to move to a better space well in advance of their lease expiration.  By promising the tenant that the broker will be able to sublet its existing space, the broker can get a foot in the door with the client well before other brokers are focused on this client.  This sublet ploy has been an effective marketing ploy even though sublets rarely make economic sense.  This doesn’t matter, however, because by the time the client realizes it’s not a deal worth doing, the broker has now accomplished its objective of firmly embedding himself into the client’s team—mission accomplished.

Here’s why subleases rarely work.  Let’s assume that a tenant has 10,000sf of space and three years remaining on its lease term.  Since the tenant has very little term left on its lease, it has a depleting asset that is worth less every day it goes unleased.  Most 10,000sf tenants that are out in the market looking for space are already leasing other space someplace else and are looking to potentially move six to 12 months out in the future. Thus, it’s a good bet that even if the broker finds a subtenant who is interested in the space, they probably don’t want to move in for a while.  Further, even assuming the broker finds a tenant, what is the likelihood that they need exactly 10,000sf?  If they only need 7,500sf, they probably aren’t going to want to pay for 33% more space than they actually need—they’ll pay for only what they need. In addition, most tenants in the market are being wooed by landlords with offers of valuable concessions like free rent and tenant improvement allowances to help defray the cost of needed alterations.  In order to sublet the space and remain competitive, it is likely that the sublandlord is going to have to offer some concessions as well.  The sublandlord will also need to pay brokerage fees to its broker as well as to the subtenant’s broker. As a result of all of the foregoing, the sublandlord often ends up with very little net benefit from the sublet.

Of course there are circumstances under which a sublet can create tremendous value for sublandlords.  There may be an existing tenant in the building who is out of space and needs to expand immediately and is therefore willing to pay a premium to get contiguous space or even any space within the building right away.  Start up tenants looking to eliminate or minimize out of pocket build out costs may also find a sublet appealing and be willing to pay a premium.  Longer term sublets with good credit sublandlords can provide an opportunity for long term stability and are, therefore, viable alternatives to more expensive direct lease deals. The fact that subleases often fail to provide real mitigation doesn’t mean it’s a lost cause all the time.

The fact of the matter is there are certainly times when a sublet makes sense.  If there are strategic reasons to exit space today or if a tenant has already vacated its space and now wants to recover what it can, a sublet can certainly make sense as a real estate strategy. However, if a broker is telling a tenant that it can sublet their space and, therefore, the tenant should consider pulling the trigger on an early move, that should be a warning sign.  Is there reason to believe the sublet will cover all of the tenant’s lease exposure or is the broker simply trying to get his foot in the door well before his competition? Fortunately, there are some ways to get to the heart of the matter and vet the intentions of the broker.

First, have the broker prepare a financial model that includes all of his assumptions and takes into account all transaction costs.  When will the space be sublet, how much space will be sublet and what are the costs of the sublet including required concessions?  Is the broker anticipating a discount to market rates for the sublet and, if not, why?  Next, do you have the right to terminate the sublet listing agreement at any time? Is the broker asking you to start the new space search before he finds a subtenant?  If so, you may find yourself obligated to a broker before you had a chance to even speak to other firms.  Some warning signs that you should be on the lookout for include:

  1. Statements from the broker that subletting will be no problem and that the sublet will cover most of your remaining obligations.
  2. Pressure from the broker to start your new space search before a subtenant for your current space is procured or, even worse, pressure from the broker to sign a new lease before a subtenant is found.
  3. Cold calls from brokers that lead with the idea of subletting your space and moving you early even before the broker knows what your specific real estate needs are.  These are often nothing more than attempts to get their foot in the door with your company before your pending lease deal is even on the radar of other brokerage firms.

Sometimes subletting excess space is a very good strategy for mitigating your current lease obligations. However, except in rare circumstances, subletting should not be relied upon to cover the tenants existing lease obligations.  Brokers are always looking for ways to get their foot in the door of companies before their competition enters the picture. If a broker’s sales pitch early hinges on a potential sublet of your existing space, it should be viewed as a big warning sign that you should stop and proceed with caution.

For more information contact Glenn Blumenfeld http://www.tactix.com/team.php#Glenn

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