Explaining Amazon’s HQ2 Decision

 

(And How Philadelphia Can Change the Story Next Time Around)

After an unprecedented 14-month public search competition, Amazon finally announced the winner(s) of its coveted headquarters decision.  To everyone’s surprise, it did not pick a city.  It picked two cities.  Amazon will be splitting its new HQ2 requirement between Crystal City, Virginia and Long Island City, NY.  While both Virginia and New York State have indicated that they put forth extremely generous economic incentives to lure the eCommerce titan, Mayor Bill de Blasio of New York City was adamant that no incentives were offered by his City.  It didn’t have to.

What a luxury that is for New York City.  They have created a compelling brand and industry destination that companies will actually pay extra to be a part of.  Many financial services firms, media companies, fashion houses, advertising firms and corporate law firms believe they must have a presence in New York City if they want to be viewed as leaders in their respective industries. New York is where the competition is and that’s where the best talent is.  It doesn’t matter that New York City has burdensome taxes and the cost of living is the highest in the country.

It’s no coincidence that the two winning regions in the Amazon sweepstakes represent the top two homes for tech workers in the United States.  Techies are more likely to live in New York City or the Beltway than almost anywhere else in the country.  So, in the end, Amazon went where the experts are. And, in case you missed it, this real estate approach by Amazon didn’t end with their headquarters decision.  Amazon also announced that it would be creating 5,000 new jobs in Nashville, TN where it will base its package delivery, transportation and supply-chain services group.  Tennessee, which is already home to Federal Express, is a state that knows a thing or two about how to deliver something “when it absolutely, positively needs to be there overnight.”

New York City, Northern Virginia and Nashville attracted Amazon because their workers have the most expertise in the areas Amazon needs.  These cities are not alone in being industry destinations.  Los Angeles is the king of the entertainment industry; Detroit owns the automobile industry; Washington, D.C. is where you go for defense or if you are significantly regulated by the federal government; Boston is a leader in the financial services and tech worlds; and San Francisco also is a destination for tech companies.  Chicago may not have a national brand like the aforementioned cities, but it has the benefit of geography:  it has no comparable city to compete with within 500 miles.

The fact is, if you create a compelling business reason for someone to be in your market, they’ll pay extra to go there.  Don’t believe me?  It’s been happening right here in our own backyard.

Even as office rents in Center City have risen to heights not seen, well, ever, no one east of the Schuylkill River is paying over $40/sf for rent.  Why is that?  Because office space on this side of the Schuylkill River is a commodity.  No one really has to be in any particular building. Thus, with supply exceeding demand (at least for now), rents for the best buildings level off at the mid to high $30s.

Now let’s look westward across the river to University City.  There are many tenants paying over $40/sf to be in the Science Center and UCity where they continue to build new buildings.  That’s because the tenants in that part of town have to be there. The proximity to the universities and health care systems is critical to their businesses. They are not just renting glass boxes to put their employees in. They are buying access to essential talent and they are more than willing to pay a premium for it just like Amazon. They don’t really have a choice.

So, what does that mean for Center City?  It means we need to find our place in the world and make ourselves a destination for a few major industries.  What CEO wakes up right now and says, “You know, we really need to be in Philadelphia because we do X”?  What college graduate or graduate student is saying to their parents “Sorry mom and dad, I know you wanted me to move back near  home after graduation but if I want to do Y, I clearly need to be in Philadelphia”?  Hardly anyone.

We need to change that story.  Where do we begin?  Let’s take stock of our strengths. Where do we have a leg up on the competition in an area that has long term potential?  Maybe it’s gene therapy and life sciences.  Maybe with Comcast and now Entercom, we can become a top three entertainment/media town.  Maybe it’s something else.  Unfortunately, we are in greater need of a purpose than most cities because we are so close to New York and Washington, D.C.  Unlike Chicago, we can’t rely on geography.  In fact, while we have always touted our proximity to New York and D.C. as strengths for Philadelphia, that geographic reality may very well be what has hurt us the most.  Why come here if you can just go there?  With those two compelling cities so close by, we need our own unique purpose in order for companies to choose Philadelphia.

Very few people truly believed we would win the Amazon sweepstakes.  It’s not even clear we could have accommodated them if we won.  In the end, this could be the best outcome for us if we play our cards right.  Immediately to our north and south, Amazon will soon be putting tremendous pressure on the labor and housing pools.  That means a lot of companies might want to bail from those areas in search of less competition and cheaper cost structures.  We’re not that far away.  We can grab them if we have a good game plan and a great story to tell.

It’s time for Philadelphia to stake its claim and become known for something more than cheesesteaks, Rocky and Founding Fathers who left us 250 years ago.  Let’s put our heads together and come up with a plan.  If we do, they will come.  And when they do, they’ll pay a premium to be here.

This article was published in the Philadelphia Business Journal on November 30, 2018.

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

 

 

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Opportunity Zone Investments Still Need to Be Good Opportunities

The new Opportunity Zones created in the Tax Cuts and Jobs Act of 2017 (the “Tax Cuts and Jobs Act”) are the darlings of real estate right now.  And for good reason. These Zones could potentially enable trillions of dollars in current and future capital gains to be deferred, discounted and even fully exempted from taxes by investing them in some of our country’s poorest areas.  If you think this all this sounds too good to be true, you may be right. These vehicles are not a foolproof path to wealth. Rather, investors must carefully assess each investment opportunity to make sure they can stand on their own independent of the potential tax benefits.

What Are Opportunity Zones?

Opportunity Zones are a community development program established by the Tax Cuts and Jobs Act to encourage long term investment in low income areas throughout the United States.   Each Governor has now designated a certain number of its State’s poorest areas to receive special tax treatment based on the most recent Census data. By investing in these Opportunity Zones through Qualified Opportunity Funds, taxpayers can receive the following benefits:

  1. If the tax payer redeploys capital gains from a prior investment into an Opportunity Zone, the tax on such capital gain will be deferred until the earlier of (a) the sale of the new asset or (b) December 31, 2026. Note that the gain can be derived from, and re-invested in, any tangible asset or business and, unlike with a 1031 tax free exchange, only the gain must be reinvested in the new asset as opposed to all of the original sale proceeds.
  2. If the new investment in the Opportunity Zone is held for at least five (5) years, the tax payer will receive a 10% discount on the capital gains tax. If the new investment is held for at least seven (7) years, it will receive a 15% discount on such capital gains tax.  Because the gain cannot be deferred beyond December 31, 2026, the money must be invested no later than December 31, 2021 to receive the 10% discount and by December 31, 2019 to receive the 15% discount.
  3. In addition to deferring and potentially discounting the capital gains tax from the original investment, if the tax payer holds the new investment in the Opportunity Zone for at least 10 years, it will pay NO TAXES on the ultimate sale of the new investment.

Let’s look at an example to illustrate how the tax benefits work.  Assume that in December 2018 Mary Smith sells a valuable piece of artwork for $5 million and realizes a $1 million gain.  On January 1, 2019, Mary (through a Qualified Fund) invests her $1 million gain in a business located within an Opportunity Zone and the Opportunity Fund then sells that business on January 1, 2030 for $3 million.  The sale of the business generates a $2 million gain for Mary.  What are her tax obligations?

Under the Tax Cuts and Jobs Act, (x) Mary gets to defer the payment of her capital gains taxes on the artwork until December 31, 2026, (y) at such time, Mary will pay taxes on only $850,000 of her gain from the sale of the original artwork (i.e., a 15% discount off of the $1 million gain) because, when the tax became due on December 31, 2026, she had held her new investment in the business located within the Opportunity Zone for seven years and (z) Mary will owe no taxes ($0) on the sale of the business because she held that investment for more than 10 years.

Investors Beware

Clearly, the tax benefits of Opportunity Zones can be substantial.  However, Opportunity Zones will only be good “opportunities” if the underlying investments themselves make economic sense.  Unlike pre-1986 tax shelters which could, and often did, become great investments even if the underlying real estate deals lost money, this will not be the case with Opportunity Zones. If the taxpayer loses money on the new investment, it could more than wipe out the benefit of any initial tax deferral or discount and render any exemption illusory.

As a result, before jumping into an Opportunity Zone investment, investors need to consider the following risks:

  1. Because Opportunity Zones are generally located in the very poorest neighborhoods, investments in these areas may be riskier than those in wealthier, more established neighborhoods.
  2. To qualify for the tax benefits, the capital gains realized from the initial investment must be redeployed into the Opportunity Zone within 180 days of the sale—a very tight timeframe. If the seller of the asset in the Opportunity Zone is aware of this time sensitivity, they may increase their asking price thereby requiring you to overpay.
  3. Some Wall Street analysts are estimating that the potential benefit of the tax deferral, discount and ultimate exemption could be worth as much as 500 and 700 basis points to an investor if things all go smoothly. There is a risk that some Qualified Fund sponsors may try to peddle investment opportunities with very modest cash on cash returns by claiming that the overall investment return will be enhanced by the tax benefits.  Thus, they may offer returns that, on a risk adjusted basis with respect to the underlying asset itself, don’t make sense.
  4. Qualified Opportunity Funds, which are the vehicles through which any investments must be made in the Opportunity Zones, are merely partnerships or corporations that can be formed and managed by anyone. The fact that they are “qualified” should not be construed to mean that they or their proposed investments have somehow been vetted or approved by any regulatory authority or that their ongoing operations or management will be monitored by such bodies.  As a result, investors need to make sure that the fund sponsors are reputable and have meaningful experience and demonstrated success with the types of investments being offered.
  5. The investor will need to pay its capital gains tax by December 31, 2026 whether or not the new investment has been sold by then. Thus, investors must make sure they have liquidity to pay this liability when the tax collector comes calling.

Conclusion

The Tax Cuts and Jobs Act of 2017 provides us with compelling incentives to make much needed investments in some of our country’s most vulnerable and impoverished areas.  However, investors need to be careful not to rush into these investments based solely on the promise of tax savings or avoidance. There is a reason the federal government had to offer such compelling tax benefits to incent people to invest their money in these neighborhoods—there is significant risk involved.  Before throwing money into these opportunities, investors will need to do their due diligence and make sure that the underlying investments are sound, and the sponsors are credible.

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Defeating Philadelphia’s defeatist attitude – What we can learn from basketball legend Michael Jordan

When it comes to competing for headquarters projects like Amazon’s, cities are just like corporations competing for customers or individuals competing to be the best in their profession; they need to honestly assess their relative strengths and weaknesses and work harder to bridge the gap between them and those they aspire to be. Too often Philadelphia has conceded defeat to cities like New York, Boston, and Washington, D.C. and taken a defeatist attitude because, in our minds, we just don’t stack up. The fact is, our attitude is killing us.

In “Mindset, The New Psychology of Success”, Dr. Carol Dweck, describes people as having one of two types of mindsets: a fixed mindset or a growth mindset. Someone with a fixed mindset believes that people are born with certain God given talents or intelligence and you cannot really change or improve your skills through practice or hard work. To them, Mozart was a genius to whom music and composition came naturally and Usain Bolt, the Fastest Man on Earth, was just born faster than anyone else.

Because people with a fixed mindset believe their fate is sealed at birth, they avoid things that are difficult. If something doesn’t come easily to them, it means they don’t have the talent for it so why waste the energy. In fact, rather than seeing practice as the necessary means to an end –success, they view hard work as an indication of failure.  They believe, “If I was really good at this, I wouldn’t have to work so hard at it.” It’s not surprising that people with a fixed mindset don’t generally become successful or reach their full potential.

On the other hand, people with a growth mindset believe that their fate is not sealed at birth and that, through hard work, anything is possible. For them, trying and failing is part of the path to success; the thrill or challenge of any endeavor comes from the learning process where setbacks and failure are simply necessary road bumps along the way. If something is hard, it doesn’t mean you can’t be successful at it or that you’re not talented, it simply means it’s a challenge worth pursuing. Dr. Dweck uses Michael Jordan, arguably the greatest basketball player of all time, as an example of someone with a strong growth mindset.

The first time he tried out for his high school basketball team, Michael Jordan was cut by the coaches. If Michael had a fixed mindset, he would have concluded that he just didn’t have what it takes to excel on the basketball court and perhaps would have tried his hand at another sport. Luckily for us, Michael decided basketball was his passion and so he decided he would outwork everyone else to make the team. Importantly, once he became the greatest player of all time, he continued to outwork everyone else. He did not equate the need to practice hard with a lack of natural ability or a sign of failure. To the contrary, Michael believed that to truly be the best, he always needed to challenge himself and not become complacent.

What does this have to do with Philadelphia and Amazon? Too often over the past 30 years I have heard why Philadelphia cannot be competitive with the top tier cities who are homes to scores of Fortune 500 companies. It’s our tax structure, our school systems, our proximity to New York or Washington or our high poverty rate. These are excuses and represent a fixed mindset by Philadelphians and the politicians who have led us over the years. It’s time to follow Michael Jordan’s lead and realize that we can be better if we stop conceding first class status to other cities and start working harder to improve the areas where we fall short. In short, we need to change our mindset.

Here are some areas where hard work and “practice” can help us become successful.

Business

“My attitude is that if you push me towards something that you think is a weakness, then I will turn that perceived weakness into a strength.” Michael Jordan.

Let’s start with an easy first step. Our attitude stinks when it comes to businesses. They are not the enemy. They are the lifeblood of any thriving city and, therefore, we need to start thinking about them as assets who will make us better. Yes, we’ve thrown out the red carpet to Amazon and their 50,000 jobs. However, what are we doing to attract businesses with 25, 100 or 500 employees? Will our politicians embrace them with open arms or begrudge them some initial tax benefits to get them to test our waters? Forget what we’ve done in the past. Let’s turn this attitude around and send a message to the business community that things are going to be different. Electing more business -friendly politicians and ideally ones with strong business backgrounds will certainly send the right signal.

Taxes

“I’ve failed over and over and over again in my life and that is why I succeed.” Michael Jordan

When the idea of tax reform is floated, many people shake their heads and say nothing can be done about it. We’re stuck with what we have or changing it would require too much work. Sounds like a fixed mindset and we all know how that usually ends—failure and unrealized potential. Yes, we have unique problems given our extremely high poverty rate. However, if we bring more top companies into our city limits, there will be more people to share the financial burdens. That means we can lower taxes for everyone. We can also be more open to new taxing paradigms like Jerry Sweeney and Paul Levy’s initiative that shifts taxes towards real estate and away from businesses. We could also analyze what other successful cities are doing in this regard and try to emulate them. Boston, for example, allows taxes generated from certain new developments to be targeted to nearby infrastructure projects that would otherwise go untouched. This program benefits both the developer and the City rather than simply putting more cash in the developer’s pocket. Let’s keep trying until we find something that works.

Public Schools

“If you’re trying to achieve, there will be roadblocks. I’ve had them; everybody has had them. But obstacles don’t have to stop you. If you run into a wall, don’t turn around and give up. Figure out how to climb it, go through it, or work around it.” Michael Jordan

What about the fact that our public-school system is irrevocably broken, and we don’t have the funds to fix it? Clearly a chicken and egg problem. If we had more deep pocketed corporate taxpayers, we’d have more tax revenues to fund our city services including our schools. And corporations don’t burden our city schools unless of course their employees decide to live in the city; in which case we’ll generate even more tax dollars. Of course, money alone won’t solve the problems with our school system. Fundamental changes are needed including more charter schools and STEM programs. Also, we need to do a better job organizing families to become more invested in their neighborhood schools. We’ve seen recent successes in this regard as strong parent teacher associations in places like Passyunk have led to better test scores, attendance and morale.

Conclusion

The fact is, Philadelphia suffers from a debilitating fixed mindset. Too many of our leaders believe that we are who we are, and we cannot change. To them, we’re not New York, Boston of Washington, D.C. and it’s useless to try and compete with them.  Hogwash. The good news, according to Dr. Dweck, is that people can actually change their mindset. That means there’s hope for Philadelphia. For us to develop a growth mindset, we need councilmembers who believe that anything is possible, that hard work and interim failures are just part of the process towards success and that we can only reach our full potential as a city if we dare to challenge the status quo. Yes, it will be hard and take time, but if we want to be the best, we need to “be like Mike.”

This article was published in the Philadelphia Business Journal on September 3, 2018.

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

 

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Corporations and Wealthy Homeowners are Not the Enemy; They’re the Solution

A lot has been written in recent weeks about the 10-year real estate tax abatement program and whether it should be continued, eliminated or scaled back.  Most of the objections come from people who feel that the abatements disproportionately favor the rich and leave out people in less affluent areas of the City.  The City Controller’s Office has recently completed a study for City Council that quantifies the economic impact of the abatement program and analyzes how different reductions in benefits might work.  The writing is on the wall and it’s all leading to the same old story here.    Attacks on this program are symptomatic of a larger problem that has plagued the City for years and ultimately will prevent us from reaching our full potential.

Let’s face facts.  We live in one of the poorest cities in the country where 25% of our population lives in poverty. These citizens need essential services that they cannot afford. That means others must subsidize them. It’s part of the social compact of living in a civilized society. However, for this to work in a city where so many have so little, we need more “haves” to move here and help shoulder the significant burden.  For too long we have depended on a shrinking number of corporate citizens to shoulder too much of this tax burden. As a result, many large companies (Arkema, Sunoco, Dow, Lincoln Financial) have left the City for more tax and business friendly jurisdictions.

Tax abatements do in fact disproportionately benefit corporations who occupy shiny new office buildings and wealthy homeowners.  That’s ok because the impact of these benefits makes us all better off.

Let’s look at an example.  In 2005, Brandywine Realty Trust developed Cira Centre which was in a Keystone Opportunity Improvement Zone.  This project was exempt from real estate taxes (as well as most other City and State taxes) through December 31, 2018.  Without the tax exemptions, this building would not have been built and today it would still be a vacant piece of land by the train tracks.

Starting in 2019, the City will begin to realize real estate taxes and Use and Occupancy taxes from this building in excess of $4 million.  FMC Tower will likewise start to generate “but for” real estate and Use and Occupancy taxes likely in excess of $6 million in 2025.  But this is only the tip of the iceberg.

Because of these new towers, University City is now a thriving neighborhood with many new jobs, more quality housing and significantly more amenities.  This means everyone’s home in University City is worth more.  And the benefit extends across the river.  With the new inventory of high end office space, many aging, class B Center City office buildings could not compete for tenants and were therefore converted into upscale apartments.  These apartments not only attracted young, well paid workers to the City who fork over wage taxes, they also increased the City’s tax rolls as low value office buildings became much higher valued apartment buildings.  None of this happens without the tax abatements.

Cira and FMC are only two examples. The Navy Yard, a land mass the size of our Philadelphia Central Business District, will eventually generate tens of millions of dollars of tax revenues that might otherwise have ended up in the suburbs or New Jersey had we not incented these companies to move there.

And if you think all of this would happen without the benefits, think again.  We have not had one new speculative office building developed in Center City since the early 1990s. Why? Because they cost in excess of $600/sf to build and very few companies want to pay the $50 rents necessary to support these costs.  The office buildings that have been built since the 1990s are either in University City in tax advantaged zones or Comcast’s headquarters.  This effective freeze on new construction cannot go on much longer if we are to remain a first-class city.  Our office stock is aging, and we are falling behind cities like Washington, D.C., Chicago, Boston, and New York where cranes are dotting the skyline with new office buildings for today’s businesses.  Most of our office gems are over 30 years old.

We all know we need more tax dollars to support our schools, our pensions and our City services.   We can either tax everyone more or bring more people into the City to help us carry the load.  The smart answer is, we need more corporate headquarters and more wealthy residents.  Eliminating or reducing the very successful tax abatement program and instituting a new 1% construction tax is only exacerbating the problem—they send the wrong message to those we need most.  Corporations and wealthy homeowners are not the problem, they are a key part of our solution.  As long as we continue to treat them as the enemy, tax them with impunity and resent them for the benefits that are needed to draw them here, we will continue on the road to ruin.

To paraphrase a line from Field of Dreams, “If we let them build it, they will come.”  This has proven true for both trophy office buildings and high-end townhouses and condominiums when tax abatements are provided.  Ms. Reinhart’s Report confirms the effectiveness of this program in catalyzing new development.  Yes, the tenants and owners of these shiny new structures are getting a gift.  However, it’s not costing us anything.  We’d be getting nothing from these properties if they went undeveloped or underutilized and, if we’re patient, we’ll get a lifetime of new, incremental tax revenues.  Ten years may seem like a long time to wait but, when you’re a City, you can afford to think in much longer terms.

Of course, there is a hidden cost to the tax abatements.  Some people are appropriately concerned about displacement of families who can no longer afford the rising taxes that inevitably come with improved neighborhoods.  However, let’s not punish the people we’re trying to attract and who we are ultimately dependent upon to pay our bills.  Instead, why not require that, once the tax abatements expire, a certain percentage of the new revenues be dedicated to low income housing developments?

There is an economic reality to real estate that we cannot ignore.  People will only build new buildings or homes if someone will pay them enough to justify the cost. With rising construction costs, that’s becoming harder to do except at the high end of the spectrum.  Tax abatements disproportionately favor the rich because developers can’t make money selling inexpensive homes or charging low end rents.  It may be that this incentive tool doesn’t work for some neighborhoods or products. That doesn’t mean it’s bad or that we should eliminate it or scale it back. It might just mean we need a different tool to help those who don’t benefit from this incentive.

Conclusion

The cities that are thriving today understand that they need to attract more businesses and higher income residents. As a result, they don’t just tolerate them, they embrace them, actively recruit them and then create an environment where they can thrive.  Given our situation, we need to change our attitude before it’s too late.  The fact that the abatement program disproportionately benefits one group doesn’t mean it’s bad for everyone else.  Sometimes you need to give a little to get a lot. And we need a lot.

This article was published in the Philadelphia Business Journal on May 21, 2018.

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

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Why All the Sublets and What Does It Mean for the Future of Commercial Real Estate?

In the past 12 months there has been a significant uptick in the number of sublets hitting the market.  And these sublets are very different from the sublets we have seen in the past.  In many instances, companies are not merely looking to shed a fraction of their space, they want to exit their premises completely.  In addition, they are not looking to get out of their space in the last year or two of their leases, they are looking to shake things up much earlier in their lease terms.  What’s going on?

What’s Happening and Why?

As we have discussed in previous articles, businesses today are changing at a pace never before seen due to technology, consolidation and shifting preferences.  That makes predicting the future very tricky for corporate executives.  Unfortunately for businesses, real estate tends to be a long-term commitment.  The bigger the space and greater the capital outlay, the longer the required lease term needed to justify the disruption and amortize the cost.  For very large clients, 10 to 15-year leases are not uncommon.  In today’s world, however, a lot can happen within that time frame that was never anticipated when the lease was first signed.

When a business has a reduction in headcount, they typically pull out their lease to see if they have any contraction or early termination rights.  If they do not have these contractual rights, subletting becomes the next best option unless a consensual deal can be worked out with the landlord.

That’s what we’re seeing today.  The recent proliferation of sublets is the result of major changes in businesses that were never anticipated when the leases were first executed.  And the frequency with which companies will encounter unexpected changes in their business will increase leading to a paradigm shift in the way they consume real estate.  Interestingly, the increase in sublet space only reflects a fraction of the underlying efficiency problems faced by businesses. Sublets are only viable if the tenant can break off and market a discrete piece of their premises (or the entire thing).  However, there are many companies who cannot realize potential space efficiencies or shed excess space without significantly renovating their entire premises.

Law firms represent one of the best examples of this phenomenon.  Almost every major law firm in the country whose lease has expired in the past five years has shed a material amount of space in its next lease.   In Center City, most Am Law 100 and 200 firms who have signed leases or renewals in the past five years have shed one or two floors.  Smaller firms (unless they are growing headcount) have shed proportionate amounts of space.

Fifteen years ago, large law firms were generally consuming between 750rsf and 850rsf/attorney depending on the type of practice and use of paralegals.  Today, these same firms are achieving ratios of between 550rsf and 650rsf/attorney.  What’s driving the efficiency is the reduction in administrative support (secretarial/attorney ratios have grown from 1.5-2/1 to 2.5-4/1), smaller office sizes and less space devoted to large conferencing, libraries and filing.

However, to capitalize on the foregoing efficiencies, law firms cannot merely move everyone off of a floor, backfill them into other floors and then jettison the vacated floor. It requires a major renovation and reconfiguration of the existing space. That means law firms need to wait until they have leverage with the landlord to negotiate a new deal with major tenant improvement dollars before they can reduce their footprint and realize efficiencies.  And, while many law firms have now gone through this transformation in the past five years, the evolution of space reduction will continue for law firms and other businesses.  Law firms and few other businesses have yet to embrace, in any meaningful way, telecommuting and hoteling concepts. These could eventually reduce, even further, the real estate footprint of businesses if they take hold.

Thus, in addition to the sublet space we’re seeing in today’s market, there is a lot of “shadow vacancy” within the real estate market that will only be shed down the road.  What does all this mean for the future?

What to Expect

With the foregoing in mind, here are some thoughts and predictions about the future of commercial real estate:

  1. Tenants will seek shorter term leases and/or more contraction and termination rights so they have more flexibility to adjust to unexpected changes in their business.
  2. To minimize capital expenditures, Tenants will settle for less bespoke work environments and, instead, try to re-use existing improvements or lease pre-built spaces. Designs will be exciting and contemporary but will reflect more generic layouts so that they have residual value to the landlord and future tenants (i.e., like co-working space designs today).
  3. Tenants and landlords will collaborate to design more flexible workspaces that can be modified by furniture changes as opposed to bricks and mortar.
  4. Larger tenants will design their space with exit strategies in mind in case they need to jettison excess space. Thus, a tenant with floors 20-30 in an office building may design floors 20 and 21 as self-contained spaces that can be easily returned to landlord or sublet to third parties without (1) requiring the tenant to reconfigure the rest of its space or (2) requiring a subtenant to build in needed amenities to make that floor self-sufficient (i.e., it may be designed to have a reception area and conference and pantry facilities to support that floor as opposed to being a special use floor like a conference center, café or records storage area that is essential to the rest of the space or unusable to any potential subtenant).
  5. Rents will increase in order to amortize needed build out costs over a shorter lease term and compensate landlords for the loss of long term certainty.
  6. Lenders will need to change their underwriting criteria as buildings will not be anchored by as many long-term leases. There will be even more focus on landlords’ abilities to retain their tenants and how the inevitable shedding of tenants’ excess space will be addressed.  Marketing plans that distinguish the building and ensure retention will be critical.
  7. As tenants gain more freedom to move and are less financially anchored to their real estate, landlords will need to create more compelling communities that emotionally anchor tenants to the buildings or provide unique value for being in that building.
  8. Co-working spaces will become more popular as more large companies seek the flexibility these options provide. As co-working operators continue to pursue larger, more traditional office tenants, Landlords will start to see them more as competitors to their business as opposed to saviors soaking up vacant space in their buildings.  The larger co-working operators will start to buy their own real estate rather than paying retail rents to compete with landlords.  The larger landlords will get into the co-working business.

Conclusion

With business changing today at an ever-increasing pace, planning is becoming more difficult and riskier.  A lot can and will happen over a 10-15-year period that was never anticipated when the lease was originally signed.  The increase in sublet space and shadow vacancy that we are seeing today reflects these unanticipated changes being faced by tenants.  As subletting is rarely a profitable or breakeven proposition, tenants will need to change the way they consume real estate going forward. And that means commercial real estate is in for a wild ride.

 

 

 

 

 

 

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How Artificial Intelligence Will Impact the Office Market

“The development of full artificial intelligence could spell the end of the human race…It would take off on its own, and re-design itself at an ever-increasing rate. Humans, who are limited by slow biological evolution, couldn’t compete, and would be superseded.”

—  Stephen Hawking told the BBC

A lot has been written over the past few years about the impact of Artificial Intelligence (AI) on different segments of our economy.  Most of the attention recently has been focused on driverless cars and vehicles as Google and others have taken the once far-fetched Jetsons prediction and brought it to the verge of reality. The fact is, AI is making major strides in many other areas and is probably a generation away from replacing many of today’s jobs and professions.  This raises a very interesting (and frightening) question for real estate owners.  What happens to our office buildings when the white-collar workforce starts to disappear?

The Problem

“Once a new technology rolls over you, if you’re not part of the steamroller, you’re part of the road. “

– Stewart Brand 

In a December 11, 2017 New York Times article, “Will Robots Take Our Children’s Jobs?”, Alex Williams details the tremendous breakthroughs that AI is making in many of today’s most coveted professions including medical, legal and even financial services.  Today, prototype robots have demonstrated the ability to outperform surgeons, lawyers and stock traders.  Technology has even made it possible to create movies starring actors who are no longer living.

Many of the industries that will be impacted by AI are the largest occupiers of office space.  By way of example, law firms have historically occupied about 15% of the Class A office space in Center City Philadelphia.  Large, national firms make up a large chunk of this industry.  One of the major drivers of Am Law 100 and Am Law 200 firm profitability over the past 20 years have been mass tort and class action litigation, where most of the billable hours involve document management and discovery—tasks that AI will soon be able to handle.  AI programs are also now able to reduce significantly the time it takes to review contracts – a time consuming task for both corporate and litigation attorneys.   And it doesn’t end there.  Companies are getting close to developing programs that will be able to do legal research and draft basic contracts. If machines can replace the legions of attorneys currently performing these functions, law firms will need a lot less office space in the future.

What about financial services firms?  It’s not just the jobs of basic office clerks and administrators that are at stake.  All bank employees currently making trades, creating hedge products and predicting future economic performance may soon be replaced by machines.  Again, as these jobs start to disappear, banks and other financial institutions will need a lot less office space.

Law and financial services are just two examples of employers who will be shrinking their ranks in the years ahead.  It gets worse.  According to Mr. Williams, the Oxford University Department of Engineering estimated that “47% of current jobs, including insurance underwriter, sports referee and loan officer, are at risk of falling victim to automation, perhaps within a decade or two.”  That’s scary stuff for anyone in those professions or anyone aspiring to those careers.  If Oxford University experts are right and about half of our jobs disappear within the next 20 years, who will be occupying the downtown office buildings?

It’s not all bad news, however; at least in the near term.  Clearly, AI and other technologies will create many new job opportunities even as they make others obsolete.  Software developers—especially those who are experts in AI — are in high demand today and earning high six-figure salaries in many cases. The automobile industry should boom as manufacturers retool their factories for self-driving vehicles and people around the world trade in their old cars for the newer, smarter ones (at least until no one needs to own their own car).

Eventually, however, many experts believe the age of singularity – where computers become smarter than humans in terms of “generalized intelligence” —is not too far off.  When that happens, we may reach the time when very few people will need (or be able) to work.  And we’re not talking about 100 years from now or even 50. It could be only 10 to 20 years according to Ray Kurzweil, the MIT scientist and author of The Singularity is Near.  What does all of this mean for office space?

The Impact on Real Estate

“The factory of the future will have only two employees, a man, and a dog.  The man will be there to feed the dog.  The dog will be there to keep the man from touching the equipment. “

– Warren G. Bennis

Real estate has traditionally been a long-term game where families and large institutions bought and held assets for generations.   While there were certainly ebbs and flows in the market, and occasional periods of euphoria and fear, real estate has generally been a good investment if you held on to it long enough.  That long term view is now looking a lot less certain based on current advancements in technology and their impact on employment.  And with technological advancements coming at an ever-quickening pace, the world can dramatically change almost overnight.  That’s scary stuff when you own real estate assets that are illiquid and involve long term commitments to fund it (debt and equity) and support it (leases).

Underwriting real estate will become more difficult and involve more risk as the economy starts to change more rapidly.  The risks will no longer be about temporal conditions in the market, but rather permanent and potentially material paradigm shifts in the nature of the workforce.  As a result, we may soon see shorter term leases as companies hedge their bets on head count, and higher cap rates as buyers factor in the risks of shrinking tenant demand. Secondary and tertiary assets, the ones that will be hit first if and when demand contracts, will continue to get repurposed and the prime assets will receive more and more attention from investors as they bet on a tenant flight to quality in a shrinking market.

Conclusion

If in fact we get to a point where most of today’s office jobs are lost and not replaced by an equal number of new, technology driven jobs, many landlords and lenders will be left out in the cold.  And for better or for worse, that appears to be the direction in which we are headed.  Everything we hear and see tells us that demand for office space is shrinking and that trend is only going to continue.  If that’s true, there won’t be enough workers to fill all of our current office buildings and many will become vacant.  The only question is, like in the game Hot Potato, who will get rid of the asset before it’s too late.

“Lo! Men have become the tools of their tools.”

– Henry David Thoreau

This article appeared in the Philadelphia Business Journal March 23, 2018

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

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Don’t Treat Your Lease Negotiations Like a Poker Hand

Everyone knows that to get the best deal terms you need to create competition for your requirement.  This applies whether you’re talking about cars, a business or your next office lease.  To create competition, you need to have viable options.  What happens, however, when you don’t really have other options?

There are many instances where a tenant may feel like it has no choice but to deal with a single party.  This can arise when the tenant has a significant amount of money invested in its space that it cannot walk away from (i.e., a lab, a high-end office or a manufacturing facility), the location is critical to the tenant’s business (i.e., a warehouse strategically located near a major supplier or customer, a retailer who has created a loyal following or a law firm located right by the courthouse)  or simply because the tenant has a lot of term left in its lease and needs to expand or contract.  In each of these instances, the tenant may have the theoretical ability to change locations; however, when all is said and done, such a change would be prohibitively expensive or ultimately harm the business.

When options are limited or seemingly non-existent, what can a company do to ensure it still gets a fair economic deal on its lease?

The Bluff: Good in Poker, Often Bad in Business

 “It is sound judgment to put on a bold face and play your hand for a hundred times what it is worth; forty-nine times out of fifty nobody dares to call it, and you roll in the chips.” 
― Mark Twain

A lot of people revert to a favorite strategy of poker players—the bluff.  Poker players who have nothing of value in their hands will bet aggressively in the hopes of convincing the other players that they actually have a great hand.  Because we are conditioned to believe that people act in an economically rational manner, we tend to believe they have a good hand if they are throwing a lot of chips on the table.  The risk reward of poker is that if someone calls your bluff, you’re probably going to lose your hand.  If, however, you can scare them off with your aggressive betting, you may win the pot even though you had a terrible hand.

It’s important to note that in the game of cards, a bluff has value even if it is exposed.  Thus, sometimes when a player wins a hand on a bluff, they will actually turn over the cards and show you that they had nothing.  Why?  Because they want to create uncertainty around the table as to their strategy.  If you show people you’re willing to bluff, you might be able to keep them bidding in a future game where you have a sure-fire winner.  Other players will refuse to show their bluff hand if the other players drop out of the game.  Again, the player is trying to create uncertainty among her opponents— “did she have a winning hand or didn’t she”?

The beauty of poker is that you get lots of chances to play and, the fact that you bluffed once doesn’t mean you’re doing it every time.  If you get caught bluffing on a given hand, it’s not fatal (unless of course you lose everything on that hand or have an obvious “tell” which signals to your opponent’s whenever you are bluffing).

Bluffing in business, however, can be fatal because you only get one shot to do your deal every five or ten years.  If you give the landlord an ultimatum by threatening to move, the landlord doesn’t believe you and then you don’t actually move, the landlord will never again take your threat seriously.  Further, if you have other leases with this landlord or their broker, your credibility in these other dealings may be questioned.

What happens in a lease negotiation when a tenant’s bluff is exposed?  The tenant is now at the mercy of the landlord who knows the tenant has no other options.  We have taken over several assignments over the years where a landlord has told us “Every five years these guys threaten to move, and they never do. We’re not buying it.”  The negotiating strategy you deploy today will impact your leverage tomorrow.

The Better Approach

“Life is not always a matter of holding good cards, but sometimes, playing a poor hand well.” 
― Jack London

Real estate is no different from other purchase decisions we make in life.  We all have preferences for different goods or services, but we are not always willing to pay the required premium for our first choice.  For example, let’s say you want to buy a nice sedan.  While everyone may agree that a Mercedes is a nicer car than a Honda, we don’t all drive Mercedes because the premium is much too steep for most of us.  Thus, more people buy Hondas given the savings or even a Lexus which, though not a Mercedes, is still more high end than a Honda. Options allow us to put things in context and assign relative values to each, so we can determine how much or how little we are willing to spend.  If you could buy a Lexus for $40,000, what would you be willing to pay for the nicer Mercedes?  Now what if you could get that same Lexus for $35,000?  Would it change your price on the Mercedes?

The key to making good real estate deals is to create options even if they are not all equal.  At some price and on some terms, a third choice can become a first choice and a first choice can fall to your second choice.  Too often tenants and their brokers go into negotiations with a closed mind and, as discussed above, they assume the outcome before they even start. If you are convinced that no other space or location will work for you, you will either be at the mercy of the landlord or you will need to bluff your way into a better deal. Neither is a great position to be in when your business is at stake.

Tenants need to keep an open mind about possible alternatives which, at a given price, could be more attractive than the one the favored landlord is offering.  Keep in mind – and this is VERY IMPORTANT– that, just as you feel you may lack alternatives for your requirement, the landlord is often equally aware that you are their best alternative for the space and are in big trouble if you don’t take it.  Knowing you have other options under consideration will help moderate the landlord’s position as they don’t want to give you an ultimatum and lose you either.

Alternatives exist within a given location as well.  Assuming you have no leverage or viable alternatives, there are ways to minimize your commitment to the space until facts and circumstances changes.  Just as we all know it’s good to secure long term leases in a bad market when rents are low and limit terms in a strong market when rents are high, the same kinds of strategies apply when a party’s leverage is not optimized.

Conclusion

Bluffing is an effective and critical strategy when playing poker. It’s a lot riskier when you’re betting your business on it for real estate.  The key to negotiating a good deal even when you believe you have no alternatives is to keep an open mind and evaluate all options.  Real estate doesn’t have to be an all or nothing exercise especially when both sides to the negotiation are feeling the same stresses.

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

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Why Exclusive Brokerage Relationships Benefit Tenants

Up until the late 1980s, commercial real estate brokers identified available space in the market either (1) through listing work that they were performing for their landlord clients or (2) cold calling to other brokers and landlords.  While residential brokers could search the Multiple Listing Service to find out what houses were for sale, no such database existed for commercial space.  As a result, when an office tenant came to ABC Brokerage firm looking for space, the easiest thing to do was show them the space ABC was marketing for its landlord clients. The more listing work ABC did for landlords, the more product it had to offer the tenant.  If none of those spaces fit the bill, ABC would turn to its market analysts who spent their days calling other brokerage firms and landlords for information about vacancies and compiling an ever-changing book of market availabilities.  Because no firm’s database was ever complete or up to date, tenants sometimes felt insecure committing their search to a single broker or brokerage firm.  It was reasonable to conclude that the more brokers who were calling with opportunities, the more likely it was the tenant would ultimately find the right space.  Today, the non-exclusive model is not only obsolete, it actually works against tenants’ interests in four important ways.

Everything changed in 1987 with the founding of CoStar, a national database of commercial real estate availabilities.  Suddenly, market information became a commodity because every broker had access to the same vacancy and “for sale” information.  Big brokerage shops who had the most landlord listings and the largest research departments were now on the same footing as small boutique firms who did no listing work at all.  There was no longer any magic or risk in space finding and this no longer represented the greatest value that brokers provided tenants.

CoStar, who now has a virtual monopoly on market availabilities after the liquidation of its only real competitor, Xceligent, is what every broker uses to find space for tenants.  While some brokers (especially in New York) will claim they have access to “secret listings” that no one else knows about, these assertions are rarely true and are, more often than not, just selling ploys to get a tenant’s business.  If a landlord or sublandlord is truly interested in marketing its space, it will insist that its broker include the availability on CoStar to maximize visibility and increase the likelihood of prospects. Only in extremely rare and sensitive cases will a company tell its broker not to advertise its space.

Despite the fact that market information is now a commodity available to all brokers, some tenants still believe that they are best served by working with multiple brokers rather than committing to one.  Here is why this approach actually hurts the tenant:

  1. To the Child with a Hammer, Everything is a Nail. Typically, when a tenant opens its requirement to all brokers, the only calls it will receive are from listing brokers who are marketing a specific asset.  Their allegiance is to the landlord, not the tenant.  Their job is to lease or sell the asset, so they spend their days calling lots of tenants and trying to convince them that the property is perfect for them. Thus, when a tenant is contacted by a broker about a particular property, it is not because that property is the answer to the tenant’s prayers; rather, it’s the broker is hoping that the tenant is the answer to the landlord’s (and broker’s) prayers.  While the tenant will certainly be exposed to some opportunities using this approach, it will not be exposed to all opportunities in the market, nor will it necessarily be shown the best options for its specific needs.

By using a single broker who isn’t representing a landlord, the tenant will be made aware of all market availabilities.  Further, the broker can help identify the best options given the tenant’s specific needs.

  1. A Competition of One is No Competition at All. It’s Negotiation 101 that, to get the best deal, you need to create competition.  Unfortunately, when tenants work with multiple brokers, they often end up focusing in on one option at a time as opportunities are brought to their attention. Because there is no structured search process and schedule, options are not vetted and competed against each other.  Deals struck in a vacuum and without context will result in poor outcomes for the tenant. The true value of a broker today is no longer finding space, but rather, getting the tenant the best deal terms among the viable options that exist.
  1. If the Broker is Not Outcome Neutral, Their Advice Isn’t Neutral Either. Suppose a tenant is working with three different brokerage firms and each has identified a different property to the tenant.  Because each broker only gets paid if the tenant chooses their particular property, it is unrealistic to think that these brokers will be doing anything other than promoting their property and telling the tenant how wonderful it is.  Who then will help the tenant objectively assess the pros and cons of the different options and compete them against each other? Whose advice can be trusted or relied upon when none of it is objective?  If, however, the tenant is working with a single broker who gets compensated regardless of which property is chosen and who has no allegiances to any of the landlords, the tenant will receive objective guidance and a committed advocate for its interests.  The best outcomes come when there is competition among the landlords, not among the tenant’s brokers.
  1. Commitment is a Two-Sided Coin. If a real estate requirement is important to a tenant’s business, the tenant deserves to know that every day, someone is waking up thinking about that need and making it a priority.  Today, most good brokers work on an exclusive basis with their clients because they have limited resources and want to know that, at the end of the day, their efforts will be rewarded.  Very few brokers will spend the time and effort to search for the best solution to a tenant’s problem knowing there they may not be compensated in the end.  Again, there is no magic to finding space any more.  20,000sf office vacancies and 100,000sf warehouses aren’t hiding any place.   The question a tenant needs answered is not “what is out there”—that is easy–, but rather, “what is the best solution to my problem”?  In the end, it’s going to be hard to solve the tenant’s real estate problem if no one is waking up every day and making it a top priority.

Conclusion 

Three decades ago, tenants had good reasons for not wanting to commit to exclusive arrangements with their brokers.  As no one had complete market information, the more brokers they worked with, the more likely it was that the tenant would find the right space.  Today, however, information about availabilities is a commodity and every firm is working from the same database.  Now, the most important thing a broker can provide is objectivity, advocacy and a daily commitment to solving the tenant’s real estate problem. That mix can only occur when the tenant is willing to pick a single advisor and let them run the process.

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

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What the 2018 Super Bowl Champions Can Teach Us About Leasing Office Space

The pieces seemed perfectly lined up. Carson Wentz, the protégé, second-year viable-MVP candidate quarterback, a well assembled group of offensive tools, and a brilliant defense had perfectly coalesced around a young head coach who understood not only how to design a play but, maybe more importantly, how to inspire a team to play for something bigger than themselves. Facing an easy close-out schedule and holding a conference-leading record, it looked like all that stood between the Philadelphia Eagles and Super Bowl LII was two (potentially home!) playoff games.  The team that got there twice but never hoisted the Vince Lombardi Trophy was electric-sliding their way into Minnesota.  Fly, Eagles, Fly!

And then, in the third quarter of a late season game against the Los Angeles Rams, scrambling into the end zone on a touchdown that was ultimately called back, Philadelphia’s Future was crunched between a pair of Rams defenders and seemed to hesitate on his way back up.  Wentz came back in and played through another four snaps, but that was it.  Along with the hopes and dreams of Eagles Nation, Number Eleven retreated to the locker room, and it looked like Philadelphia’s pessimistic prophecy was simply coming to its typical fruition – this time in the form of a torn ACL.

Now, it would be revisionist history to suggest that Howie Roseman, the team’s General Manager, took this in stride, knowing he had a Super Bowl MVP on standby. It’s quite likely that Howie, along with Jeffrey Lurie, the team’s owner, and Head Coach Doug Pederson, were as stunned as the rest of the NFL world watching events unfold, and probably spent a reasonable period mourning the loss of their pedigreed specimen. But it would be equally unfair to assume that they had failed to foresee the need for a Plan B (or many Plan Bs).  In fact, they had proven themselves throughout the season to be masters in this regard, having already found working parts to successfully replace a Pro Bowl left tackle, as well as a featured running back and star middle linebacker.

In the world of professional sports, owners, managers and coaches understand that the best laid plans often go awry.  All teams will eventually contend with adversity, and champions plan for it. Roseman believed that having a true leader, one with gameday experience who was ready to take the reins, was a necessary piece of the puzzle, and that nobody on the roster met those requirements. So when former “Franchise QB” Nick Foles became available, Roseman convinced Lurie to take an enormous financial gamble and commit an unprecedented $12 million to fill a backup QB slot.  Lurie trusted Roseman and had always been a believer in Foles, and the rest as they say, is history.  The Underdogs became Top Dogs and the Plan B became the 2018 Super Bowl MVP.

A tenant negotiating for office space would be wise to follow the lessons of the World Champions. A negotiating tenant may have selected a favorite location, and negotiations may appear to be running smoothly.  A tenant can literally have, “all business terms agreed upon,” and may already have spent time and energy designing a perfect space in that location. But until a lease is signed, the tenant should do the work necessary to protect its next best option; its viable backup.  In the context of an office lease, a “torn ACL” takes the form of a last-minute requirement for unreasonable securitization or guarantees, insistence upon the right to substitute alternative space, or an offer literally being pulled at the eleventh hour.  Any of these situations can torpedo negotiations and, without a viable backup, can leave a tenant in an extremely vulnerable position. The result can be a less-than-ideal outcome, of course, but can also result in extreme financial hardship in the form of expensive holdover rents and potential consequential damages.

In the context of lease negotiation, Plan B takes the form of an acceptable alternative that has been developed to the point of deliverability. Plan B often requires parallel negotiations; essentially full negotiations with Plan B occurring alongside negotiations for the top choice. By creating and developing a viable alternative, a tenant accomplishes at least two things. First, a literal alternative. If negotiations break down, a viable alternative provides a tenant with another option for its move, with all time and information required to change courses without compromising the process. Second, maybe equally valuable, as leverage. The mere existence of a vetted alternative provides a tenant with leverage to negotiate aggressively any truly critical lease issues that arise during lease negotiation.

Like anything else, Plan A is usually preferred for a variety of reasons, so including and doing the work to develop a Plan B does not obviate a tenant’s need to minimize the risks associated with its favored location. Reasonable actions to minimize the risk of having a deal crater at the finish line include negotiating a robust letter of intent sufficiently addressing all crucial business terms and, where appropriate, establishing a fixed exclusive negotiation period during which the parties are obligated to negotiate a lease exclusively and in good faith based on the terms of a binding letter of intent.  These protections are even more critical today, in a tight real estate market with limited options for certain types of inventory.

Howie Roseman’s prescience in developing a Plan B helped lead the Eagles to the organization’s first ever Super Bowl Championship.  A tenant’s Plan B may not receive the same public recognition but, during an extremely tense negotiation period, it can be what keeps a tenant out of the cold, and in control of its destiny.

 

 

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You Would Never Agree to This– But, Yet You Just Did

For some reason, many tenants continue to put themselves in conflicted situations with their brokers that they would never allow or even consider in any other aspect of their life or business.  Is it because they see other tenants doing this which lets them believe it must be ok, or have clever marketing pitches from brokers convinced them that real estate is somehow different from everything else?  To shed more light on how brokerage conflicts of interest hurt tenants, let’s look at some similar examples outside of commercial brokerage and see if you’d ever agree to them.

Example 1. 

You have a major fire in your home that is covered by your insurance company, XYZ Insurers.  Harry Brown, an insurance adjuster contacts you and says he actually represents a lot of the insurance companies including XYZ and would be happy to represent you in your claim against XYZ.  Because XYZ paid him $75,000 in fees last year for work he did on their behalf, he tells you that he knows how they operate and can get you a good settlement.  His fee from you will probably only be about $5,000.

Why You’d Never Agree to This.  What are the odds that Harry will aggressively pursue your claim if it upsets XYZ, a much larger client?  Of the following three potential outcomes, what likelihood would you assign to each for your insurance settlement with Harry?

  1. He aggressively pursues your claim and gets you an extraordinary recovery that leaves you ecstatic but XYZ very upset.
  2. He recommends an average or “market” settlement where neither party is thrilled but neither is upset.
  3. He recommends a settlement that leaves you somewhat frustrated but XYZ thrilled.

It’s a zero-sum game. Whatever he gets for you is taken away from XYZ.  Given Harry’s larger relationship with XYZ Company, will you feel completely comfortable with his final recommendation when he tells you “Take the deal, it’s a good deal”?

Why It’s the Same with Brokerage.  The same issues apply in brokerage.  Most brokerage firms make the majority of their money representing landlords as leasing agents, building managers, mortgage brokers, project managers and investment sales agents. For most tenants, you only provide fee opportunities once every five or ten years.  The landlord provides a steady and diverse stream of major revenues for your brokerage firm. How would you rank the probability outcomes above if Harry were your real estate broker?

Example 2.

You are considering buying a Toyota Camry from Bob’s Toyota and are working with John Smith, the salesperson.  You tell Bob that you’re also considering a Honda Civic from the dealer across the street.  John tells you “I used to work with that dealer and am very familiar with Hondas.  I’d be happy to evaluate both cars for you and help you decide.”

Why You’d Never Agree to This.  The fact is, John has quotas to make and he’s not outcome neutral here.  Even if he’s a great guy, human nature will make it difficult for him to be completely objective in his advice.  If you buy a Camry, he makes money.  If you buy a Honda, he makes nothing.  As a result, most people wouldn’t want to rely on John for this decision.  Further, how will John’s sales manager respond to John when you tell him “You know, I was strongly considering your Camry, but John convinced me that the Honda was a better value.”  That’s a conversation John would want to avoid at all costs.

Why It’s the Same with Brokerage.  As silly as this example may seem, this scenario is actually very common in commercial real estate.  If you’re looking at Buildings A, B and C and your brokerage firm also happens to be the listing agent for Building C, aren’t you in the same position as the above Toyota/Honda hypothetical?  If you end up at Building C, your brokerage firm makes two commissions as opposed to only one commission if you end up at Building A or B.  Your brokerage firm is not outcome neutral.  In addition, how uncomfortable will it be for your brokerage firm to explain that, based on their advice, you didn’t choose Building C? 

Example 3

You enter into a commercial contract to buy a small company from the mega conglomerate, ABC Company, and they breach the contract.  You suffer $100,000 in damages.  Attorney Jones calls you up and says “I understand you have a breach of contract claim with ABC Company, I’d be happy to represent you. Now, in the spirit of full disclosure, my partner, Sally Smith, did $1Million of business with ABC Company last year but don’t worry, I’ll keep her out of this completely and I’ll be your advocate. Also, because our firm obviously has a great relationship with ABC, the case will go very smoothly.”

Why You’d Never Agree to This.  Ok, are you convinced that by attorney Jones merely insulating his partner, Sally, from the case, there is no longer a conflict to worry about?  Does the $1Million a year in fees his firm stands to lose from ABC magically disappear from the equation when attorney Jones enters the courtroom to face ABC Company?  Probably not.  You see, the conflict here cannot be rectified merely by isolating one member of the firm from the case.  It’s not really a matter of preserving confidentiality. It’s the risk of jeopardizing a much larger economic relationship ($1M) that creates the real conflict and that will ultimately make it impossible for attorney Jones to be a zealous advocate for your case.

Why It’s the Same with Brokerage.  Again, the same holds true in brokerage.  Most brokerage firms who represent both landlords and tenants claim that there’s no problem representing both parties to a transaction because they create a “Chinese Wall” between the tenant and landlord brokerage teams.  By doing this they argue that the two brokerage teams can’t share confidential client information that could potentially benefit the other party. The problem is, confidentiality is a Red Herring.  The potential exchange of confidential information is not the problem.  In fact, by law, brokers are not allowed to share a client’s confidential information. The real problem, as with attorney Jones above, is that human nature makes it very difficult to act in a manner that is economically irrational; i.e., favoring a very small clients’ interests over a very large client’s interests.  Conflicts of interest that have material economic consequences to an individual will influence his or her behavior and ultimately, they will act in an economically rational manner.

Example 4 (and this one really happened).

You’ve decided to sell you mother in law’s home and, after getting recommendations for some of the best-known brokers in the neighborhood, you decide to interview two. The first broker comes in, assesses the house, and quickly recommends a listing price.  Immediately thereafter, she informs you that she just so happens to have a redeveloper client who she is sure will pay that price tomorrow thereby avoiding any closing risk or lengthy marketing period. “If you hire me today, I’ll have this sold for the asking price by tomorrow evening” she says. [Note: In real life, we selected the second broker who suggested a listing price that was $75,000 higher. After a bidding war, the property ultimately sold for $25,000 above that higher list price and $100,000 above the first broker’s suggested listing price.]

Why You’d Never Agree to This.  What is the risk here?  The first broker was attempting to represent both you and your potential buyer.  How comfortable would you feel about the recommended list price she gave you?  If she can really sell it tomorrow at that price, is it a good price for you or is it a great price for her other client?  Remember, if you sell to her other client, she gets two commissions AND she’ll get to relist the property for that redeveloper client once it’s been renovated. Further, if she can get that redeveloper client a quick purchase at a discounted price without having to get into a bidding war, she earns brownie points with that client and increases the possibility of future business. You, however, were a one-shot deal.

Why It’s the Same with Brokerage.  This also happens in commercial brokerage.  At some point in every lease transaction, the tenant will need to look its broker in the eye and ask, “Is this the best deal I can get from the landlord?”  If the brokerage firm is representing both sides, who is getting the great deal and how can you get comfortable with the recommendations you receive?  In sum, it’s just impossible to represent both sides to a transaction when the parties have completely opposite economic objectives and the advisors are not outcome neutral.

Conclusion

Every day people make rational decisions not to expose themselves to business situations that create obvious conflicts of interest.  In all of these cases, it’s just common sense that you don’t want an advisor representing you when they also represent the other party whose economic interests are completely adverse to yours.  This is especially troublesome when the other client is a much larger one with the promise of significant future business.  We also want our advisor to be objective which is very difficult when they are not outcome neutral.  Nevertheless, many tenants continue to believe that these problems don’t exist when hiring real estate brokers.  Unfortunately, they do.  In a world where conflicts of interest are getting more common and the financial entanglements with landlords are growing and getting deeper and more substantial, more and more tenants are starting to wake up and realize this is no different than the insurance adjuster, the car salesman, the lawyer or the residential realtor.

 

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