When is a Deal a Deal?

As the office market tightens and landlords’ bargaining leverage increases, tenants need to make sure they understand when they have a deal and when they don’t.  When the market was weaker and competition for space was not as great, it was usually safe to assume that when the parties verbally agreed to terms, executed a nonbinding term sheet or were negotiating drafts of the lease, the deal was going to go forward.  Now, however, that is not necessarily the case with certain landlords.  As a result, tenants need to be careful about how they proceed and who they proceed with.

In Pennsylvania, no contractual agreement for real estate is binding unless it is in writing (excluding short term leases).  Thus, a handshake deal, a non-binding letter of intent, term sheet or even a circulated lease draft does not create a contractual lease right on behalf of the tenant absent something more.  While a tenant may believe he has a committed deal, legally he probably doesn’t. The problem is that at some point short of a contractual right, a tenant may start to rely to its detriment on the promises of the landlord.  For example, the tenant may forego other opportunities and run out of time to change course once they hear “we have a deal”.

Most landlords continue to honor their word when they say they have a deal. Even if a better deal comes along before the lease is signed, these landlords know, in the long run, it’s bad business to pull a deal once they have a handshake.  Landlords who are materially invested in the market for the long term look beyond the return of a particular deal and take into account how their actions will affect future interactions with tenants and brokers.  They know that if they say they have a deal with a tenant and then revoke that deal for something better, it could destroy their reputation in the market making it hard for them to compete for and complete deals in the future. Thus, while it may make short term financial sense to pull the deal from a 15,000sf tenant in favor of a richer deal for a 22,000sf tenant, in the long run, such behavior can actually work against the landlord if they have multiple assets in the market and expect to stay invested there for the long haul.

Whereas years ago real estate was primarily owned by long term investors including insurance companies, family owned operators and REITs, today, many properties are held by investment funds who operate on a much shorter term time horizon. Landlords who are looking to flip their asset in the short term may be more concerned with maximizing short term profits than building long term relationships.  It’s not that they are doing anything illegal or wrong, it’s just that, based on their specific business model and time horizon, it often makes sense to go with the bigger or richer deal or the deal with the better credit even if it comes along after a handshake deal has been agreed upon with someone else.

What can tenants do to protect themselves?  Two things.  First, if and when a deal is struck, the tenant can insist that the landlord agree to deal exclusively with it for a period of time while the lease document is being negotiated. This is typically referred to as an “exclusivity provision.” While at this point in time, the parties may not feel comfortable entering into a binding letter of intent for the lease given the number of business terms that remain outstanding, the landlord can contractually agree that it will not actively market the premises for lease or solicit or entertain third party offers for a period of time. Likewise, the tenant can agree that it will not pursue other options during the exclusivity period while they are negotiating the lease. The parties can go even further and mutually agree to negotiate the lease document in good faith and stipulate that any attempt to change the express business terms in the letter of intent or term sheet shall be deemed to be bad faith.   If the landlord is unwilling to agree to the exclusivity provision, it probably means that he intends to continue marketing the property and that he is willing to pull your deal if a better one comes along.

If a landlord is unwilling to stop marketing the premises as aforesaid, that in and of itself isn’t fatal; the good news is that the tenant now knows who and what it is dealing with.  Knowing that the landlord isn’t truly committing to the handshake deal until a lease is signed enables the tenant to plan accordingly and manage its expectations.  Thus, the second thing a tenant can do to protect itself in the current market is continue to run its competitive procurement process in the market even after it has reached a verbal agreement with one landlord.  If the landlord is going to continue marketing its premises and shop for a better outcome after reaching a handshake deal with the tenant, the tenant should do likewise and continue to pursue its other options until the lease is signed.

When the office market was soft and most owners were invested in the region for the long term, landlords rarely pulled a deal after signing a term sheet or shaking hands with a tenant.  However, today the market has tightened and some landlords are under extreme pressure to maximize profits in the short term.  That means some landlords will continue to market space until an actual lease document is signed and there is some risk that the deal will be pulled if and when a better one comes along. Based on the foregoing, tenants need both to understand the position of the landlord they are dealing with and take the necessary precautions to protect their interests until the deal is completed.

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Wall Street Journal Highlights Rising Concerns with Conflicts of Interest in Business Transactions

In a March 3, 2016 article in the Wall Street Journal entitled “Firms Ask: Are Our Bankers Conflicted”, the writer, Liz Hoffman, highlights the growing concerns of clients in the mergers and acquisitions arena resulting from advisors who have conflicting, or apparently conflicting, loyalties.  When a company is up for sale and hires an investment banker to represent it, it wants to make sure that the banker’s loyalty is completely uncompromised and that it is committed to procuring the highest price possible.  Thus, if that investment banking firm also represents potential bidders for the company, that is a problem. Companies are becoming more and more sensitive to this issue so that even the appearance of conflict may disqualify a banker from an assignment. Adding to the problem is the growing consolidation in the banking industry which is creating larger institutions with larger client bases and broader product lines thereby creating more and more conflicts and deeper and deeper financial entanglements.

Ms. Hoffman describes how officers and directors of many companies are taking extraordinary efforts to vet out and avoid conflicts of interests as they see potential liability to shareholders should they engage advisors whose loyalties, and therefore performance, can be second guessed after the fact.  In fact, over two dozen shareholder lawsuits have been filed targeting bankers since 2014 claiming the financial advice given was tainted as a result of conflicts of interest.  One executive quoted in the article summed up the problem. “The question you ask is: ‘Will your bankers be working as hard as they can for you if they’re trying to do business everywhere else?’”

In order to minimize the chance of conflicts, prior to engaging their advisors, investment banking clients are now starting to require potential advisors to respond to detailed questionnaires, which have been prepared and reviewed by legal counsel, to identify potential business relationships which could compromise, or even appear to compromise, the objectivity of their advice.  Specifically, before hiring an investment bank to help sell the company, the company is asking how much the bank has earned from potential bidders in recent years.  According to the article, “Bankers in many cases are bristling at the heightened scrutiny” because “their answers [to the questionnaires] might prompt the company to hire a different bank.”  If there are other qualified bankers who have no chance of conflict, why go with the one who does?

As a result of the growing concern for conflicts, companies are now sending record amounts of work to smaller, boutique investment bankers who don’t have as many financial entanglements and, as a result, are less likely to be in a position of conflict with their clients.  As the large investment banks continue to grow and expand their service lines, the chances of them having meaningful business relationships with any given company increases and the materiality of that relationship grows.  Thus, being all things to all people is starting to become a negative.  Firms want a dedicated advocate whose loyalties are uncompromised and motives unchallengeable more than they want someone who does everything for everyone including their competitors and adversaries.

This increasing sensitivity to conflicts of interest is equally applicable to the real estate brokerage industry which is also experiencing rapid consolidation.  Brokers and brokerage firms are well aware of the conflicts of interest that are inherent in their ever expanding, full service business. Specifically, the majority of large firms represent both landlords and tenants in the same market and even in the same transaction.  The largest full service brokerage firm in the world acknowledged this problem in its own 10-K Securities Filing.

Our company has a global platform with different business lines and a broad   client base and is therefore subject to numerous potential, actual or perceived   conflicts of interests in the provision of services to our existing and potential   clients. For example, conflicts may arise from our position as broker to both owners and tenants in commercial real estate lease transactions. We have adopted various policies, controls and procedures to address or limit actual or perceived conflicts, but these policies and procedures may not be adequate and may not be adhered to by our employees. Appropriately dealing with conflicts of interest is complex and difficult and our reputation could be damaged and cause us to lose existing clients or fail to gain new clients if we fail, or appear to fail, to identify, disclose and manage potential conflicts of interest, which could have an adverse effect on our business, financial condition and results of operations…There can be no assurance that conflicts of interest will not arise in the future that could cause material harm to us.”

Likewise, some brokers are finding it impossible to practice with divided loyalties and are going public with the true dilemma dual agency poses.  Just last week, a senior executive from one of the largest full service brokerage firms left to join a large, tenant only firm.  In giving the reasons for his move in the press, he acknowledged the difficulty with dual representation platforms: “If you’re doing your job as a tenant advisor, you probably will bloody some noses in the process” he said.  That creates a major conflict and problem for the broker because he goes on to say, “If you’re a full- service firm, you’re also thinking about getting the next listing from the owner.”  It’s not good business to make an owner mad while representing a tenant if you really want that owner’s next deal too.

Over the past five to seven years there has been a significant amount of consolidation in many industries as companies strive to grow their revenues and capture more and more business. The problem is, you can’t really service everyone when some clients have adverse interests or diametrically opposed business objectives and they are sitting on opposite sides of the negotiating table.  As the Wall Street Journal article confirms, shareholders and boards of directors across the country are becoming more and more sensitive to these conflicts of interest because they may be called upon to justify why they hired an advisor whose objectivity was compromised or advice was tainted. As a result, companies are taking precautions to vet and prevent future conflicts of interest when engaging their advisors.  Whether its requiring the advisor to disclose the extent of its financial relationships with potential adverse parties in advance of the hiring decision or simply hiring advisors who are much less likely to be in conflicted positions, the way companies are conducting business is starting to change.

Real estate has often been slow to adapt to changes in the way business is conducted. However, given what’s at stake for officers and directors, individuals tasked with selecting their tenant broker are going to have to justify the conflicts they expose their companies to or find better ways to avoid them in the first place. Given the potential liability and opportunity for second guessing, they probably don’t want to have to explain after the fact why the brokerage firm they hired to represent their interests was also representing their landlord.

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

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What Presidential Elections Can Teach Us About Conflicts of Interest

You’re reading the paper at your kitchen table when your 14-year-old son, Bobby, plops himself next to you and says excitedly, “Dad, I’ve decided to run for Class President but I need your help.” Beaming with pride you pat him on the back and enthusiastically offer to throw yourself completely into his campaign. You know that Bobby will benefit from your experience, after all you ran for office several times in high school and college. He’ll do better with your knowledge of how campaigns should be run. Everything is falling neatly into place when the back door flies open and Bobby’s twin brother, Sam, enters the room with an ear to ear grin, proudly announcing that he is going to run for Class President. Suddenly, things have become a bit more complicated on the campaign trail.

Bobby and Sam now have a major problem and so do you. They were both hoping to have their dad completely pledge his allegiance to their cause and fight to the death to achieve their important objectives. Now you are faced with a number of unappealing options: (1) commit to Bobby’s campaign and alienate Sam; (2) commit to Sam’s campaign and alienate Bobby; (3) convince either Bobby or Sam to drop out of the race this time around or at least settle for a run at Vice President; or (4) convince mom to get involved and support one of the twins while you support the other.

You realize that scenarios 1, 2 and 3 all require you to abandon the goals of one of your sons. So you decide to get your wife involved so you can each commit to a different kid. What could possibly go wrong with that scenario?

To appease both Bobby and Sam you and your wife promise to keep your conversations with your respective candidates confidential and not to share any information between spouses. Now that you’ve given each candidate a committed advocate and have pledged confidentiality, there couldn’t possibly be a problem with the representation could there? Of course not.

You’ll have no problem posting campaign signs in the school cafeteria touting Bobby as the better candidate or prepping him as to how to attack Sam’s weaknesses in the upcoming debate. You can dig right in and zealously advocate for Bobby without guilt or hesitation because, after all, mom has Sam’s back. The conflict immediately goes away and has no impact on your personal actions because you’ve created the Chinese Wall and made sure Sam has an advocate.

Why is it so easy for people to see the splitting of loyalties in the above scenario is bound to end badly, yet many of the same people fail to see the problem of the divided loyalties in a business context?

When you think about it, commercial brokerage is a lot like presidential elections. One party to the negotiation (the tenant) wants to pay the lowest rent possible. The other party (the landlord) wants to receive the highest rent possible. You can’t make both parties happy because, like with Bobby and Sam, the objective of one is completely inconsistent with that of the other. Thus, if you advocate for one, you necessarily must advocate against the other. Creating artificial confidentiality and pawning off one’s fiduciary obligations to a cohort may sound good in theory, but it doesn’t change the client’s expectations or needs. In addition, it doesn’t change the fact that you are waking up every day working directly against one client’s interests.

How is this conflict typically resolved? In our example, the most likely outcome would be option (4): the parents would most likely convince both children to drop out (neither party gets what they want) or convince one child to drop out or run for a different office thereby favoring one child over the other. That’s what ultimately happens in brokerage as well when a conflict arises. Since the broker can’t structure a deal that achieves both the highest and lowest rent at the same time, he’ll either convince both clients to split the baby in half, thereby resulting in a bad deal for both, or convince one party that a bad deal isn’t really that bad after all.

Conflicts of interest are very messy and usually end badly for most of the parties involved. While some real estate companies continue to brush aside the realities of these contradictory allegiances, the reality still remains: you cannot represent two different people who you truly care about in the same endeavor when they have completely contradictory goals and objectives. Common sense tells us that any attempt to serve two masters will end badly. Parents know it, lawyers know it, Bobby and Sam certainly know it. Unfortunately for tenants, when it comes to their real estate broker, the possibility of collecting two commission checks on the same transaction often takes priority over common sense.

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

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Could the New Central Business District End Up In University City?

Right under our noses, the rents in Center City have been steadily rising to levels not seen in recent memory.  There are several reasons for the rapid price increases beyond mere supply and demand including: (1) the consolidation of a large percentage of building ownership and leasing responsibilities into just a handful of players making it easier and quicker to move the market, and (2) a record number of buildings having recently changed hands with the new owners insisting on higher rents to justify the prices they just paid.  Interestingly enough, the higher rents currently being realized in Center City may ultimately create longer term problems for building owners there.

The average age of Center City office buildings is over 55 years and the trophy towers that rose along West Market and 18th Street in the late 1980s and 1990s are now almost 30 years old.  Many tenants are now looking for something different that reflects a newer, dynamic office environment to support the way they work and interact today.  Where are these types of workplaces?  New buildings are popping up at the Navy Yard and in University City with many more in the planning stages.  Drexel and it’s to be announced master developer have plans for up to 6,000,000sf of mixed use development including a lot of office space in Innovation Neighborhood just west of 30th Street Station.  The University City Science Center, in partnership with BioMed Realty, have plans to develop about 4,000,000sf of new, mixed use development between 36th and 38th streets, just north of Market Streets at the old University City High School site.

Since historically in Center City, there was always plenty of available space in the existing buildings and there was a price premium to move to a new building, little new office construction has occurred in the past 20-25 years.  However, that is starting to change.  Many more tenants are starting to believe that the benefits of a brand new office building with better light, green space and amenities including outdoor space, social gathering places and a more human friendly scale justify the rent premium over the 30-50 year-old building stock.  The proliferation of new office development at the Navy Yard and in University City clearly reflects this value assessment.

As rates continue to rise in the Central Business District and the existing buildings continue to age, the price gap between current building stock and new construction will shrink, and the quality gap between existing buildings and new, state of the art buildings will widen.  The interplay of these two phenomena will make it easier for companies to decide to move to new construction.  When they make that decision, where will they go?  While there will certainly be isolated building pad sites in the Central Business District, many of these will necessarily exist within the constraints of what is already nearby— a densely populated neighborhood of standalone, older buildings. Much like the Navy Yard (though on a smaller scale), Innovation Neighborhood and University City will provide opportunities for tenants to not only redefine their work environment within a shiny new building, but also become part of a larger, modern day community centered around public green spaces, recreational activities and neighboring state of the art buildings built to a more people friendly scale.

Right now, for some companies, the Schuylkill River creates a psychological barrier that cannot be crossed.  What happens, however, if we are lucky enough to land a Google, Microsoft, Uber or Oracle in University City?  What if three or four other well established corporations join FMC and the top firms at Cira Centre in locating major operations across the river?  Given the changing economic and quality gap paradigms, isn’t it likely that other companies would want to join in the fun?  What happens then?  Demand for the current Central Business District will fall, rents will go down and it will be difficult for landlords to get tenants to come back without materially upgrading their product.

For a long time, landlords in the Central Business District have suffered with flat or declining rents. They have taken their lumps and no one should deny them their day in the sun as rents have now started to rise.  However, there are limits to how high these rents can rise before tenants start making different business decisions that could permanently change the landscape.  Increasing rents without investing significantly in the underlying assets will ultimately have consequences that short term owners may not care about.  Demand for CBD space is not completely inelastic so if the premium gets small enough, people will pay to go to something newer and better.

Conclusion

First class cities need first class office buildings in order to attract new, and retain existing businesses. Our office stock is getting long in the tooth and, perhaps as a result, we are losing major corporate occupiers and trailing other top tier cities in our efforts to attract new ones.  If you were the CEO of a new, cutting edge business looking to relocate or expand your business into a new city, which buildings in Center City would blow you away and make you decide you have to be here?

Businesses don’t operate the way they did 50 years ago. As a result, we need more new office buildings and master planned urban business communities that can support the companies of tomorrow.  While tenants may lament the fact that rents are currently rising in the Central Business District, it may be just the catalyst we need to kick-off the projects that are necessary to keep Philadelphia competitive. When these new office developments come, they may well spring up across the Schuylkill River thereby creating a very viable alternative to, or even replacement of, our current Central Business District. And if that happens, rents along West Market Street could once again look a lot different.

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

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Why Changes in Office Design are Helping to Fuel the Apartment Conversion Phenomenon

It’s happening everywhere. Former office buildings are being converted to apartments at an earthshattering pace.  Why now and when will it stop? There are a number of macro-economic reasons for the boom in multi-family development and conversions such as insecurity about long term job prospects, mountains of student loans preventing young people from making down payments on homes, and the desire to live in urban settings and younger demographics. However, another factor that has gone largely under the radar is the rapid change in office space design and its negative impact on economic returns for office buildings.

Millions of square feet of office buildings in the Philadelphia area have been converted to apartments over the past 10 years.  In addition, while we see more construction cranes around the city than at any time in recent memory, the overwhelming majority of them are for multi-family projects (excluding on campus university and health systems projects).  Even Brandywine Realty Trust which had traditionally been exclusively an office owner/developer has jumped into the multi-family arena.  FMC Tower, 1919 Market Street, EVO and their  suburban ventures with Toll Brothers all reflect the fact that money invested in multifamily may not only be a good way to diversify overall investment risk, it may also provide better long term risk adjusted returns than office buildings.

Why is that?  Let’s assume you have a Class B office building that has been struggling to achieve attractive returns. The only way to make it competitive is to undergo a major renovation to the core and shell including new windows, elevators, lobbies and HVAC system.  Once you do that, you then need to attract new tenants and provide them with a tenant improvement allowance of between $40-$60/sf.  If you’re successful in converting this to a Class A asset, let’s assume you can command a $33/sf (gross) office rent.  Let’s further assume that the operating expenses and taxes comprise $10/sf of that rent for a NNN rent of $23/sf.

Now let’s compare the economics of an apartment conversion.  Assuming that the landlord/developer performs the same core and shell renovations, he may then need to spend between $125/sf and $150/sf in fitting out the apartment units. That’s two to three times more than the tenant improvement allowance he would pay to a commercial office tenant.  Why does it make sense to spend so much more money to do apartments?  Market rents for new, higher end apartments in the city are close to $3.50/sf/month gross. That’s $42/sf/yr.  Since office operating expenses are generally higher than those for apartments (they could be between $1.50 and $2.00/sf less due to the fact that the landlord doesn’t have to clean the inside of unit), the NNN rents for apartments can be $34 /sf/yr or more—about $10/sf more than for office space. But that’s not the end of the story.

Apartments provide the landlord with credit diversification risk as compared to an office building.  A 300,000sf apartment project will involve hundreds of tenants as opposed to a similarly sized office building which could have as few as a handful of tenants.  If one of these large office tenants defaults on their lease or leaves when the lease expires, the project could be in serious jeopardy.  Conversely, no one tenant in an apartment building can bring down the investment.

However, getting back to our original point, there is another phenomenon taking place that is further fueling the conversion of office buildings into apartments.  With office buildings, the landlord needs to spend a lot of money to retain its tenants every five to 10 years when their leases expire.  These deals can be very costly in terms of new tenant improvement dollars, free rent and other transaction costs.  Conversely, renewing or replacing residential tenants is relatively inexpensive and, in a desirable project, the units don’t remain vacant for long periods of time.  This means that rent disruptions are minimized.

Up until the past 10 years or so, office environments didn’t change very much; they were fairly static.  Because nothing earthshattering was changing in the way businesses were utilizing their space, it was not uncommon for office tenants to renew their leases after five or 10 years while requiring little change or renovations.  As a result, tenants often accepted nominal tenant improvement dollars to “freshen up” their space with new paint and maybe carpeting.  Since it was relatively inexpensive to renew their office tenants (and in fact landlords make almost all of their profits on lease renewals), life was pretty good for landlords.  However, things have changed and they are likely to continue changing more rapidly in the future.

Tenants today are operating their business differently than they did 10 years ago. Many tenants  want more open space, collaborative areas, natural light and environmentally responsible offices.  They are also more efficient; consuming less space per employee than they were before. These changing requirements mean that tenants who have been in their space for 10 years or longer need more than paint and carpet if they stay in their space beyond their initial lease term. They need to completely remodel their offices and, in some cases, even move to a different building.  In fact, for this reason we are seeing more of our clients move than ever before.  Because the needed changes to their space are material, many tenants don’t want to “eat their dust” while living through “in place” renovations for a year or more. They prefer to move to new space and avoid the headache.  Because they are consuming space more efficiently, many of these tenants can more than offset the out of pocket move costs with the annual rental savings realized from leasing less square footage.

Technology is largely driving the transformation in office environments–enabling people to work more efficiently, with less space and from anywhere.  Because technology is changing at an ever accelerating pace, there is good reason to believe that office space will continue to change more rapidly than ever before.  Tenants will therefore constantly need to change their space as technology allows them to work more efficiently and differently.  A 10-year lease may seem like a lifetime and when the lease expires, tenants will need to adapt to the new reality.

Office landlords are very cognizant of this new paradigm for office space.  While an apartment conversion may initially cost more than an office renovation, some landlords are coming to the conclusion that over the long run, the tenant improvement dollars ultimately exceed the cost of a residential conversion while providing a lower rent and higher risk.

Conclusion

Demographics and macro-economic factors are clearly responsible for much of the rapid growth in apartment development and office conversions over the past 10 years. There is another, less talked about phenomenon, that is causing even leading office REITs to jump on the residential band wagon.  The rapid change in office environments brought on by technological advancements is having a major and permanent impact on the economics of office leasing.  Going forward, it will be more expensive to retain office tenants and that will directly impact landlord profits as well as their decisions about what to build next.

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

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Wine, Water and Real Estate Brokers

How much do labels affect our perception of quality? Apparently very much, as shown in study after study.

Wine

In 2001 a researcher at the University of Bordeaux, the very epicenter of the fine wine world, recruited 54 oenology undergraduates (those are students studying to get a Bachelor of Science in winemaking) to participate in a simple experiment. He had each of the students taste one glass of red wine and one glass of white wine. They were then asked to describe each wine in as much detail as possible. The students described the red wine in typical red wine terms (tannins, full bodied, robust) and the white wine was described in typical white wine terms (citrus, floral, fruit). Here’s the fun part: not a single one of the 54 soon-to-be wine experts detected that the wines were in fact identical. The “red” wine they had sampled was nothing more than the white wine with a flavorless and odorless red dye added.

The same group, of students participated in a second experiment (without having been told that they had miserably failed the first one). They were offered a bottle of expensive wine and a bottle of cheap wine – but with the two labels switched. The cheap wine with the expensive label received strong reviews (described by the future sommeliers as  “complex and rounded”), whereas the expensive wine with the cheap label was panned (“weak and flat”). Incredibly, these experts were in essence tasting the label, not the wine.

Water

Wine is pretty complex. Could labels affect our perception of something as simple as water?

Penn and Teller, the famous illusionists and entertainers, aired an episode of their television series involving a water “tasting” at a trendy California restaurant. The patrons were asked to participate in a “tasting” of exotic imported bottled water, which they were told cost as much as $7 per bottle. The set up?   All the labels were fake, and all the water was supplied by the restaurant’s garden hose. The segment of the show is hilarious, and can be viewed on YouTube at https://www.youtube.com/watch?v=YFKT4jvN4OE. One after another, the guests ooh and aah over the fabulous water, comparing and contrasting the water that came from the French country springs (the garden hose) to the water from the Norwegian glacier (also from the garden hose).  Again, people were fooled by the labels.

Behavioral psychologists have an explanation for this cognitive bias. According to David McRaney (author of You are Not so Smart – A Celebration of Self Delusion), when a label is applied to something it “leads to an expectation quality. The actual experience … is less important. As long as it isn’t total crap, your experience will match up with your expectations.”

This shouldn’t surprise you. For 50,000 years evolution has trained us to look for visual clues to steer us towards the good stuff. So it’s natural to expect more when there is a “good” label on a bottle of wine or bottle of water. What is surprising is how much our expectation actually influences our perception of the event.

Real Estate Brokers

So what does this have to do with real estate brokerage?

Labels play a critical role in real estate. Just ask Donald Trump who admits to making more money from licensing his name than from all of the real estate development in which he was the actual developer. You may or may not agree with his politics, but he is living proof of the importance of labeling in real estate.

Labels are also playing a role in the rapid consolidation we are experiencing with real estate brokerage companies. Everybody is selling out to the guys with the big, fancy labels. And why not? If the experts are right that labels influence our expectations, and our expectations in turn influence how we perceive the actual experience, consolidation should work magic – at least for the brokers. But the problem for the clients of these brokerage houses who may be pleased with the taste of the wine or the taste of the water is that the “red” wine is still white wine with red dye, and the seven dollar bottle of water still comes from a garden hose.

The fact that someone carries the business card of a large, well known company shouldn’t end the assessment of who to hire for your next real estate deal.   You need to assess what is behind the business card and make sure that the person you are entrusting the future of your business to is actually the best qualified individual based on your needs and expectations.

So the next time you’re choosing a broker, keep that broker’s business card turned face down and ask the hard questions. What skill sets and strategies will they bring to bear to get you the right real estate solution and the best economic deal? What transactions has this individual worked on and what landlords are he and his firm financially tied to which could lead to troubling conflicts of interest down the road?

In life, not everything is what it seems to be. It’s easy to be fooled, especially when people are selling heavily marketed, well known brands but what you’re really buying is the individual.  Don’t rely on labels or business cards to tell you what you are consuming, open your eyes, your ears and ask the difficult questions.  If you do, you’re more likely to avoid the garden hose.

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

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When Should You Start Thinking About Your Lease?

Most people only start to think about their real estate situation when they are coming up to the expiration of their lease term. Since many leases are seven years or more in length, people don’t think about their real estate very much. When they finally do, they are sometimes reacting to an emergency situation rather than executing on a well thought out strategy.  Even if you are too early to enter the market or execute a new lease transaction, there are things you can be doing with your real estate to better support your business or plan for the future.

Most leases involve a relatively long term commitment to a particular space and configuration.  The problem is, business is changing today at a pace that is unprecedented. What worked three years ago can become obsolete tomorrow.  That means companies need to be assessing their real estate on a constant basis to make sure it is supporting their business the way they operate today–not the way they operated when they first signed their lease.

While lease expirations provide an opportunity for tenants to re-envision their space, respond to changes in staffing levels or implement new operational efficiencies, you don’t always need to wait that long to effect needed change.  There are often things a tenant can do throughout a lease term to ensure that their real estate is supporting their business in the best way possible.

Control Your Own Destiny.  We recently worked with a company that had several years left on their lease but were out of space and, therefore, could not accommodate the rapidly expanding business. Before hiring us, they spoke to their landlord about a possible expansion, however, they could not agree on acceptable financial terms. The landlord, believing the tenant was captive, was holding out for a very high rent which the client was unwilling to pay. They hired us hoping we could secure more favorable economic terms.  Instead, we helped them engage a space planner to evaluate their programmatic needs.  It turned out that they really didn’t need more space, they needed more efficient furniture and a little reconfiguration to accommodate more bodies.  The solution was simple and cost effective even if it didn’t result in a fee for us.  It was the right outcome for the client and enabled them to effect needed change well before their lease expiration.

Seize Opportunity.  By constantly assessing their real estate needs, tenants can often identify and act upon opportunities during their lease terms.  To do this, tenants need to be informed about what their needs are and be prepared to act quickly. Tenants who ignore their real estate run the risk of ending up like Mark Twain who once said, “I had seldom seen an opportunity until it had ceased to be one.”

At any given point in time, things happen in a building that can create opportunities for a tenant.  We worked with a client who had several years left in their lease.  The company came to us initially asking if we could help them find expansion space outside of their building because they were out of space and the building was totally full.  Knowing that a two building solution was not ideal from an operational or corporate culture perspective, we started calling on other tenants in the building.   It turned out that another tenant actually had way too much space and was stressing over how to cut their costs.  We were able to work out an arrangement with that other tenant to take their excess space thereby solving both tenants’ problems.  Because the client knew exactly what it needed and was in a position to act quickly, we were able to capitalize on this situation and avoid a less than desirable alternative.

Plan Ahead.  A new client of ours was an early stage business with major growth plans.  As a result, at our first meeting we asked them to try and map out what their head count was likely to be in three years, five years and ten years. While this exercise obviously involved a lot of “crystal balling”, it quickly became evident that they were going to be outgrowing their current space before their current lease expired.  They were worried about how they were going to accommodate their growth without taking on material obligations that would increase their monthly burn rate on cash.  We reached out to the landlord and got them to identify all of the pending lease expirations within the building and had them assess the likelihood that each tenant would renew or vacate.  Luckily, this exercise revealed that there were likely to be several opportunities to expand within the building to accommodate our clients’ growth.  We alerted the landlord to the client’s needs and made sure that if any space became available, we would be notified and given a crack at it before it was marketed.  Had we waited to alert the landlord until the space was actually needed, that space may very well have been leased to another party.

In another instance we had a client who wanted to leave their existing space in the middle of their lease term because it didn’t work for them anymore.  However, they were not in a position to simply walk away from this obligation or take on an additional lease without mitigating the cost of the first lease. They were resigned to the fact that they would probably have to stick it out for a few more years and then fix things when they did their next lease.   Because we knew their current space was of good quality and they had a good amount of term left, there was probably a good chance this space could be sublet. We put the space on the market and were able to sublet it on terms that covered most of the clients’ obligation. This allowed them to execute on a much needed real estate solution years before they thought possible.

Conclusion

In today’s quickly changing business world, companies at times find that the ideal real estate solution they arranged five years ago no longer works for them today.  While many companies make the mistake of ignoring real estate until they get close to their lease expiration date, there are a number of things that companies can do in the interim to address changing circumstances with their business.  By staying on top of your current and projected real estate needs and communicating these needs to your real estate advisor, you may be able to seize on an opportunity before it ceases to be one.

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

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Potato Chips and Leasing

We’ve all done it. Opened up a bag of potato chips to find a lot of empty air where the afternoon snack should be. In the food industry there’s a name for all that air. It’s called chips-holecrjan10-1“Slack Fill”. Food producers will tell you that there is a legitimate reason for Slack Fill. They say it is necessary because of today’s high-speed packaging machinery, or to prevent the product from breaking during shipment, or to keep the bag from breaking when trucked through high-altitude areas, or to discourage theft in the stores. Right. We all know why it’s there. It’s to give the illusion of more product.

It’s not just potato chips. It happens with many consumer products. In June of this year, MCCORMICK PEPPERthe Wall Street Journal ran an article entitled “How Do Companies Quietly Raise Prices?”.  It seems that spice maker McCormick & Co. quietly reduced the amount of pepper in its iconic red and white tins by 25% without changing the price. When challenged by the reporter about this practice, the CEO of McCormick stated that “Our priority was … avoiding significant increases in the price of this favorite everyday ingredient”. Did he just say that selling 25% less product for the same price is not a significant price increase?

But food industry marketers have nothing on the real estate industry.

Let’s start with the unfortunate fact that humans are terribly inaccurate at perceiving size. Do you really know what 4.7 ounces of potato chips looks like or how many ounces of pepper would fit in a McCormick tin? Those are tough questions, so let’s start with one that seems easy: how big is a rentable square foot of office space?

If you thought it was an area 12″ x 12″, then you’re like most people, but you are also wrong. Rentable square feet, like the air in a bag of potato chips, was developed to create an illusion of getting more than what is really there.

If you ask someone in the real estate industry how  rentable square feet is determined, they will probably answer that it is the usable square feet plus an add-on factor, all determined in accordance with the standards promulgated by the Building Owners and Managers Association International (“BOMA”).

Greatly simplified, usable square feet under BOMA is the “carpetable” area with no exclusions for columns or other vertical penetrations.

The add-on factor is in theory an allocation of common areas (entry lobby, elevator lobbies, restrooms, janitorial closets, utility closets) to each tenant in proportion to their size in the building. Add-on factors typically range from 8% to as much as 32%.

It may seem complicated, but at least it’s mathematical – right? Far from it.

First, the BOMA standards are very complex and subject to interpretation. Ask five architects to determine the rentable square footage of a given office space, and you will most likely get five different answers.

Second, not all landlords follow BOMA. New York City landlords are notorious for aggressive measurements with the joke being that they measure your space to the centerline of the street (the joke is not that much of an exaggeration).

Third, the add-on factor for a building can often depend upon which floor you are on, even if you are the only tenant on the floor.

And if that’s not enough to convince you that rentable square feet is a total fiction, finally and most amazingly, the total rentable square feet in a given building can vary over time, and often increases each time the building changes ownership. For example, last year we took a hard look at 666 3rd Ave. in New York City for one of our clients. In 1990 the building was listed as having a total of 589,660 rentable square feet. By 2014 the property had “grown” by 31% to 769, 503 RSF – without adding any real space. On a simple spreadsheet, the property didn’t raise an eyebrow with an asking rate of $73 per rentable square foot. But when considering the “Slack Fill” that had been stuffed into the building over the last 25 years the effective rate jumped to $95 per square foot.

Just like the size of a potato chip bag distorts your perception of what you’re getting, focusing on the cost per rentable square foot when deciding among buildings can be deceiving. Perhaps we can take a lesson from the tags we’ve all seen on the grocery shelves that disclose the cost of the product per ounce/ pound/ or other standard unit of measurement.

If rentable square feet is not a reliable standard of measurement of what you are getting in real estate, what is? It’s really as simple as figuring out what each building will cost to house the functions your business requires. How many offices of what size, how many workstations of what size, how many conference rooms of what size, and so forth. This is your organization’s space program. And your space program should be “test fit” into each building under consideration to determine not the rentable square feet required (since we know that can be full of air) but the total annual rent you will pay to house your requirement. After all, if Building A’s rent per square foot is 12% lower than Building B’s, but Building B is 15% more efficient for your particular space program, Building B is more cost-effective.

Even if we were to be able to wave a magic wand to get all landlords to measure rentable square feet in the same fashion, test fits would still be required to determine the true relative cost-effectiveness of buildings. Differences among buildings in column spacing, window spacing, distance from windows to the building core (restrooms, fire towers and mechanical rooms) and other physical factors can dramatically impact the efficiency of a building for your particular requirements. We’ve seen the same building work very well for clients with a particular mix of walled offices and open space and work very poorly for other clients having a different mix.

And remember, everything in a real estate lease is negotiable, including the “air” that is pumped into the number of square feet you have to pay rent on. Do your test fits early in the process, and make sure your broker is working with your architect to strictly adhere to your space program requirements in performing the test fits. The process of test fitting the buildings you are considering should be more than a simple design exercise. It needs to produce a reliable apples-to-apples comparison of each building’s relative efficiency for your particular needs.

There’s nothing more satisfying than watching a landlord struggle to overcome an inherent inefficiency in their building for a tenant’s particular space program. We’ve seen landlords lower the rent per square foot, “re-measure” the proposed space to reduce the rentable square feet, and even give the tenant a lease signing bonus once it’s proven that their building is inefficient for this tenant’s needs. Everybody wants to win, even landlords. Make sure you give them objective information on the relative efficiency of their building for your particular requirement so that they can fully compete for your business. And tell the landlords you won’t be swayed by the air they’ve stuffed into that potato chip bag.

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

Posted in Leases, Strategies | Leave a comment

How to Stay Within Your Tenant Improvement Budget

A budget tells us what we can’t afford but it doesn’t keep us from buying it.”

William Feather

Building out new office space can be somewhat akin to buying a new car.  We have all walked into a car dealership with a firm budget in mind but then we make the mistake of test driving the upgraded model with all the cool features. Individually, the cost of these upgrades seem fairly innocuous; however, when we sit down with the salesperson to see the final tally, we often end up in a completely different price range than we had intended.

Once you strike your lease deal with your landlord you need to take all prudent measures to avoid falling into the trap of thinking that the hard part is over. There is still much to do and material financial risk if you don’t establish, manage and enforce a comprehensive project budget. The budgeting starts with your designer.

Establish Your Budget Up Front

If you were building a house, you wouldn’t give your architect or contractor a blank check.  You shouldn’t give your space designer one either.  Most companies have financial covenants, profit and loss goals or other constraints on their ability to spend.  Based on how much cash your landlord is providing for your build out, decide what you can afford to spend out of your own pocket.  This will form the basis for your overall project budget.

Remember, the cost of a move goes beyond just construction costs.  In building your budget, you need to factor in decommissioning of the move space, telecommunications/IT and cabling, design fees, project management fees, move costs and furniture, fixtures and equipment.  These costs can represent a material portion of your overall budget.  Make sure that your “all in” budget is clearly established up front with your designer so they know how much money they have to work with.

Designers appreciate when the project parameters are firmly established up front.  A good design is only good if it achieves the desired operational and aesthetic objectives while staying within the client’s budgetary constraints. There are many ways to achieve an aesthetic objective and the budget will often dictate which route the designer will take.

Continue to Monitor the Budget Throughout the Project

Once you establish your budget, it’s important to understand that things can change.  While your budget should include a reasonable contingency to deal with unexpected changes that inevitably occur in a real estate project, you should make sure that your pricing parameters are still being adhered to as you move through the design process.  Insist on preliminary pricing from your project manager or contractor as the design is being developed.  If some areas are coming in at prices that were higher than anticipated, consider taking steps to determine if there are ways to accomplish the desired functionality or aesthetics at a cheaper cost.

 Limit Input into the Design Process

Some companies who value participation and inclusion will seek input from many of their employees before planning their new space. While this is a laudable approach, it can come with a cost. Some employees view a corporate move as an opportunity to fulfill their wish list of office amenities, design features and top of the line equipment.  Not everyone is sensitive to budgetary constraints when asked to identify what they’d like to see in the new space. If price was never an object, people’s purchasing decisions would often turn out very differently.  Another risk of seeking broad input in the design is that once you ask for opinions, you may run the risk of a backlash should you decide not to incorporate all of those suggestions into your design.  The old adage, “It’s better to seek forgiveness than permission” often applies here.

One way to engage employees without losing control of the process is to limit input to certain options or alternatives.  If there are several design features that have the same relative cost impact but you cannot afford all of them, you might put those options to a vote. For example, glass office fronts, individual office thermostats and upgraded lighting might all be features with the same relative cost impact. If the company cannot afford all three, you might seek opinions on which one or two would be most appreciated by your staff.

Scrutinize high cost, specialty spaces

Where things can get really tricky is when you are dealing with highly technical space components such as data rooms or labs and you need to rely on experts to tell you what you need.  One approach here is to have your advisor create a comparison of what you currently have in your space with what is being proposed for the new space including a cost breakdown of any upgrades.  If and to the extent the new requirements being proposed by your lab team or IT professionals are significantly greater than  or different from what you currently have, make sure that all of these changes are justified.  Having all the bells and whistles might make for the ideal lab space; however, that can come with a cost that might not be justified.

Conclusion

The build out of space involves material cost and risk that tenants often do not plan for after their lease is signed.  A great lease deal can turn into a bad real estate deal if the tenant does not establish and enforce a strict project budget.  By following the suggestions above, tenants can ensure that they don’t buy what they can’t afford.

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

Posted in Fit Out, Negotiating, Strategies | Leave a comment

The True Cost of Free

Something happens to us when we are offered something for free: our brains shut down. Free is irresistibly seductive. It is a source of irrational excitement. Witness people who grab coupons offering a free trinket that they have no need for.  And people who return to the buffet line for more “free” food even though they are full (and are likely to feel a pang of guilt the following morning).

This phenomenon has been studied by psychologists and behavioral economists. Dan Ariely, who is both, and a frequent contributor to the Wall Street Journal, talks about an experiment he devised to measure the intoxicating power of free. In his book, Predictably Irrational, the Hidden Forces that Shape Our Decisions, Ariely describes an ingenious experiment involving the most common psychological guinea pig – college students. At the college dining hall checkout station, Ariel gave the students a choice of buying one of two chocolates. The first was a Lindt truffle, which he explains is one of the finest chocolates in the world, and the other was a Hershey’s Kiss, nice enough but nowhere near the quality of the truffle. Over the course of the experiment he changed the pricing of the two chocolates but kept the price difference constant. His results:

Scenerio             Price of                                                   Amount Sold
Lindt Truffle Hershey Kiss Lindt Truffle Hershey Kiss
A 15 cents 1 cent 73% 27%
B 14 cents 0 cent 31% 69%

Ariel repeated the experiment pricing the truffle at $.27, $.26 and $.25 and the kiss at two cents, one cent and free. Same result: with a constant 25 cent difference in price the more expensive truffle was greatly preferred until the price of the kiss was free, at which point the demand dramatically flip-flopped from the truffle to the kiss.

Ariel posits that one of the reasons for the phenomenon is that most transactions have both a clear upside (getting the chocolate) and a clear downside (parting with money), but when something is free we forget the downside (the cost of making the wrong choice).

Interesting, but what does this have to do with real estate?

Well, having a broker represent you as a tenant in your leasing transaction is free of charge. It is free because the landlord pays the tenant broker out of the commission pool created for the transaction. If the tenant is not represented, the listing agent simply gets the entire commission pool. Your tenant broker costs you nothing since he is paid out of funds that would otherwise go the building broker.

That’s great, tenant brokers are free. What’s the problem with free?

Well, as we saw with the college students in the above study, the problem is that our brains stop being discriminating in making a choice once an item (or service) is free. It’s like taking the coupon for the product that we don’t need or getting an extra plate of food. We sometimes grab it because it’s there, without thinking about the true cost.

As a result, when hiring a tenant rep broker there are two significant costs that can be incurred because of the irrational tug of being free:

  1. First, some people tend to be less selective in choosing a tenant broker because, after all, it costs them nothing. When choosing a lawyer, accountant or other professional most people look for someone who has the skill set and track record that can produce great results. Also, because these advisors come with different costs, they need to be selective in order to justify paying a premium for one or in demanding a discount from another.  Selecting a broker is often much less discriminating and sometimes comes down to who last called you soliciting your business or who you last played a round a golf with. Why not? It’s free. Of course the true cost of “free” is the cost of not choosing the best broker for your particular requirements. Choosing the wrong tenant broker can end up costing you big money on your lease deal.
  1. The second cost of a free broker is that some tenants tend to expect very little from their brokers because they are not paying for the service. Just show me some space, tell me some clever stories and make me feel good. How can I expect a lot of value from my broker – after all I am not paying them? While many companies expect their attorneys, accountants and consultants to be “smart”, “tenacious”, “creative” and “workaholics” given the large fees they pay them, they often accept much less from their brokers.  It’s enough that they are simply “nice guys”, who call them back promptly and “seem to know the market.”

Just because something is free doesn’t mean the decision comes without costs or ramifications. While picking a free Hershey’s Kiss over a more expensive chocolate isn’t going to change your life, picking the wrong broker may cost you a lot of money on your lease transaction.  The real estate market is far less efficient than the real estate industry would like you to believe and, as a result, who you choose to represent you can mean the difference between a bad deal and a very good one.

The next time you need to hire a broker, don’t let the siren song of “free” turn your brain off.  Hold your broker to the same standards that you expect of your attorneys, accountants and consultants.  If you do otherwise, you will get what you pay for.

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