Why 95% Can Be a Failing Grade in Real Estate

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

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

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

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

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

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

So what’s the score?

chart_001

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

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

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

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

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

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We Need a Brand

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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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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