With the record number of office buildings in Center City Philadelphia either being sold or currently being marketed, many tenants are wondering how the sale will impact them. While the change in ownership may appear to be a non issue for the tenant requiring only a change in where they send their monthly rent checks, imminent sales often create unique opportunities for tenants to obtain great lease deals.
There are basically two types of buyers in the marketplace. The first is an opportunity buyer who is generally looking to acquire properties that are in distress or otherwise have significant upside potential which the current owner has not or is unable to capitalize upon. They are bargain hunters looking to add value to an asset. By acquiring the asset at a good price, making some strategic capital investments, and perhaps deploying a new marketing strategy, these buyers hope to be able to drive up rents and occupancy rates to the point where they can then turn around and sell the asset it at a nice gain. Thus, a building with 25% vacancy and in need of a shiny new lobby and new restrooms might be attractive to these types of investors. Likewise, a failing, aging office building might present a great opportunity for an apartment redeveloper. Many of these buyers are private equity firms (often partnering with local developers) who have a three to seven year investment horizon. Because their funds need to wind up in the short to mid term, timing is very important to them.
The second type of buyer is really a financial buyer looking for current yield. These are typically not developers but rather large, institutional owners such as insurance companies, pension funds or wealthy individuals who are looking for safer, longer term investments that require less manipulation or repositioning of the asset. Thus, an office building which is 95% occupied with credit tenants under long term leases would be an ideal investment for these types of entities. These buyers price real estate much like bond investors price bonds: they look at the annual payments thrown off by the asset and price it based on the perceived risk. This type of buyer would generally prefer less vacancy in a potential investment building even at a lower rental rate as it is looking to mitigate risk and lock in certain returns.
Many of the financial buyers of Class A office product in the United States today are foreign investors. Faced with nominal or, in some cases, even negative returns on the sovereign debt of their home countries, these yield seekers are buying well tenanted U.S. office product at unleveraged returns of between five to seven percent in many cases.
What does all of this mean for tenants?
Assume you know that a quality, Class A office building just lost a major tenant thereby creating significant vacancy. You know that the owner is looking to sell the asset. Because the asset doesn’t really need a lot of new base building work and otherwise has a good tenant roster, it is likely that this building will not be sold to an opportunity investor (or the price will not be maximized that way). Because a financial buyer will pay more for the building if it has more cash flow, the landlord may well be motivated to provide aggressive economic terms to a good tenant in order to lease up the space quickly. Because each additional dollar of cash flow in effect gets multiplied when valuing the asset (Cash Flow/Cap Rate= Price), a landlord may care more about creating immediate, additional cash flow than holding out for higher rental rates. Note also that free rent can be a very valuable concession for the landlord especially if that free rent occurs before the sale takes place. A landlord can in effect reduce the tenant’s average rental cost using free rent and yet when it comes time for prospective buyers to value the building, the free rent (which has already burned off) will not negatively impact value.
Now assume you are interested in leasing a 50,000sf suburban office building that has been vacant for two years. You could go to the owner and try to strike a deal. However, they may not be willing to invest the additional capital necessary to do your lease deal because the asset is worth less than the existing debt or the rental rate doesn’t justify the additional investment. This could be an opportunity to partner with an opportunity investor. The investor would strike a deal with the owner (or lender if it has taken title to or control of the asset) to buy the asset in its current, vacant condition thereby getting it for a low price. At the same time, you strike your lease deal with them conditioned upon them obtaining the asset. Because they were able to purchase the asset at a bargain price AND because you eliminated the lease up risk for this investment, the buyer could offer a more aggressive rent number than would otherwise be the case. Likewise, assume an opportunity investor purchased an office building four years ago, repositioned it but the building is still 25% vacant. Knowing that the owner may need to sell the asset in the next two to three years under its fund documents, a quality tenant might be able to help the owner turn a bad investment into a very good one. By striking an aggressive deal with the tenant which eliminates the vacancy, it could significantly increase the asset’s value thereby resulting in a “win, win” outcome for both parties.
In assessing a tenant’s leverage, it is important to understand the landlord’s structure, needs and timing requirements. While there are many landlords who care most about maximizing rental rates above all else, that is not the case with every landlord and it is certainly not the case at all times. Sales (and even refinancings) can often provide unique opportunities for tenants to save the day and be rewarded for their commitment to a building.
For more information contact Glenn Blumenfeld