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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