Essential Math

Office markets are big boats. They don’t turn quickly. There’s always a delay between negative macro-economic events and declines in rental economics. After all, it’s not as if landlords see the negative event and decide it’s time to lower rents. No, they resist. As long as possible. This creates a gap between where everyone knows the market is heading and where it is otherwise defined by comparable lease data. We’ve written in the past about how eventually a declining market reaches a point of broad capitulation when landlords are more unified at the bottom – this is when nearly all tenants benefit from the down market simply by showing up. The challenge facing occupiers whom are negotiating at the front end of the downturn is how to capture the full benefit of a decline that has yet to fully mature.

The key lies in using data to educate the landlord counter party as to its alternative outcomes in the event the tenant vacates the space. Comparison math is always a vital aspect of any good negotiation. But we need more than just the tenant’s view. We must also understand the landlord’s view, especially when the targeted outcome is pushing beyond the limits of where the landlord would otherwise transact. In the early-stages of a declining market, a successful negotiation will always push such boundaries.

The essential math is often referred to as “indifference math”. It’s about solving for the economic variables associated with a discounted lease extension that are low enough to reach the point at which the landlord is effectively indifferent to whether the tenant stays or vacates. Considerations include:

• Projected market rent for a new lease to a new tenant

• Projected landlord cost to provide market tenant improvements necessary to achieve the market rent

• Projected market term

• Projected free rent

• Projected downtime associated with the procurement of the new tenant

  • (e.g., the period of time vacancy of former tenant and rent commencement of new tenant)

• Potentially some calculus for credit differential between the former and new tenant

  • (this is relevant when the vacating tenant is strong credit such that the likely replacement tenant may present a downgrade in credit)

In modeling hypothetical landlord outcomes, we invite dialogue about our assumptions. If we can engage at that level (e.g., focus on what’s likely to happen if we vacate), we have a much better chance of capturing more of the downturn vs. transacting based on the most recent comps. In general, our clients whom are looking to extend leases require substantially less tenant improvements than new tenants and when extending the lease they enable the landlord to avoid downtime.

These 2 factors, alone, translate to big swings in value for the landlord. We find that we don’t often have much disagreement with the landlord about what we call the “full retail” value of their space (it’s just that we want our renewing client to pay wholesale). For example, let’s say they believe the space is worth $70/sf. We “agree” to that assumption, but we clarify that it’s the value a new tenant might be willing to pay for the space, including all the ancillary costs necessary to procure the new tenant (TI and downtime). Ultimately, a lease transaction is a basket of economic variables (term, tenant improvements, rent, concessions, downtime, etc.) which yield a total return. In today’s market, it’s entirely possible for a landlord to achieve a better return by offering an existing tenant a 10% to 20%+ discount to the value it otherwise believes it can achieve from a new tenant (full retail). If extending the existing tenant at a 20% discount to market creates a better yield and de-risks the future, why would the landlord not choose this option?

Landlords don’t want to see this math - - - sophisticated landlords have already done it. But still, what matters most is they know you know. To be sure, knowing the math doesn’t guarantee a favorable outcome. Both parties in a negotiation ultimately make their own calculations of risk and reward. Yet failure to negotiate with the benefit of this perspective often results in a less favorable outcome. When markets are declining, it’s tempting for occupiers to simply make lowball offers. Sometimes this approach succeeds, but it’s accidental. We’re all about creating the surest path to positive results, one that leverages our considerable data and knowledge of how landlords evaluate transactions to do the essential math.