Innovation Is Hard

With the exception of the tech sector (where to innovate is to survive), big companies have a hard time being innovative. Why? Many reasons; but, most notably, the fact that true innovation is the enemy of the status quo. The status quo is a big company’s happy place. Innovation is messy and disruptive. It looks to upset the status quo in search of new, better ways. Most people don’t want change. This is why venture capital and startups exist. They aren’t afraid to “break it”, they’re designed to do so. The bigger the market a startup looks to disrupt, the more valuable it may be.

But some industries are difficult to disrupt from the outside. I think commercial real estate services is one such business. It’s a big target – a huge market. And it’s notoriously behind in these digital times. If you’re contemplating where to begin in your quest to disrupt the business, you have to start with the data. It’s everywhere, but it’s nuanced and not publicly recorded like data in the US housing market. So unless you’re inside the business, it’s really hard to get the data. The best source is large firms that are deeply engaged in the markets. There is a big opportunity to better aggregate, analyze and store data.

Beyond data, you have to isolate the focus to an individual market, since commercial real estate services covers a lot of distinct markets. Take office leasing, for example. Leasing an office is so complicated that it requires input from experts in multiple areas, including; legal, design, financial, markets (brokerage), construction, project management, etc. Big firms have distinct service lines that address many of these essential elements. The opportunity here is in how these essential services are organized and delivered to maximize their value while reducing friction in the customer journey.

For the past few years my partner and I have been working to innovate tenant services, specifically to create a technology platform with which to improve the visualization and management of data and services. We’ve done so from within one of the world’s largest commercial real estate firms, Cushman & Wakefield. Our work has resulted in the creation of something we call TenantSee. The platform is designed for mid-size companies having 250 – 7,000 employees. What’s cool about TenantSee is, for the time being, there’s nothing like it…anywhere. It has been incredibly rewarding (and hard) to innovate from within. But we’re proud of the collaboration with Cushman & Wakefield and the solutions we’ve created.

The Limited Value of a Handshake

People aren’t really shaking hands any more. Literally. And the figurative handshake has also seen better days, especially in the context of real estate transactions. To be sure, most office lease transactions are too complex to memorialize with a handshake. However, there’s a more practical factor at play that makes trust and commitment difficult. Specifically, until there’s a deal, there’s no deal.

The devil is in the details. When it comes to office leasing, it’s generally true that “grey area” favors the landlord. In other words, when the details are lacking, the landlord wins. In a shifting market where the leverage dynamic is moving away from landlords (San Francisco now), some landlords will look for ways to lull their tenants into letting time pass without committing to much, if anything. There’s strategic benefit. First, if the occupier has a favorable renewal option, the landlord will want to get past the outside date by which it can be exercised. That’s one less lever for the tenant. This also frees the landlord from a contractual obligation to the tenant, allowing them to market the space to 3rd party tenants and (potentially) create competition. Second, the closer the tenant gets to its lease expiration, the harder it becomes to negotiate a new transaction outside the building. Lastly, landlords being eternal optimists, they may believe the market will recover if they wait long enough (and depending on the circumstances, it may).

In practice, what are some of the ways landlords can slow play a negotiation? One is to simply say it’s too early to negotiate. This is usually accompanied by an explanation that it would not be “fair” to peg rent now, so far in advance of the lease expiration (fair to whom?). Another is by providing agreement to terms that are not fully understood by the tenant, for example, when a landlord offers to “turnkey” the space, either with or without a cap on its total cost exposure. Fundamentally, there is ALWAYS a cap. Landlords know how much it costs to build space in their buildings. Most tenants don’t. Hence a proposed cap may seem like a lot of money, but in reality it may fall well short of the actual cost. And when there is no cap, what usually happens is the planning and pricing get slow played such that discrepancies in what the tenant wants and what the landlord is actually willing to provide with the turnkey are revealed too late for the tenant to exercise the leverage created by a possible relocation.

There is nothing sinister about strategic negotiations. Each party should expect as much from the other. What we must watch for is disingenuous communication that creates the impression of a deal; when, in fact, the details are lacking - - - regardless of whether accompanied by a friendly handshake.

Lacking a Common Narrative

Markets are shaped by an ever-changing interplay of influential factors; including, supply, demand, human behavior, data and a collective narrative. In times of relative stability, market participants accept a prevailing collective narrative and the markets perform with a high degree of uniformity. Take, for example, the San Francisco office market of 2019. Characterized by strong tenant demand and limited supply, this market was not difficult to understand. The narrative, while beneficial to landlords and harmful to occupiers, was supported by data and participant behavior.

Over the past 3 decades, it has been my experience that markets generally settle on a narrative fairly quickly following significantly disruptive events. For example, while there was a moment in late 2000/early 2001 when landlords held fast to a false narrative the dotcom crash would not materially impact rental economics, the data quickly shaped a collective narrative of a market in steep decline. Usually, the data is so revealing that it forces collective agreement on the narrative. But here, two years into a global pandemic that has had significant impact on how we work, how we use office space, the San Francisco office market is lacking a collective narrative. The behavior of market participants is all over the map. You can find landlords that promote a confident narrative of a market in recovery, poised for material growth beginning now; and, you can find occupiers who believe the market is on the cusp of a long-term decline in which vacancy remains high and landlords are forced to substantially lower rental expectations to capture demand, which will be reduced from pre-pandemic levels.

The reason we lack agreement on a collective narrative is we lack good data. Specifically, we don’t yet know how the demand side of the equation will perform over the next several years as COVID has a lesser effect on behavior. Will occupiers lease less space, reflecting new workplace strategies that allow some or all of their employees to work remotely? Or, will companies lease more space in order to accommodate different uses that emphasize collaboration and flexible work spaces? Will we experience an interim period of reduced space needs, only to see increased needs as the center of gravity shifts back to the office?

There’s simply a lot we don’t know. The absence of hard data makes this environment uniquely difficult to navigate, causing participants to feel more comfortable with hedged bets, rather than going all in on a particular strategy. How does this look in practice? Messy. Mistakes will be made on both sides of the negotiating table. There will be a large spread between landlord and tenant expectations; and, in many cases, both sides will be able to put forth rationale arguments as to why their thesis is correct. But only time will tell. For the landlord whom creates an overly optimistic narrative, causing it to lose existing tenants because they believe they can achieve better rental economics than the tenant is willing to pay, depending upon the quality of the space and the building, this bet may prove high risk. Similarly, for the occupier whom passes on a great opportunity to restructure its lease expense now because they deem the required term commitment too long, favoring a short-term solution instead, they risk a less favorable future market dynamic, resulting in higher costs.

Over the course of 2022 and 2023, we expect the San Francisco market narrative to become more clear, enabling participants to more confidently place their bets. Meanwhile, we are operating in an environment in which we must be willing to question everything. For occupiers, this means stepping back from traditional thinking to fully assess how office space serves the company and to determine how best to go forward. The strategies will be more independent, less an expression of industry standards. To this end, tenant advisory services must include the provision of insights and data that help individual companies formulate their own market narrative. Those charged with making real estate decisions will do so without the cover of common market practices, requiring thoughtful planning and consideration to support the strategies they ultimately employ.

The Tension Between Quality Tenant Advisory Services and Commissions

The overwhelming practice in all major US Metro markets is for landlords to pay the tenant advisor’s fee. While it’s true the landlord cuts the check, the tenant is actually the payor, as leasing fees are built into the building operating budget and recouped by the landlord through rent in the same way other transaction costs are passed on to the tenant (like landlord-funded tenant improvements, free rent and other concessions). In past issues we’ve written about how this arrangement can create opacity, making it harder for tenants to align advisory fees with specific services. But this unorthodox arrangement can also create unusual negotiating dynamics where certain landlords look to leverage tenant confusion about leasing fees to cause the tenant to sign up for less favorable terms and/or to keep fees otherwise budgeted for the tenant’s advisor.

The classic example is when the landlord approaches an existing tenant and suggests it does not need an advisor and it can save money by negotiating directly with the landlord, since the landlord will not have to pay a leasing fee. This should always raise a red flag. Why? Let’s start with the premise the tenant can save money by not engaging an advisor. How? Or, said differently, how will the tenant know it’s saving money? In order to know, the tenant has to understand the full market dynamic, the available alternatives and the comparative structure of alternative transactions - - - it needs to know the value it could achieve from a properly leveraged market negotiation. Savings that equate to the value of the leasing fee would then be identified by taking the value of the fully leveraged transaction and deducting the fee. Only then has the tenant actually realized the promised savings. Importantly, the instance in which the tenant is negotiating directly, without advisory, by definition, reduces the level of knowledge it has about the market. What is the prevailing market trend in landlord-funded concessions for a similar tenancy? What if the trend is for landlords to fund $100/sf in tenant improvements, but your landlord is offering $20/sf? How do you account for the difference? What about free rent? What about expansion and contraction rights, or termination rights and other flexibility mechanisms you might build into the lease? How should you be thinking about your renewal option in comparison to the market and to negotiations you might have outside the option with the landlord? How should you use time to your advantage, when should you start?

The bottom line, the landlord whom claims they can provide an existing tenant with a “better” deal if they negotiate directly is being disingenuous, at best. More likely it’s a strategic ploy to create more value. On the other hand, it’s also important for tenants to understand that buildings owned in partnership (most) often have asset managers whom manage the assets on a contractual basis. These contracts nearly always have provisions for the payment of market-based leasing fees. However, they also may have carve out clauses that permit the asset manager to keep a larger portion (maybe all) of the leasing fees in the event a 3rd party broker is not involved. Hence there is a material incentive for some asset managers to at least try and dislodge the tenant from its advisor. In this case, not only will the tenant fail to capture the full benefit of its market leverage, it will also redistribute a fee that was otherwise budgeted for its advisor to the landlord’s asset manager. In other words, the tenant pays a fee, gets no advisory services and executes a more expensive lease than it otherwise should…not a good result.

In our practice, we refer to this type of landlord as “oppositional”. You might think we look to avoid oppositional landlords by steering our clients clear of their buildings, but we don’t. Why not? Because it may turn out the optimal leasing solution happens to be in such a building. It’s relatively easy to work around the oppositional landlord’s tactics. Our approach involves taking the fee off the table by transparently identifying the fee as a transaction cost for our client (the tenant). This does two things; 1) it puts the fee where it belongs, as a line item transaction cost to the tenant and 2) it eliminates the power of the fee as a lever for the landlord. Maybe the tenant is paying the leasing fee for a lease extension transaction at its existing building; whereas it would incur greater expense for moving and tenant improvement costs associated with other scenario we’ve negotiated. Or, maybe the cost of the fee is a material factor that renders the existing lease scenario less attractive compared to relocation. At the end of the day, we are driving total transparency of all appropriate leasing solutions so the client can make an excellent, informed decision. And, by the way, even when negotiating for our client to pay the fee directly, we can easily create solutions to mitigate its cost, for example, offsetting the fee with free rent. It’s important to remember that leasing fees are akin to the tail that wags the dog. For a typical 10,000 sf lease of 5 years in San Francisco, the market fee is $3/sf/year, or $150,000. With the market average starting rent at ~$74/sf, this 10,000 sf lease would be valued at about $4M. The fee represents 3.75% of the lease value. It is less than 2.5 months of rent.

As long as tenant advisory fees continue to be paid by the landlord, markets will have a small percentage of oppositional landlords who seek to create tension around the fee to enhance their negotiation position and, in some cases, keep the fees for themselves. Navigating this dynamic is easy when there is total transparency and clarity around the role of the tenant advisor, the services being provided and the value of market-based fees. Successful outcomes begin by having the right conversations with prospective advisors to understand how they define the relationship between their services and the fees they earn.