Meet WALT
WALT, or weighted average lease term, is an essential metric in the valuation of office buildings as it forecasts the stability of future cash flow. WALT was less important back when office markets like San Francisco were seeing aggressive year over year rent growth. Back then vacancy was worth more than leased space, the theory being a buyer could take advantage of vacant space to capture higher rent (necessary to justify inflated pricing which baked in aggressive rent growth assumptions). However, in the broader historical context of valuation, the idea that vacancy is worth more than occupancy is antithetical to defining value. Indeed, the more prevalent (and logical) approach to value hinges on the quality and duration of the net operating income. Of course, this approach is less sexy as it disables a seller’s capacity to “sell the dream”. The buyer is buying stability and yield, both of which are measurable going in.
Occupancy being more valuable than vacancy is good news for occupiers. To be sure, WALT is the catalyst that makes the early restructure transaction viable. It’s the reason a landlord will (and in many cases should) accept a near-term reduction in rent (despite remaining term on the lease) in exchange for additional term commitment on the back end. For example, let’s say an owner had a loan maturing in 3 years, the building is 30% vacant and the balance of the leases expire within 2.5 years. The anchor tenant’s lease (40% of the total space) is up in 2.5 years. Add to this a market that is over 30% vacant with rental economics trending down. This is a bad dynamic for the capital partners (landlord). Regardless of what they choose to do at loan maturation (sell or refinance), having more WALT will be valuable. Consider that existing tenants may be paying 30% or more above the current market value of their space. Adjusting the lease to market immediately and extending the term may be a winning scenario for both landlord and tenant.
While the near-term impact to the landlord’s cash flow can be significant, it is often less onerous than the outcome it would otherwise face if the occupier chose to vacate its space on expiration of the term. Understanding this risk is central to navigating the early restructure negotiation. When space goes vacant in a market like San Francisco, the first variable to consider is what we commonly refer to as down time. Down time is the period between when one tenant vacates, and another occupies. In San Francisco, it is now common for space to sit vacant for upwards of 24 months. On top of down time, landlords must also consider the capital required to secure a new lease. Typically, a new tenant will need to improve the space to suit its needs. The cost to build new space can easily exceed $200/sf. Finally, there is risk. This is a tough time to bet on positive future outcomes, a time when the bird in hand is truly worth 2 in the bush. The biggest risk is market trajectory, meaning what is going to happen to rental economics over the course of the remaining in place term. While adjusting to current market will feel lousy to the landlord, the future state may be significantly worse.
At the end of the day, occupier leverage creation necessitates a keen understanding of counter-party vulnerabilities. Understanding the value of WALT and its specific implications for your current landlord is a good place to begin to assess your opportunity for a favorable early restructure.