The Negative Deal
Investors invest in office buildings to generate a positive return on their investment. Return is created in 2 primary ways, one is through ongoing profits generated from the individual leasing transactions completed within the project, and the other is through financing activities (taking on debt which allows the investor to pull equity from the investment or selling the asset). This TenantSee Weekly is focused on the first of these 2 scenarios, the one in which the landlord seeks to create positive cash flow through its leasing activities.
Market conditions have deteriorated so significantly that, in some cases, landlords face transaction outcomes which fail to generate positive cash flow, transactions which lose money – so called “negative deals”. Why would a landlord elect to spend heavily on a new transaction which ties up its space in a long-term lease only to lose money? The answer lies in understanding the alternative; specifically, what happens if the landlord chooses not to make the negative deal. When the market trajectory is like that which we’re currently experiencing in San Francisco, informed landlords recognize the value of their space is on the decline and securing new transactions will become more difficult over time, with available space sitting vacant for increasingly long periods of time. Hence, the “bird in hand” is indeed “worth two in the bush”. Of course, the scale of the loss matters. There is an inflection point at which it makes sense to not do the money losing deal, to wait for a better outcome.
As landlords struggle with negative deals, one thing they can do is endeavor to put themselves in a position to recover value through a future sale. Many will seek to preserve a higher base rent (or “face rate”) by loading the deal with concessions, a form of financial engineering. Here, despite having to give up on the objective of generating positive cash flow, they can hang on to the hope of a productive future sale, as the higher face rate will translate to a higher net operating income (“NOI”). NOI is capitalized to formulate a valuation. Cap rates vary based on a host of factors and market cycles. The lower the cap rate, the higher the value. For example, an asset having net operating income of $25/sf and selling for a 5 Cap is worth $500/sf.
Office investors presently face a generationally challenging environment in which they must choose the least undesirable outcome from a host of otherwise lousy choices. From the occupier perspective, it’s important to contemplate transaction values based on “market”, not on whether a given landlord is positioned to generate a positive return, given the market. The distressed landlord will argue it can’t offer anything further because to do so would result in a negative deal. But this does not mean this same landlord won’t go there. The market trajectory will not find an artificial floor based simply on landlord discomfort with losing money, just as rents rose from 2015 to 2020 irrespective of the occupier’s struggle to pay such rents. The market cares not for how it impacts its participants. Fear not the negative deal, as it just may be the key to a better future.