This, or That?
Negotiations are always about (or should always be about) this or that. There’s always something else, maybe that something else is nothing (as in sometimes the best thing to do is nothing at all). Decisions made without proper consideration of all relevant alternative scenarios are decisions made poorly. As important, in the context of office lease negotiations, the best negotiated outcomes are directly correlated to the extent to which we understand the alternatives of the landlord counterparty. This is a bit counter intuitive, allow us to explain.
For tenants looking to negotiate with an existing landlord in a rapidly declining market, the maximum value the tenant can achieve is a function of how close it can get to the landlord’s point of economic indifference. There is risk in every negotiation. In the landlord’s case, the risk lies in whether it can achieve a comparable or better outcome by allowing the tenant to vacate. This risk was highly mitigated in the frothy markets leading up to the pandemic. Today, for all but the most trophy buildings and the best spaces within such buildings, landlord risk has been significantly amplified. Indifference and risk look different to each type of landlord orientation (cash flow, future value, or REIT), but the base line math we do in identifying their risk is always the same and involves careful consideration of the landlord’s likely outcome if our client vacates the space.
We solve for the following variables to inform our view:
Downtime: The period from when our client vacates the space to when the landlord has a new tenant in place
Tenant Improvement Cost: The cost the landlord will incur to renovate the space for a new tenant
Free Rent: The value of market free rent concessions
Rental Rate
Term
Net effective rent (NER)
Capitalized Asset Value Impact
In our tenant advisory work, when seeking to negotiate an outcome in which the tenant stays in the existing building, we model the most market-aggressive value we believe is achievable (based on our assumptions for the landlord’s alternative scenario). We focus most on the NER implications (the landlord’s cash flow). Our objective is to find a landing place that, while substantially lower than that which a third-party, new tenant would pay in the open market still creates a positive NER variance for the landlord. Look at it like we’re negotiating for wholesale, not retail. If the landlord is heavily future value oriented (focused on juicing NOI for a future sale), they may not be willing to engage on these terms. But if they’re NER-focused (and the market is forcing most to get there), our approach should win every time.
Of course, it’s also true that we’re often able to create substantially better outcomes where the tenant relocates to new space. This is because the third-party landlord, who already has vacancy, is in a bidding posture, feeling the pain of the vacancy and more fully aware of the realities of the soft leasing environment. The existing landlord may, or may not, have fully realized these challenges (landlords are eternal optimists). Explaining our assumptions and creating buy-in with the landlord is among our greatest value to our clients. When we’re able to make the conversation about the alternatives, about what the landlord will face if our client vacates, and we’re able to reach relative agreement on these assumptions, we focus the negotiation on rationale data-backed solutions and reduce the chances of an emotional, uninformed reaction to our aggressive proposal. Be sure your advisor has the skills to identify the full landscape of optionality (on both sides of the deal), and knows how to put that information to good use in creating winning solutions.