From Blend and Extend to End and Extend

The so called “blend and extend” deal structure has a number of applications, among them a scenario in which a landlord might account for a downward adjustment to a tenant’s rent by amortizing the value of the adjustment with interest into a new term.  Say, for example, a tenant has 3 years remaining on a lease and the market value for the space has dropped from $75/sf to $60/sf.  The landlord would adjust the rate to market ($60/sf) and spread the $15/sf differential over the new term.  If the interest rate were 8%, and the term 7-years, this would add $2.80/sf to the rent. 
 
These days, a new type of transaction has entered the market.  We call it the “End and Extend”.  This is when the landlord outright forgives the rent differential in exchange for extended term.  To be sure, landlords are (generally) slow to make this adjustment.  It does not feel good to forgive rent.  So why are they doing it?  Because it creates a better outcome than the alternative. 
 
The value of forgiven rent is a concession, no different than other concessions the landlord would have to make in negotiating a new lease for the space (e.g., if the existing tenant vacates).  Hence, this value should be thought of from the perspective of how it compares to the other concessions.  A $15/sf/year rent forgiveness over 3 years equates to a total concession of $45/sf.  When packaged with other market concessions, like free rent and (possibly tenant improvement allowance), the landlord is faced with a total cost to make the transaction. How does it compare?  Today, landlords face the prospect of significant downtime to market vacant space (this can be upwards of 2 years), and if they do new construction, it will be very expensive (tenant improvement allowances for new deals are often in the $150/sf+ range).  Indeed, the value of the forgiven rent (the “end”) may compare favorably to the alternative. 
 
The key to a successful End and Extend transaction lies in a strategic approach, informed by market knowledge.  If your lease rate is materially above market, and the space works well such that you would look favorably on extension, now may be the right time to consider the End and Extend.

Knowing Your When

We see a lot of confusion in the market around when to begin negotiations.  It’s not an insignificant consideration.  In fact, when you begin can make a huge difference in the outcome.  It’s understandable that tenants would not know when to start.  Brokers are not always keen to start at the right time, since compensation is derived by transacting and the closer the tenant is to lease expiration, the faster it will need to transact (and the fewer options it will have).  Good for the broker, bad for the tenant.  This creates a misalignment of interests that discourages thoughtful consultation on the front end – the more time a broker spends on a project, the lower the compensation.  On the other hand, brokers often market their services to tenants in ways that are decidedly more about getting attention than they are based on realistic solutions.  For example, a client of mine recently received a marketing email from a broker that detailed how the landlord was in trouble, having recently lost several tenants.  The project had mounting vacancy and a pending loan maturation -- common factors in the market today.  The message went on to suggest that now was an excellent time for my client to negotiate favorable terms with this distressed landlord.  Finally, there was a FOMO element in which the broker noted he has been meeting with and advising other tenants in the project.  The message was sufficiently interesting that my client forwarded it to me.  But here’s the thing, my client has 5 years remaining on its ~8,000 sf lease and the very circumstances the broker suggested as a catalyst for action are the exact reasons why the landlord will not be interested in engaging in talks to restructure the lease.  This landlord will focus on filling vacant space, not on lowering in-place rents on leased space.  These types of marketing campaigns can create a false narrative about leverage and cause tenants to engage in fruitless efforts to negotiate when there is no chance of success. 
 
Look, we’re the first to say that leases should be reviewed throughout the term, not just as they approach expiration. Business needs change.  So do markets.  In certain situations, the mid-term lease can be favorably modified.  Indeed, we’ve had excellent success recently negotiating restructure transactions which result in immediate reduction of the rent expense (along with other concessions) in exchange for term extension.  But there’s a lot to consider before undertaking these types of negotiations. 
 
There’s 2 ways tenants get timing wrong; too early, or too late.  Both are ineffective, but the former is less damaging as you can always reboot the dialogue later when the time is right, whereas in the case of the latter, you’ve lost your opportunity to create and exercise leverage.  We call the tenant who starts too early a  “LeverageLESS Tenant”.  Our term for the tenant who begins too late is “Captive Tenant”.  The LeverageLESS Tenant gets nowhere with the landlord, while the Captive Tenant’s negotiating efforts yield an outcome that is less favorable than the market would otherwise offer because they’ve failed to capture and exercise their leverage.
 
Understanding your “when” requires smart analysis.  We do so by building a financial model to underwrite the sweet spot between the market, the existing lease expiration, the unique landlord/lender motivations, and the specific leasing circumstances at the subject property.  Helping our clients identify their when is among the most important things we do as tenant advisors.  While we’re compensated the same as other brokers, we take a decidedly different approach by offering front end consultation that is not biased toward transacting.  In the end, while we miss out on quick-hit fee scenarios, our practice is more valuable because we deliver better results to each client.

Sweet Spot

How do you know when you’ve fully accessed market leverage in negotiating a lease extension?  It’s when you find the sweet spot, a place in which the economics of the potential relocation lease match the lowest value the existing landlord is willing to offer.  This is not a simple exercise of identifying the asking rents for alternative sites and asking the landlord to match.  No, instead, it’s a byproduct of a carefully orchestrated negotiation that involves 2 main elements: 
 

1. A multi-building negotiation with comparable buildings in which the tenancy is the subject of successive competitive bids by landlords seeking to win the deal.

2. A thorough analysis of the existing landlord’s cost/benefit in keeping the tenant at a steep discount to the “market” value it would otherwise achieve if securing a replacement tenant for the space.

 
The results of the competitive market process define the value for comparable space, while lending credibility to the possibility the tenant will choose to vacate the space -- an important consideration influencing how aggressive the existing landlord will be in the extension negotiations.
 
When sufficiently motivated by the competitive market process, the existing landlord will underwrite the cost/benefit of keeping its tenant compared to the alternative of finding a new tenant for the space.  Indeed, the negotiation with the existing landlord should center around the assumptions it is making about securing a new tenant.  These include the amount of time it will take to get the new tenant (downtime), the cost of tenant improvements required to secure the new tenant, and the rental rate it can achieve.  For example, a landlord might value its space at $75/sf when the value we’re pushing for on an extension if $55/sf.  Yet despite the big gap in rental rate, our $55/sf extension stands to generate as much (or even more) return for the landlord.  How is this possible?  Because of the market, specifically the amount of time it typically takes landlords to fill comparable vacancies, and the capital necessary to win a new tenant (tenant improvements).  These are material considerations, having significant negative impact on the landlord’s return.  A prudent landlord will accept a substantially reduced rental rate from the existing tenant because the lower rent extension generates more value and avoids risk. 
 
This is how we access and exercise market leverage.  It’s how we help our clients find the unique sweet spot that is the full market value of their tenancy, both in terms of its relocation options, and in terms of an extension of the existing lease. 

A Big Decline in Rents, Four Years in the Making

Throughout 2020, the prevailing sentiment among investors in the San Francisco office market was one of relative optimism.  After all, despite the fact tenants were prohibited from occupying their buildings, they continued to collect full rent.  The buildings were full, with vacancy hovering around 4%.  Sure, companies weren’t happy about paying for space they couldn’t use, but business was good.  In many cases the tech sector (which makes up most of San Francisco’s office occupancy) was booming due to an even greater reliance on and usage of tech caused by pandemic driven changes in how people were living.  Throughout the course of 2020 there was no reason for San Francisco investors to panic, as few (if any) office occupiers were showing signs of developing long-term hybrid or remote-first strategies.  Most were simply focused on solving for ongoing operations as a temporary reaction to the pandemic.  Yet early indicators did point to a future in which companies would be shedding office space, as some expiring leases were not replaced.  This, coupled with the addition of new supply, caused a big increase in vacancy to nearly 12% by year end.  Despite this large uptick, the brunt of the sluggish demand dynamic was being felt in the sublease markets, where rental economics more accurately reflected the true state of the market.  Despite a total closing of the office market in 2020, average asking rents ended the year off just 6% from the pre-pandemic high.
 
Early 2021 was characterized by optimism for the vaccine.  Office investors were preparing for the great return to office.  There was even a narrative that demand would increase as companies became more thoughtful about addressing health concerns, including shifting away from high density occupancy scenarios to provide workers with more space.  The vaccine came, but by winter a mutated version of the virus was once again surging, causing companies to delay return to office plans.  By the end of 2021 investors were quietly expressing concern at the growing sublease market amidst mounting evidence of companies demonstrating a lack of conviction to renew expiring leases -- often choosing to downsize and do short term extensions, reflecting ongoing uncertainty.  By year end, vacancy stood at over 18%, another large year over year increase.  Somehow defying gravity, average asking rents were off less than 4% from the prior year.
 
2022 was when the new narrative about office officially began to take over the market.  This is when it became clear that prolonged behavioral changes in how people work had become highly valuable to employees.  The tech sector was quick to embrace remote work, realizing how such policies could help them recruit and retain talent.  This is when office investors officially began sounding the alarm.  Macro-economic events were also beginning to shift negatively, including concerns over inflation, prompting the Fed to begin increasing interest rates in the summer of 2022.  By late 2022, companies had begun to throttle back, starting with freezes on aggressive new hiring campaigns, quickly followed by layoffs.  The year ended with piles of sublease space and a direct vacancy factor above 24%.  Yet, here again, average asking rents held relatively firm, down less than 50 basis points.
 
By 2023, the extent of investor and lender distress became widely known.  In the 2 years prior, investors and lenders favored the “extend and pretend” approach to addressing broken capital stacks, a strategy in which the parties agreed to muddle through for another couple of years, hoping the markets would (magically) shift in their favor.  By 2023, there was enough evidence of market destruction that public entities could no longer avoid marking to market.  Capital partners started getting realistic about their options, resulting in several asset sales that showed the scale of the damage – vacancy-challenged assets were worth less than 50% of the pre-pandemic value.  One would expect such a clear indicator of market value to trigger a big drop in rent, yet it didn’t.  Rates finished the year down about 5.5%.
 
Today, four years since the pandemic first changed how we use office space, average asking rents in San Francisco stand at $69.22, down about 13% from the historical high of $82.15.  How is it possible that rents have fallen so little while all other market indicators have moved so much?  New investors are valuing buildings at less than 50% of pre-pandemic values.  We’ve had 17 consecutive quarters of negative net absorption, and demand continues to be sluggish.  34% of the market is vacant and available, and there’s easily another 10% of space that could be available (and soon will be).  The slow and delayed decline in rents has been a function of several factors.  Firstly, the fact so many San Francisco office assets are/were held at a cost basis that could only support peak rent values.  These capital stack structures were built for continued rent growth, with limited margin for error.  Fundamentally, they simply can’t meet the market.  For a time, many have just sat on the sidelines, doing nothing.  There was no reason to lower rents since they would not be able to transact, in any case.  Second, its human nature to avoid that which is painful, to accept loss.  San Francisco was the darling of the office investment market in the decade running up to the pandemic.  Many very smart investors made big bets here.  It’s difficult to tell your investors you’ve lost all their money, natural to want to delay having to do so.  Also, given the healthy net operating income of many buildings at the onset of the downturn, it took time for market circumstances to translate to distress.  Lastly, a higher percentage of the leasing activity has been centered around the so called “flight to quality”, meaning the space being leased is premium space, a subset of the market that has outperformed all others, where rents are still at historic highs.  This has had the effect of pulling the average asking rent metric higher.  Collectively, these factors combined to create an artificial floor on rents.
 
Ultimately, rent values will be correlated with the supply/demand market dynamic.  We now anticipate bigger declines in asking and taking rent based on the reset of capital stacks through steeply discounted building sales.  Investors will have to either recapitalize their investment and choose to lease space at a loss based on the thesis that asset value will return at some future time provided the building maintains occupancy (a tough bet), or they’ll have to sell to give a new investor a lower cost basis and pathway to leasing success.  Either way, market demand, but for in the supply constrained premium space segment, will not continue to pay rents which are untethered from reality.  The market always finds its bottom. 

Thinking About Physical Spaces

I suspect most of us are caught off guard by change at scale.  When thinking about the pace of change over the last 15 years, it’s clear we’ve entered a new era, one in which technology is enabling us to rethink EVERYTHING.  Change in how we design and occupy physical space is inevitable.  The skyscraper boom began in the late 1800s and the product playbook in urban core office markets has remained mostly unchanged for decades.  Similarly, the ways in which the office product has been developed and owned, the investment thesis, has been largely unchanged in how it relies on capturing the best occupants in leases that reflect the highest possible pricing and the longest possible term to generate stable net operating income and bankable future value.
 
When I walk around downtown San Francisco today, I see ghosts of decades past.  It’s the early 1990s, I’m on California Street wearing a suit and tie, carrying a briefcase, like nearly all the other businessmen pushing their way along a crowded sidewalk.  The buildings I see all around me are home to the headquarters of companies like Chevron, McKesson, Bank of America, Wells Fargo, and others.  In terms of years, that wasn’t so long ago.  But when you think about it in terms of technology, it was generations ago.  We must accept the omnipresence of ever accelerating levels of change.  This isn’t just about the office markets.  It’s affecting all facets of how we live.  E-commerce continues to shift how/if we use physical spaces to buy goods.  Crypto and blockchain are changing currencies, reshaping how we transact.  Technology has changed the music and publishing industries, the ways in which we consume the products.  Change is EVERYWHERE.
 
Yet, it’s difficult to modify physical structures to keep pace with technology.  You can’t rewrite the code of an office building.  We’re in the early days of a new beginning for office, a time when someone is going to reinvent the product and get it (mostly) right.  We’re starting to see the characteristics of this new product emerge.  They include more flexibility, both in terms of the space itself and in how the customer engages with it (e.g., less long-term fixed lease obligations).  The financial structure, the ways in which investors finance and generate profit from the office product must change, as well.  The next gen office product will have these qualities.
 

• Well-located building, with excellent daylight and compelling outdoor spaces (maybe views)

• Amenities integrated into the building, including dining, bar, meeting spaces, recreation space, fitness, and spa facilities.

• Service staff

• Flexible spaces to accommodate a variety of uses, built to a high standard with high-end furniture, including the capacity to be rearranged on-demand.

• Availability to rent space on flexible terms, by the month or year.

• State-of-the-art technologies to enhance the occupier experience and enable the customer to access the product via app.

• Short-term residential offering integrated into the project.

 
Ultimately, the future of the office product will reflect a melding of many concepts.  It will have the serviced and flexibility aspects of coworking and hotel spaces.  It will be accessible via app, able to be arranged just like an Airbnb.  To be sure, the initial investment will be high, requiring deep pocketed, patient investors.  The product pricing will have to be expensive to generate ROI, but the customer should be willing to pay more for its quality, services, and flexibility. 
 
This is one way to fully embrace the changing needs of the customer, to meet them where they are.  Investors are beginning to play with changes around the margins, integrating new elements into their existing offering.  Yet so far, none have been bold enough to leap into the future to create something that does not currently exist.  But it’s the right time to do so.  What do you think? 

Bottom?

Have we hit bottom in the pricing of San Francisco office assets?  Maybe. 
 
The historical measures by which office buildings were valued, a function of capitalized net operating income, doesn’t apply to assets having large vacancy and limited weighted average lease term (“WALT”).  These assets are trading at a simple cost/sf metric.  Investors take a long-term view of the investment, betting the value for San Francisco office will, ultimately, recover.  They may or may not use debt to finance the acquisition – where there is limited occupancy, they may not be able to secure debt.
 
To determine the right price/sf, investors look to the quality of the building, its historical lease performance, its location, projected rental economics, necessary capital spending, and replacement cost (e.g., what it would cost to build new today).  Well located, vacancy challenged, older office inventory has generally been trading in the low to mid $200s/sf; values which are more than 70% less than they were prior to the pandemic.
 
While these values represent historical lows, depending on the asset, they don’t necessarily lead to success.  The investor is still making a bet on office amidst the backdrop of a market that is ~40% vacant.  Counterintuitively, the more assets that trade at these low levels, the more competitive the market becomes, making it harder to win deals based on offering the best rental economics.
 
We may be at a relative bottom, but the path forward for San Francisco office is still not clear.  Some assets may no longer have any value.  Only time will tell if these bets pay off for the investors.  In the meantime, occupiers will continue to enjoy the benefits of better deal terms.

Modern Workplace Planning: Solving for Experience Part VII: Design and Construction

One common mistake tenants and their advisors make when negotiating the office lease is failure to properly account for design and construction implications.  These are important considerations.  Space design plays a vital role in determining the efficacy of the space, how it translates in terms of value to the employees.  Construction is expensive, representing a material component of the tenant’s total occupancy cost.  Gaining understanding about design and construction at the right time in the transaction process provides useful data in the context of effective negotiations.
 
Design should begin once the purpose of the physical space has been determined (Part I).  The design steps are sequential.  Programming, then schematic design, followed by design development and finishing with construction drawings.  The purpose of the space informs design.  Today, purpose has been steadily shifting away from the provision of one-to-one physical spaces for employees to work, especially in hybrid or remote-first workplaces where a lot of the work is done from other places (e.g., home).  Instead, the physical space is increasingly about facilitating the types of interactions that can’t be accomplished as well through technology.  These include mentoring, collaborative teamwork, and culture-building activities. 
 
Programming is where the designer focuses on the ways in which the space will be utilized, breaking the use into groups, and detailing how many people the occupier seeks to accommodate by group, and which groups need to be next to each other.  The program is used for test fit plans with prospective buildings. The test fit is an important step in which each building under consideration is studied to see how well the floor plate accommodates the program. Floor plates vary not just by size, but also in terms of where the core is located (e.g., center vs. side core).  The best fit will result in a need for less space and provide the best flow. 
 
Next, the design phase advances with the top choice building(s) to schematic design. Here, the basic layout (wall configuration) is planned.  This phase often requires multiple rounds and discussion.
 
Design development is where detail is added to the schematic design.   These details include finishes for walls and floors, lighting, electrical needs, and reflected ceiling.  Advancing the plan to this level early enough allows us to gain valuable perspective on the cost to build.  Absent an understanding of the potential cost to build, tenants are forced to negotiate blindly, often settling for a tenant improvement allowance from the landlord, which is lower than the cost to build, leaving them exposed to a potentially large capital spend.  You can’t effectively negotiate for maximum value when you’re missing key information.
 
Alongside the advancement of the design, a good tenant process will include engagement with construction professionals who can illuminate the cost implications of the design and provide ongoing counsel regarding schedule.  Here, again, tenants often fail to timely engage construction professionals resulting in added project cost as they contend with expensive holdover scenarios and/or overtime costs to accelerate the completion of construction.  Construction consideration should be introduced to the project schedule from day one, meaning the schedule should be built backwards from the target occupancy date, giving appropriate time for development of construction drawings (the last phase of design), contractor bidding, contractor selection, permits, and construction.  These late-stage elements of the project are expensive and difficult to compress.  The timeline for strategic market engagement should thus be established sufficiently early to protect the later stages of the project.
 
The most important thing to know about modern workplace planning is that it requires full scope expertise, a team of professionals whose input is orchestrated in the right sequence to maximize value.  Among the key roles of the real estate advisor is to play quarterback in helping select, properly sequence, and engage this team.  The best tenant advisors have a holistic perspective that includes expertise and experience in all facets of the project. 

Modern Workplace Planning: Solving for Experience Part VI: Negotiating the Lease

Leases vary by building, by market, and by market circumstances.  In most major metros, when dealing with larger buildings, the lease document is sophisticated and complex, addressing a broad range of variables that will have a material impact on the occupier’s experience at the building, as well as its cost of occupancy.  If you’ve done a good job negotiating the letter of intent, you should begin the lease negotiation phase from a position of relative strength.  However, even when the letter of intent is fully maximized, there’s still a lot to negotiate in the lease.
 
Tenants are often turned off by a long lease document.  Yet we’d rather have a long, detailed lease that contemplates the full range of issues that can arise between landlord and tenant, because when the issues have not been properly clarified, it leaves the parties open to misunderstandings which can lead to problems.  Think of the lease as an operating manual for your tenancy.  It’s the place where you go to understand the rights and obligations of the parties.  Negotiating the lease should be a collaborative effort in which your real estate advisor works hand-in-glove with your real estate attorney.  Notice we specified “real estate” attorney.  Negotiating a real estate lease is a highly specialized undertaking, best accomplished by a real estate attorney whose practice is solely focused on this work.  General counsels, or other lawyers not well versed in the nuances and market specific dynamics of lease negotiations will simply not be able to capture all the appropriate value. 
 
A little about market fluctuation.  In tight real estate markets, like that of San Francisco in 2019, landlords aggressively protect their document, offering as few concessions as possible.  In these markets, the lease tends to afford the tenant less flexibility, less value.  In fact, landlords will reject otherwise reasonable arguments a tenant may make simply because they can.  Most office leases are drafted by the landlord.  The starting point is decidedly landlord favorable.  To be sure, there are law firms that have made a practice of continuing to advance new takes on lease concepts that favor the landlord.  When the markets permit, these firms win clients by advocating increasingly restrictive language that limits the occupier’s rights.  For example, in the pre-pandemic madness of the San Francisco market (4% vacancy),  a new take on subleasing emerged in which the tenant was precluded from subleasing its space at a discount to market, or, on terms that were less than those being achieved by the landlord in its direct leases.  This is a ridiculous position for any landlord to take, and nearly all landlords understand that subleases often transact at a discount to direct leases due to a host of factors, including limitations on term, and fewer concessions, to name a couple.  Just because the market has softened, do not expect the landlord to proactively offer a more favorable lease document.  Leases must be reviewed word by word with careful consideration given to each clause.
 
As with the negotiation of the letter of intent and all other phases of a good real estate process, there is a cadence to the lease negotiation.  The very first step is to establish a complete, consolidated redline document that accurately reflects the tenant’s full comments to the landlord’s proposed document.  Adding new items in the future will be seen as moving backwards in the negotiations.  Bear in mind, these documents are negotiated via a series of “trades”.  It’s a bit of “…we’ll give you this, but we need that”.  In our experience, the exercise of continuously trading drafts back and forth is not the best mechanism for achieving agreement.  After the initial draft and comments, we typically recommend one more turn, followed by a meeting in which the attorneys, principals, and real estate advisors can come together to discuss the open issues.  Competent real estate attorneys understand the market.  There is a dance that goes on in which the attorneys argue the issues back and forth.  Experienced attorneys (and real estate advisors) know the landlord and tenant arguments and the market-based resolutions that should be achievable. 
 
Lease issues fall into 2 main buckets; 1) real world stuff that will happen and needs to be understood, and 2) academic issues, which while potentially important, are highly unlikely to ever come to pass.  The most important aspects of an effective lease negotiation are the knowledge and communication skills of the advisors/lawyers.  The concepts addressed in the lease can easily be misunderstood, leading to protracted, unproductive negotiations.  When the parties sit together and express their concerns about the issues, we discover the concern may be misguided due to a lack of understanding and/or there is an easy solution.  But this level of communication is not achieved when the lawyers are merely trading the standard arguments back and forth via drafts.  We find that only the most experienced lawyers and advisors have enough knowledge to be creative.  Otherwise, they hold onto the textbook positions, making it harder to reach agreement.  Retaining a real estate attorney is therefore one of those moments when it makes sense to pay up for more experience.  It’s also important to have the experience be local.  A great real estate attorney in New York will be less effective at negotiating a San Francisco lease than a great, San Francisco-based real estate attorney because the markets do fluctuate and many elements of the lease relate to the local market norms and issues (e.g., earthquakes are a real factor in San Francisco, not so much in New York).
 
Getting the lease right, maximizing your position on all the important clauses addressed therein, is the last step in a great real estate process.  Mistakes at this critical juncture can materially impact what is often a long-term arrangement, and these mistakes can be very difficult to correct downstream. 

Modern Workplace Planning: Solving for Experience Part V: Negotiating the Letter of Intent

The letter of intent (“LOI”) is a non-binding document (although in unique circumstances they can be binding) which captures the terms and conditions upon which the parties have agreed and becomes the basis for a legally binding document (the lease).  The best LOIs are highly detailed and cover a wide range of topics from rental economics to flexibility mechanisms (like expansion, contraction, termination, and extension options) to operating expense inclusions and exclusions, and much more.  The occupier’s ability to include more items in the letter of intent varies somewhat by the circumstances of the market.  In tight markets like San Francisco circa 2019, landlords could get away with limiting the level of detail covered in the LOI.  Why would a landlord want to limit the LOI in this manner?  Because they gain leverage.  Most tenants don’t enter into the lease negotiation until late in their market process, meaning they’ve burned through a lot of the project schedule and will soon need to transition to design and construction in order to get the space ready on time.  In short, limiting the terms of the LOI is a way for the landlord to jam the tenant on timing, forcing them to be more conciliatory to preserve schedule.  In this current environment, nearly all tenants can enjoy the benefits of expanding the content of the LOI. 
 
It matters how you begin.  In soft markets (most urban center markets are now soft), the best way to begin is with a detailed Request for Proposal (“RFP”).  The RFP is vital as it does not commit the occupier to any specific positions, instead asking the landlord to respond with its specific position on a wide variety of topics.  Different landlords have different motivation to capture the tenancy.  Strategically, we always want our clients to negotiate with multiple landlords at the same time, creating a bidding dynamic in which the value achieved with each prospective lease outcome gets progressively better for the tenant as the negotiations unfold, round by round.  In some cases, the initial landlord proposal may be proforma, not reflecting a lot of movement off the quoted “asking economics”.  However, right out of the gate, some landlords may choose to get aggressive, offering terms we could not have predicted.  In distressed markets its difficult to predict how low someone will go, so why do so?  That’s the argument against beginning with an offer.  To be clear, the RFP must be thoughtful and detailed.  These discussions become sequential, with the expectation neither party will go backwards.  It’s thus harder to introduce new concepts into the negotiation downstream.  You want to get it all in there from moment one.
 
If the competitive set has been properly established, you will be evaluating comparable assets at incomparable pricing.  It’s our job to guide the negotiations such that we bring everyone down to the lowest common denominator.  After several rounds of negotiation, we often see relatively comparable value being offered.  But the key is to carefully measure and compare each unique offering such that you are capturing all the differences.  The best outcome is when the top choice site (which is typically the highest cost) concedes to meet terms which are otherwise associated with the lowest cost site.  How we communicate with counter party brokers is extremely important. For starters, we’re always truthful – strategies based on lies fail.  What we share and don’t share, the overall quality and consistency of our external communications helps shape the ways in which landlords respond.  Remember, landlords are very good at interpreting the market, in reading between the lines to get an advantage in the negotiation.  Seemingly small details can materially impact the quality of a landlord’s offer.  Too often, we see tenants and their advisors carelessly signal a desire to stay in the existing space, for example, causing the existing landlord to immediately scale back the level of concessions it would otherwise offer.  These mistakes can be costly.
 
Negotiating a great letter of intent is part art, part science.  Like the market process which comes before it, the LOI negotiation is a direct manifestation of the strategy – it’s where strategy goes from theory to action. 

Modern Workplace Planning: Solving for Experience Part IV: Implementing an Effective Market Process

You’ve identified the purpose behind your physical space needs, you’ve created a thorough project budget and schedule, and you’ve developed the right strategy.  It’s now time to implement a market process. 
 
What is “…a market process”?  In the context of office leasing, market process is how you engage the market.  It ties to your strategy, with sensitivity to the objectives you seek to accomplish.  The market is where you implement your strategy, where you take it from theory to reality. 
 
The first step of our market process is to create external messaging that aligns with your objectives.  These are the talking points we will communicate to the market.  One thing about urban commercial real estate markets, they have “big ears”.  You can count on your market activities being tracked carefully by all the real estate service firms.  This is a good thing.  Why?  Because we want our external market message to be absorbed, indeed repeated throughout the market. 
 
When an occupier is considering staying at an existing site, for example, they must also carefully consider alternative sites, even if their first objective is to stay.  By the way, it’s important for occupiers to be cautious not to reveal too much about their objectives as they interview prospective advisors, because you only hire one firm, and if you interview four, that means three firms you didn't hire now understand your objectives.  This information will quickly be communicated in the weekly market meetings all major service firms hold.  Firms track active market demand, and all the major firms have investor-side (landlord) practice groups.  It’s quite possible one of these firms also advises your landlord.  Hence, the individuals not hired are likely to report details about the occupier’s objectives (to the extent known) to the group.  This can harm leverage, for example, when the occupier shares that its primary goal is to extend the existing lease and that information gets to the landlord.  In this instance, the landlord will behave differently during the negotiations, making fewer concessions because they do not perceive as much threat of losing the tenant.  The most basic element of a good external market message is that it makes it more difficult for any one counter party to easily assess your objectives.  The goal is to put everyone on a level playing field in which they must compete fully for the tenancy.
 
Once the external messaging has been established, site selection begins.  Here, we identify alternative sites and set about conducting physical inspections of these sites.  This is a vital step in the process.  This activity also reverberates around the market, making the external messaging more credible.  The credible threat of losing the deal is the single most effective lever we have in accessing value.  The goal of the site selection process is to identify a short list of sites, all of which could potentially fulfill the objectives.  Importantly, this list must include more than just unique buildings.  It must also be comprised of the right owner motivation profiles and asset dynamics, those that will help drive value.  It’s important to understand the three distinct landlord motivations profiles, cash flow, future value, and REIT, in addition to being fully aware of the capital stack dynamics of each asset, as these variables will materially influence value creation.  By way of example, in today’s San Francisco office market, there are many assets that simply cannot transact at market due to debt and equity constraints.  Negotiating with these buildings will not yield a positive market outcome.     
 
Once the short list has been established, the negotiations can begin.  This is where we manage a bid process in which landlords bid for the tenancy.  We initiate this process with a request for proposal (“RFP”) in which we detail our client’s objectives and ask the landlords to provide specific responses to all the items included in our comprehensive RFP.  In today’s market, beginning with the RFP is a critical step because the market is so fractured, we can’t be certain how any landlord will respond.  Some may choose to begin the negotiations at levels we would not have otherwise anticipated. This is a multi-phase, offer/counter-offer process designed to extract increasing levels of value as the process evolves. 
 
The best market process is one that communicates relative indifference, one that keeps the counter parties on unsure footing.  It’s not about dishonesty, or subterfuge, it’s about providing a platform to access the full range of value each landlord is willing to provide.  The market process must be thoughtful, intentional, and properly managed.  These are the hallmarks of an effective market process. 

Modern Workplace Planning: Solving for Experience Part III: The Right Strategy

Once you’ve established the purpose of your physical workspace, and given careful thought to budget and schedule, it’s time to develop the right strategy. This is a vital step prior to market engagement. Good strategy is not always obvious.  At a minimum, any effective real estate strategy will include simultaneous assessment of multiple deal scenarios. Why would this matter? For starters, negotiation outcomes are not known.  At the beginning of the process, the favored outcome may be to stay in the existing space. However, as the process evolves over multiple rounds of negotiation, we often find that things change in ways that may cause the desired outcome to shift. For example, when the existing landlord offers terms that are materially less favorable than those achievable through relocation. 
 
Strategy is not about getting a deal done as quickly as possible. It’s about getting the right deal done at the right time. The right deal is the one that maximizes the desired outcome. The right strategy is a byproduct of having carefully considered the full spectrum of variables influencing outcome.  Take, for example, the concept of leverage. Leverage is multi-faceted. There is market leverage, which is the fundamental state of the occupier’s leverage in the market given the macro dynamic and assuming a good process. Today, occupier leverage is significantly higher than it has been in decades. Hence, tenants can expect to achieve more favorable outcomes. In soft markets, tenants can access a base level of leverage just by showing up. It doesn’t require strategy. But this base leverage only gets you so far, it leaves a lot of untapped value on the table. 
 
Accessing maximum value requires a much deeper knowledge. Things like the specific leverage dynamic within each asset. Each building is comprised of a capital stack (equity and debt), leasing risk based on current vacancy and upcoming expirations, and ownership motivations. Thus, notwithstanding the broader market dynamic, each building is uniquely positioned to compete for your tenancy. And that’s the right way to think about it…competition. Our strategic approach is about managing a multi-round bidding process in which landlords compete by offering ever more favorable terms to capture your tenancy. Given how significantly domestic office markets have shifted from tight to soft over the past 4 years, we often find capital stack distress. This is when, for example, the original equity has been wiped out and the value of the loan may or may not be on par with the asset’s market value. It’s no exaggeration that upwards of 40%+ of the assets in a market like San Francisco are experiencing some level of capital stack distress. Some of these buildings are in a state of limbo in which they’re not actionable because the only lease scenarios they can offer are significantly above the current market. A poorly designed strategy would be one which fails to recognize this fact, one in which valuable schedule is wasted on the inclusion of non-actionable negotiations. Furthermore, when we think about owner motivation profiles, we look to categorize the landlord into one of three basic categories, including, future value, cash flow, or REIT. Each type behaves differently, negotiates differently.  It’s critical to understand counterparty motivations.
 
The building stack or the status of the existing tenancy, is also a valuable datapoint.  A building that is currently showing as 90% leased may, in fact, have sizable lease rollover falling within the time frame of your negotiation, which translates to risk. Risk is one of the key components in leverage creation.  The more risk a landlord faces, the more value we can extract.
 
When we know the desired outcome, we can build custom strategies to get there. It’s a simple concept.  The complexity lies in building the strategy, in gathering and interpreting the right data to inform strategy.  As with all parts in this series, each is sequential. You can identify your purpose, establish budget and timeline, but absent the right strategy, you will still fall short of optimizing the outcome. Think of your advisory partner as a strategic consultant, not a “space finder”. Most brokers can find space options. Only the best possess the skills and experience to build the right strategy.

Modern Workplace Planning: Solving for Experience Part II: Budget and Schedule

Last week we established the importance of defining “the purpose” behind your workplace, especially those elements of the workplace which are expressed through physical spaces.  This is the first (and vitally important) step companies must take before they begin a real estate process (e.g., the process of acquiring space).  Once established, the next step is to think carefully about budget and schedule.  These considerations, much like the discussion of purpose, are greatly aided by working closely with your real estate advisor.  Here, again, companies must shift how they think about the engagement of real estate advisory services.  Having the right real estate partner on board from the very beginning facilitates access to critical data and insights.  The process of properly defining the budget and schedule are both areas in which the advisor can play a key role. 
 
Establishing a budget before market engagement is important for several reasons.  Firstly, a good budget will detail a range of total occupancy cost outcomes (low to high), comprised of estimated costs for each facet of the project, including the following:
 

• cost of consultants (architects, contractors, brokers, lawyers, etc.)

• cost of space (range, low to high based on broker-provided market data)

• cost of FF&E

• other related costs (AV, Security, Move, IT)

• cost for tenant improvements

 
As we’ve noted previously, the right approach to the workplace requires input from leaders in all key segments of the business.  The objective is to establish agreement on the projected outcome up front so that when we go to market, we have the clarity to execute cleanly, to avoid misfiring on important financial aspects of the mission and having to backtrack.  Believe it or not, we see this happen time and again.  One of the most common mistakes companies make is the failure to bring everyone to the table, day one.  In particular (and this is a “head scratcher”), they fail to fully consider the financial implications of acquiring physical space (cash, balance sheet, P&L).  Companies always have financial priorities.  For example, a company may be preserving cash to fund acquisitions and therefore be sensitive to real estate transactions requiring a lot of cash.  Or maybe the finance team is primarily focused on EBIDTA because they’re preparing to sell the company and valuation is a multiple of EBITDA.  Real estate solutions can be tailored to meet virtually any essential financial outcome, but the parameters must be known in advance.  

Getting the schedule right adds significant value to the overall project, as execution is either enhanced or constrained by schedule.  Most real estate projects are sensitive to the exercise of market leverage, a dynamic that fluctuates with the passage of time.  This graph shows how leverage declines over time.  To ensure full access to market leverage, terms must be negotiated during the optimum window.  When working from a future lease expiration date, for example, the project schedule must be established such that ample time is given to the consulting, market engagement, lease negotiation, design, and construction phases.  The design and construction phases are limited as to how much they can be accelerated, and the cost of such acceleration is high.  Hence, those aspects of the schedule are more fixed.  When too little time is allocated to the schedule, market engagement and negotiation are the 2 areas which suffer the most.  Compromising these phases of the schedule results in lost value.   You must do all you can to provide adequate time for these phases to play out.  The schedule is provided by the broker-partner at the very beginning of the project, with full consideration of strategy and the market dynamic.

Establishing the right budget and schedule is the 2nd topic of our 7-part series, Modern Workplace Planning:  Solving for Experience.  Next week, be on the lookout for Part III:  The Right Strategy. 

Modern Workplace Planning: Solving for Experience Part I: The Purpose

A Seven Part Series brought to you by TenantSee, powered by Cushman & Wakefield

In the years leading up to the pandemic, most medium and small companies defined their office space need based on headcount (current and projected), space programming, and industry/sector norms.  The exercise was mostly formulaic.  The primary differences in the offices of a small, regional law firm compared to those of an AM Law 100 firm would be scale, the cost of finishes, and the quality of the building and views.  It was planning for the same outcome, just at different levels on the cost spectrum.  Companies having a larger portfolio of offices would typically create a “workplace strategy” that included guidelines around programming (e.g., space layout, office size, critical adjacencies, growth factor, finishes, FF&E, etc.).  These guidelines could then be used to inform the real estate process across geography.
 
Today, defining the physical workplace starts by asking a simple question:  Why do we need a physical workplace?  There is a spectrum of workplace solutions, with the extremes being fully remote to fully in-office.  How each company determines its place on this spectrum is a highly individualistic undertaking, requiring key stakeholders to identify the experiences they seek to promote and consider how best to facilitate such experiences.   It requires a deep understanding of how the workplace supports the core values and most important objectives of the organization.  Importantly, whatever the workplace strategy, to be effective it must be fully aligned.  Approaches to workplace which are disconnected to the organization’s behavioral reality will be ineffective and harmful (e.g., leadership favors those fully in-office despite purporting to support hybrid).  There is no more “safety in numbers” where executives can hide behind the industry trend. 
 
The shift to individualized planning is not easy to process.  It has left many medium and smaller companies uncertain how to proceed.  They’re concerned about spending too much capital on physical space solutions that may prove insufficient due to continued changes in how we work.  They have fractured belief systems in which leadership operates one way while the employees prefer another.  They often take a “hedged” approach, resulting in garbled messaging, missed opportunities, and broad-scale discontent.  Leadership must take care to avoid supporting their chosen strategy with empty logic.  The classic example being “…we’re more productive in the office”.  If this is true, provide the data.  If it’s an unsubstantiated argument selected because it seems like the right thing to say, it will ring hollow and cause harm.  Remember, too, it’s a fact that most of the tasks of white-collar work can now be done from anywhere. 
 
The experiences you’re solving for with the modern workplace are those which involve human interactions which are not filtered by technology.  These include mentorship, collaboration, client-facing activities, and culture building activities.  Even remote-first companies create physical space for these activities, they just don’t (necessarily) view the office as the most effective place.  For a great example of the kind of intentionality and consistent messaging essential to an effective workplace strategy in this changed world, listen to David Solomon, CEO Goldman Sachs. He talks about the invaluable human networks Goldman Sachs builds through its offices.  These networks are vital to the firm’s success, part of its secret sauce.  Yes, there’s certainly employees at Goldman Sachs that don’t want to be fully in-office.  It’s a free market and they have a choice.  Importantly, Goldman’s leadership has clarity on their “why” and they communicate it consistently throughout the organization.  Those who determine working from home is worth more than being part of Goldman Sachs are free to do so.  In the end, leadership must determine which employee experiences it seeks to promote and facilitate and which approach to workplace best accomplishes the desired outcomes.  It’s about creating experiences.
 
What are some other considerations that go into defining the modern workplace?  Many.  For starters, it’s important to think about employee demographics.  Where do you find your ideal employee?  In which geographic region(s) are these employees most concentrated?  Do you believe in a fully distributed model, enabling the firm to hire from anywhere?  What are the implications of managing your workforce, given the range of approaches, local to fully distributed?  What are the cost and competitive implications of varied workforce outcomes?   It’s only recently that technology has allowed companies to migrate their white-collar workforce from local to global.  Who you plan to hire should drive how you think about your workplace. 
 
Once you’ve determined which experiences are being facilitated within your physical space(s), you must consider how frequently these experiences should occur.  This will guide you toward understanding where you sit on the spectrum, from remote to in-office, or somewhere in between.  Many companies have adopted hybrid solutions.  But these must be contemplated beyond just which days people should be in the office.  Purpose matters.  If your plan is to force employees to the office X days per week just to have them perform the same tasks they can perform from anywhere, why?  How should your physical space be designed to maximize its value in promoting the critical experiences?  What layout?  How much space?  What technologies must be incorporated?  What other aspects of the physical environment matter?  Things like location (proximity to transit and amenities), quality of building, FF&E, and natural light/views must be given careful consideration.
 
With the benefit of full consideration, most modern physical space solutions will look decidedly different than they did pre-pandemic.  How?  For starters, companies usually need less space because they’re designing for purpose, not headcount.  Design changes are also common.  Things like fewer private offices, more collaboration space, better client-facing spaces, and advanced technologies, including Zoom rooms and conferencing spaces built to facilitate both virtual and in-person meetings (simultaneously).  In many cases, companies will trade up for higher quality buildings offering more amenities, like restaurants, retail, and fitness facilities.  In fact, while the amount of space leased goes down, it’s often true the cost goes up. 
 
Who should be involved in these initial planning activities?   Executives from finance, people, real estate, and operations.  Indeed, determining the workplace strategy is among the executives’ highest value activities.  Real estate service providers like Cushman & Wakefield have already shifted their strategic workplace consulting practices to meet the demands of the modern workplace.  We draw from a large body of global client engagements to help guide clients through the planning journey.  The purpose.  This is where you begin.

Where Does It Hurt?

Office lease negotiations typically cause pain for one party because leverage is rarely balanced such that the outcome is a true win/win.  Sure, the actual winner will suggest the other party also won (after all, they got the deal), but sometimes winning feels a lot like losing.  That’s OK.  Markets ebb and flow.  What matters is that you know how you’re hurting the other party.
 
Successful negotiations evolve from awareness.  It’s rarely about dictating terms. Ego, pride, ignorance, and poor communication limit the pathway to success.  The “table pounder” can only be effective when the counterparty has no option but to deal with him.  Even still, a one-way negotiation misses opportunities to create a better outcome.  It’s through learning what matters to the other (and why) that we can advance the negotiation more effectively.   It’s also important to take a fact-based approach to the market.  Conjecture and hyperbole have no place in a well-structured negotiation. 
 
Over the years, I’ve come to identify a handful of negotiation styles.  Perhaps the worst of these is the decision-making executive who has not participated in any of the negotiations but who maintains final approval rights, and always takes the approach that whatever has been negotiated, there’s at least 15% more value to be extracted.  When negotiating on behalf of a well-known financial firm I encountered this very character.  We had been negotiating for months and arrived at a term sheet that was deemed acceptable by all parties, but which needed to be approved by the CEO.  Sure enough, he wasted no time tearing apart the terms, all while providing some colorful (and unsolicited) commentary on our negotiating skills.  I listened, waiting for an opportunity to tactfully counter his tirade (he was also a speaker phone screamer).  Thankfully, my moment came in the form of an unexpected gift when he revealed that he had recently had lunch with a CEO friend whose firm had completed a lease in the same project in which our (fast collapsing) deal had been negotiated, but on terms that were substantially more favorable.  This was his basis for ripping up our term sheet.  Well, it just so happened, the deal he referenced was one I negotiated.  Let’s just say the terms he described were wildly inaccurate.  In this moment, my credibility having been significantly upgraded, I was able to regain control of the narrative and talk the CEO off the cliff.  A rare stroke of luck, for sure.  But absent such luck, there would have been very little to do but attempt to re-trade the terms, very likely killing the deal.
 
Each party has limits to what it will do, to what it can do.  Years ago, this time I was on the landlord side of the table, I was representing a building in which the anchor tenant’s lease was expiring.  Market conditions favored the occupier, and we went into the negotiations knowing we had a lot at stake.  The tenant was being advised by one of the top brokers at a top-tier firm.  A meeting was set in which the tenant’s advisors came to present their proposal.  It was painful, very painful.  In fact, it was so bad, my colleague (my boss) quickly began scratching numbers on a sheet of paper (the tenant’s advisors had spreadsheets, we used a Bic pen and a calculator).  After about 3 minutes of silence, my boss looked up from his chicken scratch and said, “…based on your proposal, we’d be better off boarding up the building for the next 5 years”.  He was right.  The tenant’s advisors had taken their leverage too far.  The proposal did not reflect the facts of the market, nor was it remotely tethered to a reality in which any landlord could reasonably act.  It was a true non-starter. 
 
Today, most occupiers in San Francisco enjoy historically strong leverage.  It’s a welcome shift from having endured the opposite dynamic for the better part 2 decades preceding the pandemic.  This is your moment to create long-term value.  But know how you’re hurting the landlord.   There’s pain that hurts and there’s death.  You want to keep your landlord alive.  Your rightful exercise of the full market leverage to which you are entitled will hurt.  But be sure to leave them capable of performing, of providing a great product for your occupancy experience.

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.

The Office as Hotel

I participate in a lot of “conversations” on LinkedIn in which people argue that office buildings should be as flexible as hotels.   I love to explore the possibilities, the idea the office can be something different, something better.  But sometimes these conversations are so detached from reality it makes my head hurt.
 
There was a time when office buildings were more like hotels.  A time when the investment thesis and the financial structure were decidedly different than today.  Take The Russ Building, for example.  A San Francisco landmark, The Russ Building was built in 1927.  It was the tallest building west of Chicago for 30 years.  When I first came to San Francisco in the late 1980s, portions of The Russ Building interiors were still as they were decades earlier.  Floors were pre-built with offices.  These offices were individual rooms, accessed via a door off the common corridor.  What’s more, there was another door inside the office connecting it to the adjoining office.  If an occupier wanted to expand, they could simply open the door and rent the office next door. The set up was anything but custom.  To me, this is one of the design issues with short-term solutions, the fixed design may not fit the purpose.  We don’t get to design our hotel room.
 
The bigger issue, however, is one of economics.  It cost a lot of money to construct buildings and spaces.  This is among the economic realities which push office landlords to seek long-term commitments (this and others).  If a landlord builds a speculative office space (many are), they can choose to be more flexible in how they lease the space, meaning they can do shorter-term leases.  They do their best to anticipate the needs of the customer, to ensure their spend will result in a space that has lasting value for multiple users (much like a hotel room).  But most landlords are constrained in how much they can deploy this approach.  Indeed, they’re necessarily limited to a small portion of the building’s leasable space.  Why?  Because of the financial structure underpinning the office investment.  In most cases, the landlord and its partners are investing not in perpetuity, but rather, for the purpose of achieving a certain return objective within specific time parameters.  Further, they usually have lenders who lend based on variables like WALT (weighted average lease term), NOI (net operating income), CAP Rates, DCRs (debt coverage ratios), and tenant credit.  None of these masters is served by short-term leasing.  Sure, you could look at the aggregate NOI created from short-term flex leases over a comparable period to determine if it generates less, equal, or more income.  It should result in more because it’s riskier.  Occupiers should be willing to pay more for the flexibility of not being locked into a long-term lease (they’re usually willing to do so).  But even if the case can be made for more income over a comparable period, the structure is fundamentally not financeable. 
 
I believe the office market will continue to offer an increasing supply of flexible leasing options.  Sometimes this will be curated and run by the landlord, directly (Tishman Speyer is doing this well). Other times, landlords will hire a third-party operator.  Flex options will be good for the market, but they’re unlikely to account for more than 20%.  It will remain important, even more so now, for companies to create spaces that are custom designed to facilitate fulfillment of the specific purposes for which they have an office.  This is not “one size fits all”.  Hotels are hotels and offices are offices. 

Successful Negotiating Strategies for Office Tenants

Many business executives know how to negotiate.  Indeed, it’s a vital skillset essential to advancement in nearly all careers.  But not all negotiations are equal.  Negotiating leases on behalf of office tenants, for example, is a specialized undertaking.  As with all negotiations, successful tenant lease negotiations are highly correlated with understanding the motivations of the counterparty.  This means knowing everything about the landlord, including the equity and debt positions, the investment thesis, the leasing dynamic at the building (vacancy, lease rollover, etc.), the value of any recently completed comparable lease transactions in the building and in the market, and the overall market dynamic.  These factors are fundamental to assessing leverage.  Yet even when these basic elements are in place, the act of exercising leverage also requires special skills. 
 
The best tenant advisors are highly skilled at constructing value propositions that bring the landlord as close to indifference as possible.  What does this mean?  It means the landlord has reached the point at which it is becoming indifferent to whether it completes the proposed transaction, or not.  That’s when you know you’ve extracted as much value as you can from that particular landlord, given a set of specific market circumstances.  Good tenant negotiations must always be sensitive to the alternatives, both from the perspective of the landlord and the tenant.  Understanding these alternatives, coupled with deep knowledge of the counterparty motivations, is where great tenant advisory begins.  When you cross the line beyond which the landlord can achieve a better result by not doing your deal, you’ve pushed too far.  However, it’s also true (especially today) that the capital structure of a given asset (remember, you’re not negotiating against a building, or even people, as much as a set of financial realities) may preclude the landlord from doing what it would otherwise need to do to offer a competitive proposal -- to prevent the tenant from choosing another building.  It’s often the case the tenant is willing to pay more to be in its top choice building.  The best negotiations are set up so that lower valued buildings drag down the value of the top choice building.   In other words, the top choice landlord is forced to compete with other landlords offering more compelling economics to the tenant.  This, too, is a skill-based exercise in that advisors must be credible in their approach.  Bluffing, or endeavoring to lower values of one type of asset by leveraging that which can be achieved in a non-comparable asset, for example, is rarely effective.  Excellent communication is essential.  When tenant advisors take a “black box” approach, they’re far less likely to get the other side to show material movement.  Why?  Because people don’t respond well to empty threats or bluffing.  On the other hand, people take effective action when dealing with facts.  The tenant broker who tells the landlord her client can move and save $2m dollars without any supporting data will be much less effective than the broker who shows the landlord specific examples of how it can achieve such savings and provides market-based analytics as to why it’s in the landlord’s best interest to match those economics (e.g., shows sensitivity to and awareness of the landlord’s alternatives).
 
We often find that executives underestimate the complexities of constructing an effective tenant negotiation.  Perhaps our industry is to blame, as many brokers lack the resources, knowledge, and skills to employ the strategies noted above, causing executives to suspect the whole lot of us as being relatively unskilled.  We’re not.  The best tenant advisors help their clients navigate markets through a consistent, replicable process.  Not surprisingly, the efficacy of their approach makes them more credible with landlord counterparties.  Remember, a good tenant advisor will sit across the negotiating table from the same landlords many times in her career.  Those who advocate strongly for their client using fact-based, high integrity negotiating strategies will be respected and consistently create more value.  When choosing a tenant advisor, take the time to understand the strategies they propose to employ in achieving your objectives.  It makes all the difference.

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. 

Conflict in Tenant Advisory

Years ago, I was a partner at The Staubach Company, one of the industry’s most prominent tenant-only advisory firms.  The Staubach Company was a highly ethical business, full of skilled tenant advisors.  One of the firm’s core value propositions was that its advisory services were free of conflict.  The conflict narrative is powerful in how it seemingly separates the conflict-free advisor from most other brokerage firms which serve both occupiers and landlords.  Tenant-only firms often differentiate themselves with statements like, “…when you hire us, you never have to be concerned that we’re beholden to a landlord who pays us millions of dollars each year in fees”;  or “…we fight harder for you because we’re not concerned about our relationship with the landlord”.  To the unknowing audience, these statements can make it seem that all so-called “full-service” firms (those with diverse practices) are incapable of providing ethical, conflict-free occupier advisory services.  When you consider the spectrum of tenant-only firms is very small, as a sales tactic, this is a brilliant approach in that it significantly narrows the competitive landscape, making it more probably the tenant-only firm will be hired. 
 
But as with most marketing approaches, the argument for tenant-only firms is more fiction than reality.  For starters, there are numerous types of conflict.  The conflict tenant-only firms want you to focus on is the one in which the full-service firm may be advising the landlord, as well as representing the interests of the tenant - - - so called “Dual Agency”.  It’s important to note that within most full-service brokerage firms, practice groups consist of brokers who focus mostly on advising clients on one side of the table.  For example, those in the landlord practice group are generally not doing a lot of tenant advisory work, and those who advise tenants don’t usually represent landlords.  In any case, the provision of services, when properly engaged, is the subject of a working agreement which delineates the fiduciary obligations of the advisor (regardless of which side of the table she sits on).  What’s more, the Dual Agency conflict has been the subject of much industry regulation, including disclosure requirements.  In other words, there is a bright light on the potential for Dual Agency related conflict.  What’s less apparent is a type of conflict that is not regulated, one which can ultimately do far more damage than Dual Agency.  This is when the tenant advisor represents 2 companies, each of whom is focused on the same space.  Without disclosure, you’d likely not know that you lost your top-choice space to another tenant who was also advised by your advisor.  Conflict can manifest in a variety of ways, not all of which are apparent.
 
In addition to hyping one form of conflict to the exclusion of others, tenant-only firms often push the conflict narrative because it distracts from some very important deficiencies which are inherent to the tenant-only model.  Good advisory is ultimately about accessing vital data and knowing how to use it.  Negotiating optimal outcomes for the tenant client requires deep knowledge of the market, including market research, information about the capital stack (debt/equity), which tenants are active in the market, the value of transactions being completed in the market, and the motivational profile of each landlord.  Tenant-only firms lack critical resources from which these data sets are gathered and accessed, whereas the best tenant brokers working within full-service firms draw from the various practice groups within the firm to advise their tenant clients.  When you don’t know, you don’t know.  Tenant-only firms try to cobble together the data, but they operate at a significant disadvantage.  These deficiencies can translate to materially less value for the tenant client.  For example, when you don’t know the landlord just completed a transaction in the building for 20% less than the value being offered to you.  Or, when the landlord defaults by failing to fund the tenant improvement allowance due to its failing equity position in the asset, something a broker with access to a capital market practice would have been able to readily identify (and avoid).  To be sure, client exposure caused by the limitations of the tenant-only model is substantially more consequential than the conflict issue on which these firms base their value. 
 
Understanding conflict, in all its manifestations, is important.  But it’s also critical to assess advisors from the perspective of the full scope of services they provide, and to understand how these services are structured and informed.  In other words, look at the full picture and be wary of fear-based selling which strives to cast doubt on the ethics of others, while distracting from full consideration of the essential elements to good advisory.

A Case for San Francisco

San Francisco. 49 square miles hugged tightly by the ocean and the bay. Her raw beauty is matched only by the raw ambition of her people.

Breathtaking views at every turn. Iconic bridges span the water. The Golden Gate, regal in its vermilion splendor, and The Bay Bridge, San Francisco’s steady workhorse.

Stroll down 2nd Street to Oracle Park or catch the Warriors at Chase Center. Cruise the streets in a driverless Waymo, sipping artisan coffee. Each moment here is defined by style, spontaneity, and a unique sense of place.

San Francisco’s architecture is stunning. It includes the greatest concentration of Victorian homes in the U.S. This is a city bold enough to build for beauty rather than just function. Edwardians, modern marvels, converted warehouses, and daring designs stand shoulder to shoulder in proud defiance of the ordinary.

Her people are diverse and worldly, fostering an incredible array of global cuisine. Brilliance gathers, fueled by proximity to Stanford and UC Berkeley, igniting a powerful tech ecosystem and abundant venture capital. Ideas spark, and dreams become reality.

The fog, always quietly lurking, sneaking its way under the Golden Gate and over the hills, cooling some neighborhoods while leaving others sunny and warm. The average temperature is 62.5˚ F. But layers matter, as temperatures can shift by 10˚F or more every day.

Some will speak disparagingly of her. They talk about her demise. But they don’t know her. You see, San Francisco is not her past, or even (so much) her present. She is her future. She rewards the brave, adventurous spirits who call her home. I am proud to be among them.