Flexibility Can Be Expensive

These days, many companies place a premium on flexible leasing. This is understandable in a time marked by uncertainty about the office. It is also a byproduct of a shifting market in which landlords have increased the extent to which they offer flexible solutions. Less obvious is how flexible leasing can end up costing significantly more than longer-term leasing.

A flexible lease is usually under three years in term. It is almost always a pre-built space, often furnished and ready for occupancy. Flexible leases come in the form of both direct and sublease offerings. Subleases may be discounted to market because, absent protections such as a recognition agreement from the landlord, they present a risk of losing the space if the sublandlord defaults. Yet high-quality subleases that align with the type of flexible offerings otherwise being provided by landlords are usually priced similarly. These spaces are not discounted and are often priced at a premium to the longer-term market.

In other words, flexibility costs more. This is true in part because landlords must rationalize the expense of building new space over a shorter term, and it is more difficult for them to create a positive impact on asset valuation with short-term leases. As a result, flexible leases carry a higher cost.

There is also an element of market risk, especially when the rent trajectory is rising. For example, rents in San Francisco appear to have hit bottom and are beginning to trend upward. A tenant that signs a three-year lease today is likely to face higher leasing costs in roughly two years when addressing the expiration, whereas it could have locked in a historically lower cost for a longer period. As markets improve, leasing options also diminish, making it harder for tenants to find high-quality space. Finally, as leverage begins to shift back toward landlords, concessions are often reduced quickly.

To be sure, choosing a flexible lease may be the right answer, regardless of the longer-range cost implications. But it is important for tenants to recognize that flexibility can be expensive.

Is Your Window Open?

Among the more routine elements of our business advising tenants is the art and science of analyzing opportunity, or what we call “looking for open windows.” When markets shift, as they did post-pandemic, we think it is important for occupiers to take stock of their lease, the market, and the specific dynamic in the building in which they lease space.

Somewhat surprisingly, this analysis is not intuitive to many of the companies we speak with. Instead, they believe they are stuck with their lease until the end of term. Sometimes that ends up being true.

But when it is not, when the so-called window is open, tenants can derive significant benefit from a lease restructure.

But just as windows open, they close.

The circumstances that lead to opportunity typically involve a distressed capital stack. The equity may be wiped out, a loan may be maturing, or both, all against the backdrop of steep declines in the market value of the asset. When this type of distress is present, a tenant who is willing to commit to extended term may find a landlord who is ready to reduce the existing rent immediately and contribute concessions in exchange for that term.

We have written about this strategy in the past. We even have a name for it: “End and Extend,” meaning end the high in-place rent now and extend the term.

What causes the window to close?

It is usually a reset of the capital stack, which may come in the form of an asset sale, an infusion of fresh equity, and/or a new loan. A reset takes the pressure off and allows the landlord to lease at market. After a reset, if the building has vacancy, it is common to see a flurry of new leasing activity.
When all of this is happening, the landlord loses its motivation for disrupting the tenant’s in-place cash flow.

In other words, there is no longer a reason to reduce the existing rent, irrespective of an extension offering.

While the San Francisco office market is in the early stages of a recovery, there remains plenty of distress and, potentially, open windows. We refer to the process of analyzing specific situations as part art and part science. It is art in that one must aggregate a great deal of data, historical, current, and projected, to paint the right picture and craft the negotiation strategy.

The science is in running the models that inform the opportunity.