A sinking American office market raises questions about the impact and value of tenant improvement allowances to owners and investors. In a note to me, a veteran portfolio manager suggests shifting the T-I burden to tenants--the industry practice in most other world markets. He argues that would reduce future volatility and buffer U.S. office investors in the next cycle from the severity of losses they now face in today's tailspin. Leasing brokers probably will take issue since this shift would impact commission volumes and tenant moves, and my correspondent would prefer that I not use his name to maintain good relations with them. But his arguments are worth considering. Here is his analysis:
Contrary to much of the rest of the world, U.S. office practice is landlords fund a substantial portion of tenant improvement costs. The allowance is generally less for lease renewals than for new leases, and the allowance is greater for longer lease terms than for shorter ones, and more for strong credit tenants than weak ones. It is not uncommon for landlords to amortize significant amounts of "above market" allowances as additional rent at an above market interest rate, say 8 or even 10%. When cap rates are lower than the interest rate there is an arbitrage that puts money in the owner's pocket on valuation or sale.
Typically, the T-I allowance shrinks in tight markets and expands in soft markets. In really soft markets, allowances can approach "turn key" and in combination with other concessions such as free rent, moving allowances, lease pick-ups, and above-market broker commissions, it is not uncommon for the net present value of a lease to turn negative, sometimes by as much as several dollars per sq. ft. per annum. Why would a landlord do this? Well, fixed operating expenses can easily run from $8-20 per sf per annum, so even if the lease is a net loser, it at least diminishes the carrying cost of fixed expenses on vacant space. Thus the sayings, "no honor in vacancy" and "just make the deal".
But landlord T-I allowances contribute to the extreme volatility of office sector returns and associated risks compared to other sectors--warehouses, apartments and retail which are much less capital intensive (in the retail sector, the tenant pays for most if not all of the fit-out). In a down economy, not only do office rents and associated net operating income decline, but concessions and capital expenditures also increase, whipsawing cash flows. One could argue that even the best quality, optimally located office building in a top tier U.S. city is not really a "core" investment due to the exaggerated effect that capital expenditures have on yields throughout the cycle. Yet, people tend to think of Class A office assets in the top eight MSAs as the epitome of core investments.
Now, the current down market presents formidable hurdles to accepted practice regarding landlord T-I allowances. Owners are hanging on for dear life having gone "long asset" and "short liabilities" for any properties acquired in the 2005-2007 timeframe. Their ability to meet debt service obligations (even at current historically low floating rates) is in jeopardy as interest reserves crumble in the face of declining rents and increased T-I allowances and free rent concessions, not to mention the prospect of having to pay down debt at maturity. In many cases, equity has been wiped out completely and they are just hoping and praying the world changes. How then, can they possibly manage the increased T-I allowances expected by the market?
Maybe it is time for a broad-based campaign (admittedly in the face of market forces and accepted practice) to shift the T-I burden to tenants. That's how markets operate in most of the rest of the world. What would be the benefits?
- Volatility of financial performance (and associated risk/return characteristics) of the office sector would be drastically reduced. Office properties could then exhibit truly core characteristics for top quality properties in the better markets.
- The true cost of an office move would be better accounted for in the market. It is likely that fewer tenants would be inclined to move if responsible for the full cost of fit-outs. As a result, more tenants stay put, further dampening office sector volatility.
- The office sector would be "greener". While LEEDS Gold and Platinum interiors are laudable, there is nothing more sustainable than utilizing your in-place improvements for a longer period of time.
Who would be the possible losers?
- The construction/building materials industries would not like the drop-off in activity that might result from tenants moving around less frequently.
- Leasing brokers would be similarly affected with lower overall leasing activity. Lease renewals typically pay lower commissions and tenants' brokers might lose influence in the market.
- In some cases, leasing brokers get paid commissions based on "gross rents" that are exaggerated because they include an amortization of landlord tenant improvement costs. These might be scaled back somewhat.
That might be a small price to pay for a less volatile and more sustainable future for the office sector.
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