If you have looked for office space in San Francisco during the past couple of months, you may have been surprised to see such a large discrepancy in rental rates for similar spaces. With vacancy rates dipping across the country and burgeoning signs of tenants wanting to secure large blocks of space again, landlords are now playing poker: Do I do a deal today or do I wait?
You must understand how buildings are financed and valued to understand the landlord’s position. Most buildings are leveraged with a certain amount of debt that was secured on the basis of a certain amount of building vacancy. Also, when determining how operating expenses are paid, most leases are evaluated on the basis of 95% of the building always being occupied. Since the 2001 dot.com bust, most landlords have suffered through higher vacancies then their original financing called for. They have been forced to absorb the difference in running their buildings between true occupancy levels and the 95% occupancy rule.
Landlords have been compelled to make almost any deal—even if it’s not profitable—as long as it will curb the cash “bleeding” and bring in some money to pay for the operation of the building. As a result, the market has been in a “free fall” the past few months, with rental rate prices dropping to their lowest levels since 1996.
Now vacancy rates are starting to drop to levels that meet some landlords’ financing expectations. Today landlords are facing the decision to lease or not to lease based on how a transaction will affect the “value” of the building.
A building is valued based on the gross rent of the building minus operating expenses. The result is net income. Net income in turn is capitalized at a rate of return by dividing net income by this rate to determine the value of the building.
Once a building has achieved its financing vacancy rate, any deal made is considered the latest rental rate for the building, which in turn is used to determine the value of a new gross rent potential. This is the main reason why there are such market rent differentials today. It is better for some landlords to show a higher rental rate and leave a space vacant then it is to accept a market-rate or less deal that would have a negative effect on the value of the building.
As a tenant, what should your strategy be to secure the best deal?
First, hire a good real estate broker. Real estate brokers are more valuable than ever. Not only do they find space, they find space that will give you the best value in an uncertain market.
Second, concentrate your efforts on the buildings that have the most vacancy. Look for spaces that require the least amount of tenant improvements to meet office needs—tenant improvements are extremely expensive against the owner’s bottom line.
Third, look for buildings that will give you the longest lease you can find. In the current market, rental rates are more likely to skyrocket than to go down. If you are forced to sublease in the future, at least your risk will be minimized. |
