Keys to Unlocking Real Estate Value in Tigh Markets
By exploring all options and minimizing risks, tenants can obtain value - even in tight real estate markets.
Kris Bjorson, International Director and Head of Retail/e-commerce Distribution, Jones Lang LaSalle (Feb/Mar 07)
For many global markets, don't count on simply knocking on the front door to drive down base rental rates as your negotiation strategy. You might be second or third in line with less money. Don't take it personally. With vacancy rates stabilizing well below 6 percent, expect to see limited viable real estate alternatives, rising rental rates, and confident landlords. So if base rental rate is non-negotiable, how can you obtain value? Let me share some tips based on my experience.

Think about where you need to be located in a tight market. Take an objective look at your current distribution network, warehouse operations, and anticipated space needs. Analyze customer service levels and operating costs. Evaluate the financial trade-offs of each distribution network scenario and target geographical areas for this location. This information can help you communicate with a landlord or justify an increased base rent to the executive management team.

Strike a Win-Win Business Relationship
Minimize the adversarial, transactional nature of the real estate process. Make the location issue an opportunity to develop a "win-win" business relationship with all parties. Talk to your customers, suppliers, and partners about their space availability in tight warehouse markets. You may be surprised to find someone you know with too much or too little space and uncover a hidden opportunity. This can deepen your current relationships by collaborating to avoid a cost increase for your (and potentially their) business.

If you don't find a solution through your network, focus on the landlord. Consider sharing more information about the costs, issues, and challenges associated with your supply chain. Discuss the impact of the location on your distribution environment and how it may constrain your needs and plans. By your sharing this information, a landlord or its representatives may respond in kind to help overcome your location concerns and illustrate how this location may be a competitive advantage for your business. Take the liberty to ask some additional questions about real estate costs, deal flexibility, and obligations. Listen intently. You are establishing a business relationship with the landlord to define specific goals that maximize flexibility and minimize risk.

One of the easier things you can negotiate is an extended early-access period for additional free rent. Typically, landlords in a tight market will grant tenants a one- to two-month free-rent period to secure occupancy-storage permits and install material-handling equipment, trade fixtures, and cabling. This period is too short, and you end up paying rent while you relocate, receive, and store inventory. With an active industrial real estate investment market setting record high sales prices, landlords also tend to use free rent, instead of rent reduction, as a mechanism to simultaneously show a tenant a lower effective rental rate on a net present value basis and illustrate a higher stabilized annual yield to an investor at the lowest possible capitalization rate.

Remember that landlords have to balance the interests of multiple parties. Incentives should be negotiated to motivate everyone to deliver the space on time and in code compliance, especially if the landlord assumes any construction obligations.

Typically, tight market leases will be silent on the issue of landlord performance, specifically in advance of the lease commencement date as it relates to landlord construction. Therefore, if denied access to the space due to the completion of the landlord's improvements or any other such landlord responsibility, then consider a provision that matches the holdover provision of your existing lease. If not applicable, try to structure the lease where the landlord pays a delay-of-possession penalty equal to at least a cumulative per diem base rental.

Seek Flexibility in Options
Think about the demands from your client base - lower prices, better service, and more flexibility. Apply this model to real estate. Keep in mind that everything is negotiable and approach the negotiation from a reasonable and practical business perspective.

Real estate flexibility comes in the form of options: renewal, expansion, contraction, termination, purchase, etc. Pursue you options relentlessly. Remember a real estate option is an exclusive benefit to you, the tenant. It is a future event and is typically difficult for anyone to determine its present value during the negotiation. Although the landlord often gains the luxury of continuous cash flow on a longer term or contiguous space with a desirable tenant, the ability to achieve real estate flexibility is negotiated more on a case-by-case basis rather than as part of an overall plan. Consider the concept of ongoing, fixed rate options to be public enemy number one to every landlord.

A renewal option provides you with the ability to renew the lease term for a specified number of years. If granted by a landlord in a tight market, expect one to two terms of three to five years at a fair market rental rate, no less than your current rental rate. From your perspective, if granted a fair market rental rate for your renewal, make it governed by a broker-driven arbitration process. Brokers have the best local market knowledge and are aware of available landlord concessions under similar circumstances. If the broker does not have a conflict or business interest with the landlord, this methodology will be to your benefit as the tenant. If successful, try the "percentage of fair market" approach as a way to recognize the value of your continued tenancy as an offset to a landlord's downtime, marketing, and improvement costs associated with attracting a new tenant. Be aggressive with a 90 percent request but expect to achieve 95 percent to 97 percent in a tight market. Ideally work to structure three, five-year renewal options at a fixed rental rate for the first or all options. Use "percentage of fair market" as a backup, with a six- to 12-month prior written notice from tenant to landlord for purposes of exercising each option. All other terms and conditions shall be substantially the same as in the primary lease.

For new speculative developments in a tight market, take the majority of a multi-tenant building, if applicable, with an exclusive "staged expansion" option and an ongoing right of first refusal to all contiguous space. You are delivering the landlord the initial value proposition so take the time to leverage your ability to control your growth within the same building. "Staged expansion" means typically trading the size of the expansion space and window of time to exercise at the same rental rate negotiated for the initial space.

Tight markets are a good time to request a termination option. Landlords tend to be bullish on their ability to backfill the space at a higher rental rate. In some of the tightening real estate markets across the country, we have been able to negotiate the right to terminate a three-year lease at any time after the initial 18 months at no termination penalty to be exercised upon nine months' prior written notice to the landlord. If the landlord seeks a penalty, seek a fixed number based on unamortized costs or try to trade a longer length of notice for a lower penalty.

Due to the liquidity of the industrial real estate investment market, the most difficult option to secure is a fixed purchase option. Try (especially for single-tenant buildings) to get an ongoing right of first refusal to any bona fide offers the landlord receives to purchase the building. If the option is granted, you can do the math to see if this unilateral right makes sense for your company. If rejected, you may pursue a participation in the percentage of profit received by the landlord or a cap on any real estate tax increases resulting from the sale.

Shift Risk

Build on a win-win business relationship, be flexible, and then spend time seeking mutual ground on the allocation of risk between landlord and tenant. Risk negotiation falls under landlord or tenant obligations in the lease documentation. Use both your legal counsel and real estate advisor to address the shifting risk related to building integrity and capital improvements.

In an industrial triple net lease expect the landlord, at its sole cost and expense, to assume full responsibility for the foundation and structural portion of the exterior walls and roof. All other maintenance, repair, or replacements will be your responsibility as reimbursed to the landlord via operating expenses or one-time payments. Chip away at this language by adding floor slab to the definition of foundation, or roof membrane and skylights to further expand the meaning of roof. In a multitenant building, push back on any items shared by the other tenants, such as parking areas and building systems. Accept sole responsibility inside the four walls of your space but fall back to a pro-rata share of the building or complex, whichever is less. On existing buildings, press hard to shift the replacement costs and capital improvement items to the landlord. At a minimum, prorate such costs over their useful life to limit your financial exposure to the length of your tenancy.

You are paying premium rent in a tight market; be passionate about your ability to maintain flexibility and shift risk. Don't be afraid to adjust your negotiation strategy based on insight from your landlord or market dynamics. Remember the overriding reason to be in this market. Don't let the impulsive, transactional nature of real estate skew solid business decisions. Make professional arguments to achieve a win-win solution for all parties.

Kristian D. Bjorson is the managing principal of the Logistics Practice Group for The Staubach Company, a full-service, international real estate strategy and services firm that provides innovative solutions for companies seeking distribution, manufacturing, and industrial space. The above information highlights some of the services offered through a value-driven service strategy called REALogisticsSM which integrates front-end logistics consulting with real estate implementation services.