Risk Management

The Counterintuitive Commercial Real Estate Market

Falling real estate prices don't automatically produce a traditional buyer's market.
Marie LeoneSeptember 4, 2008

Unexpectedly, the current downward drift in commercial real estate prices isn’t translating directly into cheaper rents for corporations. Faced with the sudden uptick in inflation, landlords are finding ways to collect more money from lessees.

To be sure, the Moody’s/REAL Commercial Property Index reported a 9.6 percent decrease in prices in June, compared with the same period last year, and a decrease of 11.8 percent from the October 2007 peak. The report, which was released in August, measures the change in transaction prices for commercial real estate assets based on the repeat sales of the same assets at different points and time.

The June index is the fourth consecutive month of negative returns, and shows a negative return over a two-year period. And while the 10 largest cities in each property type — industrial, office, and retail — are performing better than the national average, the aggregate numbers continue to drop. For instance, nationally the price of industrial space declined 9.3 percent from the previous quarter, and 7.8 percent from a year earlier. The price of office space sunk too, by 5.9 percent since the second quarter, and 7.8 since 2007. Meanwhile, retail space declined 4.6 percent from the previous quarter, and 7.7 percent over the past year.

On the leasing side, a similar trend is playing out. The commercial real-estate market is showing signs of “negative absorption,” says Marisa Manley, president of Commercial Tenant Real Estate Representation, a New York City-based broker that advises corporate tenants. That means that more space is becoming available than is being leased or bought. As a result, the law of supply and demand is helping to cut rental rates and creating incentives for building owners to offer tenants additional concessions.

But that doesn’t always translate into lower rents. Indeed, landlords are tightening up lease structures, and there’s an escalation in the number of clauses finding their way into contracts. In fact, come renewal time, landlords will be working to extract as much as they can from tenants in terms of passing along rising operating costs. Meanwhile, CFOs and corporate real estate managers will be looking for their opportunity to lock-in better long, and short-term deals.

In the recent past, when inflation was in check, landlords became comfortable with billing tenants a simple fixed increase to cover building operating expenses. Landlords preferred to avoid billing tenants directly for operating expenses because it was costly and time consuming to itemize and disclose all the charges to the tenants, says Manley.

Now, however, as the economy moves toward an inflationary environment, tenants can expect landlords to seek more aggressive formulas to recover costs rather than a simple fixed rent increase. Corporate managers should expect to see new leases that include variable rent increases based on such external metrics, as the consumer price index which reflects the national inflation rate, or the porters’ wage increase, which is a local union contract staple that raises the pay scale of building maintenance workers.

Such increases can raise rent by nearly 20 percent, posits Manley. The hikes are a mechanism for landlords to preserve their return now, and will act as a profit center in the future when inflation wanes, she adds. That’s what what happened in the 1970s and early 1980s.

If they sense tenants will reject variable costs in their lease agreement, some landlords will boost the fixed cost above the standard 3.5 percent annual hike and justify it by offering a more attractive amenities package. For example, Marshall Cohen, a partner in the real estate law firm Cohen & Perfetto, notes that he and his partners are seeing proposals that offer glass walls on buildings, sheetrock ceilings that replace drop ceilings, and upgraded carpeting—all included in a higher rent.

For spaces that have to be built out, landlords will try to distinguish themselves as owners of premium properties by luring tenants with little things such as upgraded hardware and lighting packages or by extending the free-rent periods beyond the first few months, says Louis Perfetto, the managing partner at Cohen & Perfetto.

Further, tenants should ask landlords whether current property taxes of the building are being abated by a tax-incentive plan. Many tax incentives fade or disappear entirely in the later years of the program. The issue may be blurred further if a tenant signs up for a 20-year lease at the tail-end of a program. That means, says Cohen, that the additional taxes due when the tax break runs out could come as a shock — and an unbudgeted one — to a CFO. After all, contracts usually pass tax hikes through to tenants.

Still, new trends are emerging that may change the leasing dynamic. Manley identifies two significant ones: tenants are choosing real estate sites outside of traditional city or industrial centers and are exhibiting a preference for so-called green buildings. Regarding the first trend, Manley points out that many companies no longer feel compelled to do business in traditional business districts. For instance, advertisers don’t believe they have to cluster on Madison Avenue in New York—or even in New York at all.

What’s more, many top executives that have the choice to relocate company headquarters are choosing sites near their homes. Such locations cater to the executives’ suburban or rural lifestyles and are usually cheaper than big commercial centers. Over the past few decades, many private equity firms moved from New York’s Park Avenue to Fairfield County in Connecticut, notes Manley.

In other cases, the top brass is kept in the city center — along with a board room and a posh reception area — while back-office functionaries are dispatched to the suburbs where real estate is cheaper.

Meanwhile, the corporate appetite for environmentally friendly buildings is growing. And while executives look to polish their corporate image and use the green label as an employee recruitment and retention device, landlords are using green buildings as a lure. In general, both trends are being helped along by improvements in telecommuting and outsourcing technologies that allow companies to relocate employees outside of city centers.