Recently, Steve Ballmer, the Microsoft CEO, agreed to pay a whopping $2 billion for the L.A. Clippers. That was an astonishing price for a franchise that had historically been the laughingstock of the NBA and, after 30 years, had only recently made it to the playoffs. What made the price so remarkable was the fact that just last spring, the Sacramento Kings sold for a then record NBA small market franchise price of $535 million. Prior to the King’s sale, the record price for a small market team was $450 million (for the Golden State Warriors). Certainly the new, healthy television contracts are responsible in part for increasing franchise prices; however, they cannot explain why someone would seemingly ignore the “market”. Something else is going on.
Why is it that an NBA franchise is worth $450 million to one person and $2 billion to another? Certainly Steve Ballmer, who has an estimated net worth of over $20 billion, has more money to throw around than most folks. However, he is a shrewd businessman and wouldn’t pay four times the going price just because he has the funds. He clearly saw value and opportunity that others didn’t.
According to the L.A. Times, when asked how he could justify the record breaking purchase for the Clippers, Mr. Ballmer responded: “In the sense you could say my aspirations for the Clippers on the court are matched by my sense of how to think of these things financially. When you buy a tech company, you don’t say what is it? You say, what can we turn it into?” In sum, the reason he paid so much more for the Clippers than anybody else is that the team was worth more to him than to anybody else. He believes that by applying his unique business acumen, he can ultimately create value from the Clippers that no one else could match. Thus, when deciding what he would pay for the Clippers, it was largely irrelevant to him what other people with less acumen and vision had previously paid for NBA franchises. Similarly, the new owner of the Sacramento Kings, Vivek Ranadive, justified his then record setting price for similar reasons. You see, Mr. Ranadive is Indian and he has aspirations to make the Kings the adopted team of his native country and expand their market to include India’s as yet untapped one billion plus potential fans. If he is even partially successful, $535 million will seem like a steal.
What does all of this have to do with office leases? When it comes to commercial real estate, people are often obsessed with knowing what other people are paying for their space. This “going rate” or “market rate” often takes on a life of its own and tenants often blindly allow it to dictate their own leasing decisions. Before Mr. Ranadive bought the Kings, the average price paid over the prior 10 years for a small market NBA team was $382 million. Had he blindly adhered to these market prices, he never would have offered $535 million and would not be the owner of the Kings today. Likewise, had Mr. Ballmer adhered to everyone else’s valuation benchmarking for the Clippers, he would still be trying to buy an NBA franchise (he previously lost out on the Kings). However, despite paying significantly more than anyone else thought was reasonable, both of these men feel strongly that they will make huge profits on these investments. On the other hand, a future buyer who lacks Mr. Ballmer’s or Mr. Ranadive’s vision would be crazy to pay what they paid for their franchises just because someone insists it’s now “market.”
Just as an NBA franchise has a different value to Mr. Ballmer and Mr. Ranadive than it does for other potential investors, office space may too be worth different things to different tenants based on their unique circumstances, needs and alternatives. Blindly accepting or agreeing to terms merely because other tenants accepted them, or allowing these “market” comparables to dictate what is best for your business might not be the best course of action. Sometimes, the fact that you are in line with everyone else may be a bad sign. In the words of Mark Twain, “Whenever you find yourself on the side of the majority, it is time to pause and reflect.”
Tenant’s enter into lease deals under all sorts of circumstances, and the deals they ultimately cut with landlord’s reflect these facts. Thus, a tenant who renews his lease without competing it or who has no alternatives because he is so financially invested in his build out and cannot leave is going to pay a premium for his space. However, the fact that he agreed to pay a premium doesn’t mean that another tenant with many alternatives or with no attachment to the space should be willing to pay the same price. What space is worth to one tenant isn’t necessarily what it’s worth to another.
The opposite can be true as well when it comes to renting space. Sometimes it may be okay to pay a premium for space if it makes good business sense. Let’s say that as part of your business plan, you think it’s imperative to upgrade to a nicer building in order to attract top talent and also show clients and prospects that you are successful and here to stay. You visit a beautiful Class A building which meets all of your requirements. Assume your broker tells you that deals have recently been concluded in this building for $28/sf but the landlord is now insisting on a rent of $32/sf and won’t budge. What should you do? While the recent deals may tell you that you would be overpaying at $32/sf, the fact is that this space may be worth more to you than it is to other businesses and is still the right decision for you. Conversely, another company may have a completely different assessment. They may decide that because clients never visit their offices and their younger workforce cares more about having an air hockey table and cappuccino bar than granite lobbies, they are only willing to pay $24/sf for office space. Therefore, this tenant may not be interested in that building even at the previous $28 pricing. Market comps tell you what space is worth to other people; they don’t tell you what the space is worth to you.
Clearly NBA franchises are not exactly like office space. Office space is relatively abundant whereas NBA franchises do not become available very often. Thus, supply and demand are different for the two purchases. However, the Clippers’ sale does illustrate that, in business, beauty (and value) is often in the eyes of the beholder. Blind adherence to the concept of an established “market” price, whether in the context of NBA franchises or commercial office space, can lead to poor business decisions and missed opportunities. There is danger in merely following what everyone else is doing. Companies need to evaluate what any space will do to advance their own unique business and strategic plan. Only then can they determine what they are willing to pay for it.
For more information contact Glenn Blumenfeld