We have all played that tile game where there is one empty space on the board and you need to slide all the tiles around the board to create a picture or desired sequence. It’s a very difficult game due to the fact that there is only one open space to move the tiles at any given time and the wrong move will ruin everything you’ve created up to that point. If there were two or even three empty spaces, the game would be a whole lot easier. Well, real estate is very similar to that board game. The amount of vacancy in a market at any given time is just like those open spaces in the tile game. Finding and taking advantage of the largest vacancy, therefore, is the key to winning the commercial real estate game.
Most large brokerage firms put out quarterly and annual market reports which describe the current state of the commercial real estate market including, among other things, market rental rates, absorption rates (the rate at which space is being consumed or given back into the available inventory) and vacancy rates. While this information is certainly interesting, it doesn’t always tell the full story. For example, if a market report states that vacancy in Conshohocken is 13%, that doesn’t mean every building in that submarket has an 87% occupancy rate. Those published rates are merely averages across a larger market segment. However, some buildings in Conshohocken may be 5% vacant and, therefore, demanding high rents, while other buildings may be suffering with 22% vacancy and, therefore, willing to offer very aggressive rents.
The best way to obtain a great real estate deal is to break the larger market up into a lot of smaller, building specific markets and, in particular, identify suitable properties that have the highest vacancy rates. Each building is, in effect, its own sliding tile game. The more vacancy (or “open tiles”) it has, the easier the game will be for that negotiation. While a 13% vacancy rate in the large submarket may indicate that rents might be relatively expensive, if the tenant has in its short list of prospects a building that is 22% vacant, it can change the whole dynamics of the negotiations with all buildings under consideration.
In virtually every submarket around the country there exists some level of vacancy (i.e., empty tiles). Thus, Landlords are painfully aware that at any given time, there is more space available in their market than there are tenants who actually need space. Because no landlord wants to end up with that vacancy (or a disproportionate amount of it), they will do what is necessary to attract tenants from other buildings in order to lease up their space when it becomes available.
In most cases, over time, there is a flight to quality when real estate supply exceeds demand. Thus, when vacancy pops up in a trophy or Class A building, the landlord will often lower its rents or offer aggressive incentives to attract tenants from lesser quality buildings. When the price differential becomes palatable, many tenants will upgrade their space. This flight to quality happened in Philadelphia over the past 10-12 years. In 2003-2005 there was approximately 3,000,000-4,000,000sf of vacancy in the trophy sector and now there is very little. These landlords made aggressive deals (in some instances narrowing the gap between trophy rents and Class A rents to only a few dollars/sf), tenants moved up in quality and, when the dust settled, the normalized market vacancy had shifted to mostly Class B and Class C buildings. With no tenants to fill their space, many of these landlords converted their office buildings to apartments and condominiums.
If a tenant can find a suitable building that is in relative distress (including its current building should the tenant move), it should be able to secure a very good deal even if the larger submarket is relatively strong. Thus, while a 20,000sf tenant may appear to have little clout in a 5,000,000sf office submarket, if they are looking at a 50,000sf building (a smaller tile board) with 30,000sf of vacancy (lots of open tiles), they have the ability to turn a landlord’s potential bankruptcy into a very viable investment– resulting in significant negotiating leverage.
Over the past few years, business has been very good in the Delaware Valley and, as a result, many new firms have been formed and existing firms have expanded. This has lead to tighter real estate markets and rising rents. When high quality space becomes available (i.e., Cross Pointe), it has leased up quickly and at premium rates. With few move opportunities and rising rents, some suburban tenants have been frustrated. In effect, the increasing demand has shrunk the number of open tiles in the board game making it harder for tenants to maneuver and ultimately achieve their ideal outcome. Many of these tenants had heard stories of other companies who only two or three years ago were getting great deals in their market and now that it’s their turn, the market has turned. That has added further to their frustration. Well, things may soon loosen up in the King of Prussia submarket.
The recently announced relocation of a significant number of Shire Pharmaceutical jobs in Chesterbrook will effectively increase the number of “open tiles” in the King of Prussia submarket, thereby creating new opportunities for tenants in the next few years. Make no mistake; the vacancy that will be created in Chesterbrook will have a ripple effect throughout the King of Prussia and surrounding office submarkets. As one of the nicer office products in the suburbs, Chesterbrook will ultimately fill most or all of this vacancy but at whose expense? Unless there is considerable new job growth or the relocation of a large, new employer into the suburbs, this vacancy will simply be transported to other, lesser quality or located assets. No one wants to end up with this vacancy when the tile game is over. As a result, everyone should be getting aggressive to fill their existing vacancy before the Shire move and/or secure their existing tenants on a long term basis so that there is no risk of a relocation when that large vacancy hits the market.
The key to making good real estate decisions is to understand your relative leverage in the marketplace at any given time by understanding how many moves you can really make and how much leverage you have for each option. If and to the extent a building is disproportionately burdened by vacancy (or will be should you decide to move out), there should be a good opportunity to secure favorable lease terms. Ultimately, every landlord knows there is more space in their market than there are tenants, and no one wants to end up with more than its fair share of the market vacancy. Because each building effectively represents its own tile game, and tenants are moving, downsizing and going out of business all the time, there are often buildings that will value your tenancy more than others. By focusing on the smaller markets (i.e., the individual buildings) as opposed to the statistics for the larger market, you are more likely to end up winning the game.
For more information contact Glenn Blumenfeld