In our last blog posting, we talked about different kinds of property buyers and how tenants may be able to use a pending sale as leverage to secure favorable lease deals. Well, what happens to a new or existing tenant’s bargaining position after a new buyer acquires the property? Unfortunately, new buyers often see their building and the market through much rosier glasses than the selling owner and, as a result, things may be very different.
With all of the sales activity in Center City Philadelphia over the past year, it is not surprising we have had lease negotiations which spanned the ownership of two different landlords. In fact, in a few cases, sales occurred while we were still exchanging proposals. As we discussed in our last blog, a landlord trying to position his asset for sale may very well strike an aggressive deal in order to grow Net Operating Income and, therefore, increase the sales value of the property to a financial buyer. Given that additional Net Operating Income gets multiplied into a higher sales price, it may very well make sense for the owner to cut an aggressive rental deal today even if the rental rates will be less than what they could have obtained if they held out and waited for a better deal. However, while the seller was looking to maximize value today, the buyer is looking to maximize value in the future. That means they probably have more optimistic views about the future than the seller and they aren’t going to rush to do an aggressive deal.
Whenever a buyer underwrites an office building investment, he needs to make certain assumptions about what will happen in the future. For example, if there is existing vacancy in the building, how long will it take to lease the space, how much will landlord need to invest in the building and pay out in transaction costs to lease that space and what rental rate will he be able to realize? Similarly, the landlord will look at the existing rent roll for the building (i.e., the schedule of existing leases including rental rates and lease expirations) and make his best guess about which tenants he can retain, at what cost and at what rental rates. The more optimistic the buyer’s underwriting assumptions, the higher the price he will be willing to pay.
As many of the office buildings in our area are being sold through a competitive bid process and the sale is awarded to the highest bidder, there is a very good chance that your new landlord‘s expectations for your rental rate are higher than anyone else’s.
What does this mean for existing tenants of the building who might be considering a lease renewal or expansion or new tenants looking to maybe move into such building? First and foremost, it probably means that the new landlord thinks he should be getting a higher rent than the prior landlord was asking for. When this buyer ran his financial model which told him how much he could pay for the building, he thought there was upside potential in the building or he wouldn’t have been willing to pay more than everybody else. Thus, he will be highly motivated to prove his underwriting assumptions correct by holding out for lease deals that meet or exceed his underwriting assumptions. By way of example, if the prior landlord was doing new lease deals for $28/sf, the new buyer may very well have assumed he could get $30.50/sf rents thereby justifying a higher purchase price. When the first new or renewal tenant approaches this landlord after the sale, the new landlord is unlikely to take less than the $30.50/sf upon which he based his purchase price. If he takes less, he immediately is conceding he was wrong in his analysis; a potential problem especially if he has investors who bought into his initial underwriting.
Thus, new owners may often have higher expectations than prior owners. Of course there are exceptions to every rule. An opportunity buyer (as opposed to a financial buyer) who got a huge discount on the purchase price due to a 30% building vacancy may have leeway to strike very aggressive deals in order to quickly lease up the property and then flip it. However, with respect to Class A office buildings in Center City Philadelphia, Wilmington, DE or other markets where the assets are fairly stabilized, it is likely that the new owners are going to be patient and hold out for richer deals than the prior owners.
In several instances, we have actually seen new landlords immediately revoke the outstanding lease proposals of their predecessor owner and issue new proposals with much less aggressive terms. In each case the new owner (and new listing agent) stated that they have a very different view of the market and building. Although nothing changed in the building or the fundamentals of the market, the deal terms or “market rate” for the building suddenly changed simply because the new owner had a different view of the market or a different vision for the asset.
This can be very frustrating for the tenant as his rent is increasing overnight merely because of a change in ownership. He is getting the very same space and building but for a higher price. What can he do?
Unfortunately, something will probably need to happen which forces the new owner to question his underwriting assumptions. If and to the extent he gets new tenants or renewing tenants to accept his new terms, his assumptions will be validated and rents may very well increase even higher. However, if a significant tenant leaves the building because the rents are too high or he continues to lose prospective tenants to other, less expensive buildings, he may, at some point, be required to change his strategy and expectations. Remember, his underwriting assumptions not only involved projections about what rent he could obtain on new and renewal leases, but also what his future vacancy would be and how long it would take to lease the space. Ultimately for his investment to pay off, he needs to meet all of these assumptions and not just the rent. Thus, he may not be able to wait too long to lease the space and may ultimately be forced to offer more aggressive terms to accelerate the lease up period.
When there is a change in ownership of a building, the first few tenants who negotiate with the new owner will have their work cut out for them. There is a good chance things will become more expensive. If and to the extent the new owner can successfully realize his pro forma projections on the first lease deals, it will embolden him to push forward with even higher rents and fewer concessions to improve his return. If, on the other hand, he has been overly optimistic and has missed the market, the tenant may once again have an opportunity to strike a good deal. In sum, while the highest bidder is the best friend of a selling landlord, he often makes for the toughest negotiator when it comes to doing lease deals.
For more information contact Glenn Blumenfeld