Articles & Learning

The Renewal Game: How to win from a tenant's point of view

By: Jeffrey Lerch, CPM

For many companies, the prospect of renewing a lease is a time consuming process that interferes with its ability to do business. Often, it is much easier to renew the lease in order to minimize disruption and maintain continuity of operations. It is often perceived to be much easier to simply contact the current landlord and negotiate the terms of the lease renewal directly. While the desire for this efficiency is understood, at what cost is it accomplished for the tenant?

Assuming that a tenant’s occupancy needs will remain static, there is little reason to consider relocation outside of functionality, geography, aesthetics, amenities, or the like. Absent these, renewing the lease is often the best strategic business alternative.

A renewing tenant expects a fair market transaction, inclusive of free rent, tenant improvements, or other concessions that might otherwise be offered to new tenants. But how does a tenant know what a “market” transaction truly is? What is the difference between the landlord’s asking rent and the final negotiated rental position? How much free rent is appropriate? How much tenant improvements should be given? What other lease provisions should be negotiated?

The only way to truly attain a market transaction is to:
1. Negotiate multiple positions;
2. Leverage those positions against each other; and
3. Build a level of indifference in the landlord’s mind regarding your preference the current space in comparison to others.
Only then will a landlord have earned the right to receive the rental stream represented by the ultimate lease commitment. But, is a market transaction good enough, or does it get better? In certain instances, there is much more at stake.

The Landlord’s Downside:
In many cases, a “market” renewal transaction is actually a windfall to the landlord that is based in the fact that he does not have to incur the costs associated with procuring a new tenant. Those costs include the operating expenses and debt during the marketing period, tenant improvements, and marketing costs.

Lost revenue is considered only to the extent that it covers the operating expenses and any debt, as this is the true cost of a landlord’s vacancy. Tenant improvements are typically higher for new tenants than for renewing tenants, so we consider the incremental difference between the TI Allowance. Marketing costs include any expenses that are beyond those paid for by the ordinary marketing efforts for the building, and may include broker luncheons, promotions, or giveaways. Leasing commissions are typically not a consideration, for reasons discussed later.

In negotiating a renewal, the landlord’s alternatives look something like the following.

	"Market" Renewal	New Lease
Square Footage	10,000 RSF	10,000 RSF
Lease Term	60 months	60 months
Base Rent @ $2.25 psf/mo FSG	$1,350,000	$1,350,000
Exepenses During Market Period @ 8 months	$0	($64,000)
Debt During Marketing Period @ 8 months	$0	($60,000)
Free Rent @ 5 months	($112,500)	($112,500)
Tenant Improvements	($100,000)	($200,000)
Marketing	$0	($10,000)
Landlord's Net Position	$1,137,500	$903,500
Difference	$234,000 or $0.39 psf/mo = 21%

 

These figures show the opportunity cost to a Landlord for losing a tenant. So, when a landlord negotiates a “market” renewal transaction, he is actually quite relieved at not having to sweat the significant downside that comes from letting a quality tenant slip away. Net result: It’s always cheaper for a landlord to keep an existing tenant than it is to find a new one.

Therefore, why would a tenant be satisfied with a “market” renewal, when there is so much more in play?

Diverging Goals and Focus:
A landlord’s business is real estate and he conducts real estate transactions daily. He is an expert in the industry and the real estate negotiating process is second-nature to him. He knows exactly what needs to be done in order for a tenant to even consider relocating. As with any business, the ability to increase return on investment lies in maximizing revenue and minimizing expenses. Accordingly, the landlord’s top consideration for any real estate transaction is to get the highest rents while keeping expenses low (inclusive of free rent and tenant improvements). The more effective he is in doing this, the greater his cash flow, property value, and return on investment. Absent appropriate pressure, the landlord has little incentive to concede to a tenant’s demands to sweeten the deal.

A tenant’s business is often something other than real estate, but the goals are essentially the same: maximize income and reduce expenses, with rent being a considerable operating expense. However, unlike the landlord, a tenant only conducts the real estate process once every several years. What is needed is a clear, concise plan that evens the playing field by giving the tenant a leg up on his opponent.

The Plan:
The first step a tenant must take in renewing a lease is to have a deliberate and strategic process that often demands just as much time and resource as the initial lease acquisition. This requires both intention and action in order to demonstrate a position of indifference to the landlord that his building is the best solution for the next term of the tenant’s occupancy. Only when the landlord believes that there is a high probability of losing his existing tenant will he begin to make meaningful concessions.

A tenant’s intention is demonstrated by a willingness to consider alternative buildings, whereas action is a collection of deliberate and meaningful steps toward acquiring an alternative lease. Importantly, both must be believable in order to have an impact.

A successful renewal process will incorporate the following elements:
Start Early: Time is, perhaps, the most critical component of the renewal strategy. Landlords know exactly how long the lease acquisition process takes and how much time a company needs internally to evaluate and make decisions of such magnitude. The average office lease should be commenced 12 months prior to lease expiration, but this amount can vary depending upon the size and complexity of the transaction.

Engage the Process: In order for the renewal process to have the desired effect, the incumbent landlord must believe that his tenant is actually considering alternatives. This requires the tenant to conduct a credible evaluation of properties, which includes the following steps:

• Tour alternative buildings: Get out and physically see what the competition has to offer. Not only will this help you to understand the market, but it will also transmit intent, which will eventually reach back to your current landlord. The commercial real estate market is incredibly efficient at communicating market activity. Commercial real estate professionals hold weekly meetings to discuss market activity. Often, this information is shared with other brokers and owners.
• Negotiate multiple positions: All negotiations require leverage, and in real estate negotiations, this is best accomplished by posturing one landlord against another. Landlords will improve their positions if they know they are competing with others for a tenant. The only way to gauge this is to have multiple alternatives.
• Maintain confidentiality and control: Landlords will use whatever tools they have to gain intelligence over a tenant’s negotiations. Often, this includes phone calls directly to a tenant’s staff. Inform your key employees that the company is considering its leasing alternatives and will make the best decision based on all available information. Do not make lightly of the process and do not share details with those who are not directly engaged. Above all, any communication with the landlord should be done through a designated point of contact, whether internal to the company or through an outside representative.
• Demonstrate indifference: The single greatest mistake a tenant can make is telling the landlord that you want to renew your lease. Instead, tell the landlord that you are considering renewing your lease and leave it at that. Don’t offer up additional information or details. Keep the discussion limited and be reserved. Remember, negotiating is a game and there is no point in giving the landlord any more reconnaissance than necessary.

The Truth About Brokerage Commissions:
Many landlords tell tenants that they can expect to pay a higher rental rate if a broker is involved in the lease renewal transaction, but they can avoid that if they simply negotiate the lease directly. How convenient does this make it for the landlord? We might as well let the IRS calculate the itemized deductions for our income taxes, too! After all, we have to pay our fair share of taxes, right?

Let’s go back to the fact that real estate is the landlord’s business, and he does it every day with the goal of maximizing income and minimizing expense. The more control he has over the process, the more efficiently he can accomplish these goals. A professional real estate consultant can help a tenant take control over the process and drive meaningful value to the bottom line – something that the landlord would rather avoid.

When it comes to commissions, how much are we talking about, really? In many markets, the commission paid to a tenant’s representative is between 3-5% of the gross rental income over the life of the lease. In the example above, using 4% equates to $54,000 or $0.09 per square foot per month. At first, this might seem like a sizeable sum, but consider the fact that a 10,000 square foot transaction typically requires 9-12 months of effort on the part of the broker. Moreover, a broker must share a sizeable portion of this amount with his sponsoring firm and with his team. Often, the net benefit to the individual averages 25% of the total commission earned.

Many landlords compensate their own brokers for renewal transactions. Absent a tenant’s broker, the landlord’s representative takes the entire amount, regardless of whether they are internal to the company or a third-party firm. While a tenant’s broker may increase the total commissions paid on a transaction, it is unlikely that the amount will exceed the total commissions payable for a new lease should the tenant decide to vacate.

The fact is that landlords understand the value that a reputable agent brings to the transaction. Accordingly, most landlords will gladly compensate a tenant’s broker if it means the preservation of a tenant. Of course, there are some holdout private landlords who still try to play hardball, but even they often concede in the face of a potential vacancy. Commissions are the landlord’s cost of doing business. If a tenant is truly getting a “market” deal, lease commissions are immaterial to the negotiations. Remember, it’ cheaper to keep a tenant than to find a new one.

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