How Far Down Can Rents Go Before Landlords Say No

We all understand that in order to make a deal both sides have to agree to it. With the current office market slowdown, landlords are now faced with the possible signing of leases at the lowest rental rates since 1994. With average rents plummeting across the country, are landlords faced with the prospect of having to accept any deal and at any price to get their buildings filled? Is there a level of rent that could be offered that a landlord simply has to say no to that deal?

Tenants certainly understand what a great position they are in if they need to secure office space today. Landlords are offering all of the amenities that they were forced to offer back in 1994 to attract tenants. These incentives include higher build out allowances, free rent, lower rent, and buying out current leases. Unfortunately, a number of tenants think that they can ask for anything and every landlord will just jump to accept these offers to make a deal happen. They have forgotten the principle, that a deal has to work for both sides or a deal will not be made. For a tenant to understand how low a landlord could go in rents and what concessions they could expect to secure, they have to have an understanding of what a landlord has to consider in costs in order to agree to a lease.

Lets assume a tenant wants to secure Class A office space at $24.00 per square foot, fully serviced. The tenant needs 4,000 square feet and needs six private offices, one conference room, storage room and kitchen. The space that the tenant has identified was last renovated five years ago. Class A office buildings in large metropolitan cities such as San Francisco have a base operating expense of between $12.00 and $15.00 per square foot. This means that in order to keep the building operational, whether the building is leased or not, this amount has to be spent. Today, build out costs range from a low of $45.00 per square foot for a minimum basic build out to as high as $80.00 per square foot. Assuming a five year lease to amortize these costs means that each year $9.00 to $16.00 per square foot (not including carrying costs) would have to be expensed against gross rents. Brokerage fees, architectural fees, permitting fees and management fees easily can add another $2.00 per square foot per year in expenses. As you can see with this example the landlord at best will break even, at worse lose up to $9.00 per square foot per year doing this transaction. This example does not take into account what a landlord further risks if the tenant defaults prior to their lease expiration or what this rental rate would do to the ultimate value of their building with their lenders or investors.

I was marketing a space for a landlord recently that was offering a good Class B building space at $24.00 per square foot, fully serviced for 3,000 square feet. We were telling prospective brokers and tenants that the owners would be willing to build out the space based upon a mutually agreed to plan built to our building standards. We recently received an offer from a tenant that offered the building $22.00 per square foot, fully serviced flat for five years. They wanted three months free rent up front, they wanted ten private offices built out, a kitchen and shower, one conference room and wanted the landlord to wire the entire premises for phone and data. The original estimate for build out was $70.00 per square foot. Clearly the landlord had to say no to this deal.

Tenants can get great deals in today’s office market. Landlords want and need to make deals but in order to get a deal done you need to understand landlords’ costs. When choosing a broker, make sure that you choose a broker that understands both sides of the negotiating process. Choosing a broker that only works with tenants and does not have experience working with landlords may not give you the right information or leverage to truly position your offer to get you the best deal while actually getting the landlord to say “yes” instead of “no”.