By Ken Ashley
(ATLANTA) March 7th, 2011
No matter what market conditions are, we frequently get questions about what is “fair” for a term or length of lease commitment. If corporate users
could get landlords to commit to a scenario where they could unilaterally terminate every year, every month or even every day, then that would be just dandy. Wouldn’t that flexibility make the corporate real estate game easy? This would be the equivalent of writing in pencil; you could erase your mistakes and start over.
As a corporate officer or real estate director, you know well that the more flexibility a company can gain in its real estate portfolio, the better. It’s hard enough to forecast the future without having to worry about a super long-term lease (witness the Middle East unrest of recent weeks).
So what are the major reasons that landlords insist on such long term commitments from their tenants – AKA customers? We see situations where corporate users have never had to think like a landlord. They don’t understand the risk, the capital, return metrics or the vagaries of the financing markets for holders of real assets. Real estate is a great mystery that goes unsolved and uninvestigated.
Many tenants simply assume that a landlord is out to get them. While this certainly could be the case, many if not most landlords are fair capitalists like you and me. They allocate capital, take market risk and hope for a market return.
I know we can all agree that profit is a good thing. However, looking at this from the tenant’s perspective, it’s like that piece of cake at a friend’s birthday party: it must be kept reasonable and proportionate.
Walk a Mile in My Shoes
One of the basic principles of negotiation is to understand the concerns and motivations of your opponent. If you can “think like a landlord” and look at your tenancy as he or she would, you will be able to not only plan your approach, but swat away bogus arguments like a pro. Fundamentally, your tenancy, and the resulting cash flow, is an asset that provides value. In order to win the prize, the landlord must have a building (think of this like a factory), then pay to put raw materials into that physical plant in order to make deals happen. In sum, they are running a business, but the decision making approach is driven by, among other things, the form of ownership and capital structure.
For example, an asset manager for a life insurance company is likely looking for long term value appreciation and is not overly worried about short term cash flow. In many cases, life insurance companies pay all cash for even the largest asset. The decision makers are salaried and usually long tenured professionals. They take a careful and deeply analytical look at deals. They are risk averse on the credit front and will wait for a company that fits their profile of perceived strength before they will commit.
Publicly traded real estate investment trusts (REIT’s) are driven by Funds from Operations (FFO) which is a figure used by to define the cash flow from their operations. It is calculated by adding depreciation and amortization expenses to earnings, and sometimes quoted on a per share basis. In other words, they are effectively focused on net profit on a per share basis.
A Man in Full
Perhaps the most stereotypical landlord is the one describe in the famous Tom Wolfe book A Man in Full. This landlord is a merchant builder and a gun slinger. He (yes, usually a man, at least up to now) will take massive risk, borrow horrid amounts of money, and in general do anything legal to make a real estate deal work out.
I respect individuals like this and some of them become very, very wealthy. I also treat them with great caution because their risk tolerance would have most people crying out in pain like little babies. The focus for entrepreneurial, highly leveraged landlords is cash flow early and cash flow often. They will say what it takes to get you to agree to a deal. As Ronald Reagan used to say, “Trust, but verify.”
What Would You Like in Your Margarita?
While we are primarily discussing term of commitment in this post (we will cover tenant improvement dollars in another post), a tenant real estate transaction is a recipe that is run through a financial blender with an answer spit out on the other side. Once again the answer depends on what kind of company you are negotiating with – IRR, Cash Flow or impact on Asset Value are a few metrics that landlords use to evaluate your transaction.
So, lease term is a major factor in how “sweet” the deal is for several reasons. A longer commitment will give the landlord a bigger period of time to amortize cash put into the deal and therefore allows ownership to achieve its objectives while keeping the lease rate low. In addition, it allows the investors to take margin over a longer period of time instead of having to cram all the profit in a shorter period of time. Term also creates tremendous value, because investors – whether in real estate or on Wall Street – look at defined cash flow with great interest.
The deal can be analyzed by MBA’s with computer models and they can tell you what flavor your Margarita will be at the end of the term. Those MBA’s may say the same thing, but insurance company asset managers hear something different than The Man in Full developer with a big hat and more of a taste for Scotch.
Rules of Term
It sometimes helps to think of your company’s tenancy in terms of where you lay your head at night:
· A hotel room at $350 for 31 days is $10,850
· A corporate apartment might easily be 50% of this amount at $5,425 a month
· Your 30 year mortgage might be 50% again or $2,712.5 a month
Flexibility cost money on a per day basis, but allows you to change plans quickly. Commitment can be expensive, but if you are in an environment where your managers have the experience and maturity to make longer term forecast, then a longer lease term, like a 30 year mortgage, is the less expensive option.
Finally, we did not discuss here but are acutely aware of market pressure when setting all terms, from length of commitment to rate and cash in the deal. But start with the basic understanding of what the landlord is thinking. Look at it through the lens of the market, and layer in your own situation. Then we bet, with a good advisor, the situation will be come clear, or at least easier to swallow. Enjoy your drink and tip your waiters.