What’s the most advantageous position to be in when it comes to negotiation? The position that knows exactly what the other side wants. If you know your opponent and what they’re after, you’ve got a much better chance of negotiating a deal favourable to you than someone walking in blind.
After working in commercial real estate for over 20 years and being involved in thousands of commercial leasing contract negotiations, I can tell you that for tenants, knowing your “opponent” (otherwise known as your future landlord) is crucial to negotiating the best possible deal.
Now, when I say “know your opponent,” I’m not talking personally. Sending a private investigator to dig through the trash of your potential future landlord is not only a bad idea, it’ll probably land you in some legal trouble. What I mean when I say “know your opponent” is to know what type of landlord you’re dealing with; this way, you have a good idea of what their potential motivations and objectives might be so that you can negotiate from a position of power.
So, how many types of landlords are there? You’ll love this - there’s only two! Institutional and the creatively-titled non-institutional. So, what’s the difference? Keep reading. In this blog post, I’m going to explain institutional vs. non-institutional landlords and provide some advice for tenants on negotiating favourable terms for their lease.
An institutional landlord refers to a life insurance company, pension fund, or Real Estate Investment Trust (REIT) that owns a commercial property as part of its overall portfolio. The fact that one building is only a “part” of the whole portfolio is important to remember when negotiating with an institutional landlord (more on that later).
So, what’s the objective of an institutional landlord in a lease negotiation? The best way to explain is with an example. For this example, we’ll use a pension fund: The Ontario Municipal Employees Retirement System (OMERS).
How Institutional Landlords Set Rents
OMERS decides to buy a 10-storey office building and has its asset manager, Sarah, determine the rent that should be charged per unit.
So, how does an asset manager calculate rents? First, she puts a poster up on the wall with hundreds of different numbers. Then she buys a pack of darts.
Of course not. Far from arbitrary, the process is actually complex and involves a fair amount of both quantitative and qualitative analysis. Since this isn’t a post about how to be an asset manager, I’ll keep this as brief as possible; here is a list of the main items an asset manager evaluates that prospective tenants should familiarize themselves with:
- If existing (not new) building, she will look at the current rent rolls and other financial data
- The expected rate of return for OMERS
- How this asset fits into OMERS’ overall portfolio
- How value can be maximized (can rent be raised, operating costs lowered, etc.)
- Amount of capital repairs required (roof, HVAC, parking lot, windows, etc.)
- Rent rates of similar buildings in proximity
- How much capital will be needed for tenant improvement allowances, leasing fees, and vacancy allowances
And plenty of other things.
The result of all this investigation and analysis is what we call the Basic or Net Rent per square foot. Once that has been established, institutional landlords will rarely change the rent for two reasons:
- Real estate assets are generally purchased as long-term investments; even though market rates will ebb and flow over the holding period (the length of time the owner holds the asset), institutional landlords are well-capitalized and can afford to withstand supply and demand dynamics over a long period of time.
- The building is only one part of a larger portfolio (remember I said this would be important to remember?); while a tenant may see a building with 20% vacancy and think they’ll get a great deal because the landlord is desperate, the reality is that that one asset is only a small piece of the institutional landlord’s total portfolio, which has a vacancy rate of 2%; therefore, the landlord is not at all desperate, but actually in a strong negotiating position.
Why Institutional Landlords Are Unlikely to Lower Your Rent
A common mistake many tenants make is assuming that the Net Rent is something malleable that institutional landlords are open to negotiating. In actuality, the Net Rent is used to help determine the overall value of the building, which is what institutional landlords truly care about.
To help explain, I’ve put together a simple example based on our fictional 10-storey building:
- 10 storey suburban office building with 20,000 sq.ft. per floor (total area = 10 X 20,000 = 200,000 sq. ft.)
- Vacancy rate: 0%
- Current Net Rent: $18.00 per sq. ft. per year
- Market capitalization rate: 5%
Current building valuation (based on Net Rent):
- Total yearly income = $18.00 X 200,000 sq. ft. = $3,600,000
- Valuation (applying the cap rate of 5%) = $3,600,000/0.05 = $72,000,000
Building valuation with a $3.00 per sq. ft. decrease in Net Rent:
- Total yearly income = $15.00 X 200,000 sq. ft. = $3,000,000
- Valuation (applying the cap rate of 5%) = $3,000,000/0.05 = $60,000,000
A $3.00 per sq. ft. reduction in Net Rent results in a $12,000,000 loss in terms of the building's overall value.
As you can see, even a small concession in Net Rent results in a drastic change to the building’s overall value and may even make it undesirable for the institutional landlord to keep depending on expected rates of return.
Don’t worry. If you’re dealing with an institutional landlord, there are ways to negotiate a favourable lease.
Making a Favourable Deal with an Institutional Landlord
There are ways tenants can negotiate a favourable lease with an institutional landlord and that is by asking for inducements.
Inducements are basically incentives that institutional landlords can offer tenants to make the space seem more attractive. The most common inducements are as follows:
- Free rent: offering the tenant the ability to occupy the space for a set amount of time rent-free
- Tenant Improvement Allowance (TIA): a certain amount of money (usually expressed per sq. ft.) that the landlord will reimburse to tenants if spent on improvements to the space
- Cash allowance: this differs from a TIA in that the tenant can seek reimbursement for items not directly related to improving the space such as desks and computers
- Moving Cost Allowance: a reimbursement for moving costs incurred by the tenant
Of course, landlords are under no obligation to offer any inducement at all. If you’re a tenant negotiating in a strong market, it might be difficult to convince an institutional landlord to offer even one inducement, whereas in a weak market some landlords may be willing to offer all four.
As you can see, many factors - both micro and macro - play a role in determining how willing (or unwilling) an institutional landlord will be to negotiate, which is why it’s so important as a tenant to have a comprehensive grasp on these factors before entering into any negotiation.
‘Non-institutional’ is a catch-all bucket for all landlords that aren’t institutions. Don’t think that just because you’re dealing with a non-institutional landlord that your landlord is an actual person. Many non-institutional landlords are actually corporations that act very similarly to institutional landlords with some key differences:
- Non-institutional landlords generally don’t have a portfolio of other investments; in fact, it’s not uncommon for non-institutional landlords to own only one building; therefore, when dealing with non-institutional landlords, the building’s vacancy rate matters.
- The building’s value does not play as crucial a role as with institutional landlords; often, non-institutional landlords won’t have a board of directors or operating committee to answer to and have more latitude to lower rents with less risk.
The key difference to note between types of landlords is that the metrics (rents, valuation, etc.) of the actual building you would like to lease is much more important when dealing with a non-institutional landlord versus an institutional one. In a weak market, a non-institutional landlord will probably be more open to negotiation - especially if that building is the only one in the landlord’s portfolio.
How To Negotiate Favourable Lease Terms
Now that you’ve read this blog, you have all the information you need to walk into your next lease negotiation and get what you want - go get em’, tiger!
What we covered here today is important, but it doesn’t even begin to scratch the surface of the information needed to negotiate from a position of power. Don’t forget, people in this business do this for a living and even the brightest, most informed tenants can’t expect to effectively negotiate a favourable lease with little or no experience.
What’s a tenant to do? Hire an experienced commercial real estate agent!
Real estate agents sometimes get a bad rep as tenants see them as little more than salespeople. I’m not saying those agents don’t exist - we’ve got our share of ‘bad apples’ just like every other profession - but an experienced commercial real estate agent can do a lot more for you than find space. A great agent acts like a consultant, not a salesperson, guiding tenants through the complicated process of negotiating commercial space and ensuring the resulting deal is the best possible outcome for the tenant.
Can you lease commercial space without the help of a commercial real estate agent? Sure! You can also defend yourself in a criminal trial without a criminal defence lawyer, but I wouldn’t recommend it. The job of a commercial real estate agent is not simply to find commercial space (if that’s all your agent is doing, get a new one), our job is to ensure you make the best possible real estate decision.
If you’re looking to lease commercial or industrial space, make sure to get M Commercial Realty on your side so you can bring some heavy ammunition to your next negotiation!
By Steve Peres
Learn more about Steve Peres.