Before the COVID-19 pandemic, it was common for tenants in “Class A” buildings to ask for significant improvements to office space as a part of their real estate lease. In essence, this practice allows companies to obtain a highly-customized office as part of their agreement.
The owners of Class A office buildings would routinely agree with these demands because it was normal and customary in the market. And for longer-term leases, the costs would be underwritten by the rent paid by the tenant.
But things have changed. There are numerous and increasing office vacancies, and some companies are debating whether they will even need office space in the future. Many businesses now ask for more flexibility and shorter-term leases, putting a strain on property owners as they look to earn a return on investment and secure financing.
The result is that in many cases, it may no longer make financial sense for commercial property owners to pay for custom office renovations and property improvements upfront. There’s simply no guarantee the tenant will stick around long enough to make it worth their while, especially if the initial lease is short-term.
Here’s some information on this situation and insight into what we can expect moving forward.
Pre-pandemic, it was customary for commercial tenants to sign 10-, seven-, and five-year leases. These terms made it easier for property owners to secure loans. And office customization was palatable because there was plenty of time for amortizing the cost of the improvements and maintaining a steady ROI.
Today, however, businesses are looking to sign one- to three-year leases or one-year extensions on their current arrangements. They don’t want to make long-term commitments because they have no idea how their business will look in one year, let alone five.
This trend causes significant follow-on effects, as lenders don’t want to provide long-term loans without long-term leases backing them. Financial institutions typically agree to five to 10-year commercial real estate mortgages when they’re supported by a rent roll with an average term—but that often isn’t possible when tenants are angling for shorter periods.
The lack of long-term tenants also creates difficulty when valuing the office space because short-term leases are fundamentally less valuable to the owner in terms of refinancing or trading the asset. In turn, property owners may opt to charge more to make up for the lack of a long-term commitment—but the increased costs could scare many companies away.
And, fundamentally, owners are also now less likely to agree to property improvements or customized offices—the chances of recouping their investment shrink dramatically.
Let’s say a doctor is looking for some office space and signs a 10-year lease with a property owner. This physician needs the office arranged in a specific way to meet with patients, and the cost to retrofit the space is $50 per square foot.
When averaging these numbers over the 10-year lease, the office’s customization will cost the landlord $5 per square foot per year. Therefore, if the doctor pays $40 per square foot, the landlord nets about $35 (though, for simplicity’s sake, we aren’t counting expenses like mortgage interest and maintenance). Since there is a 10-year period to make money on this investment, the property owner could accept these terms and be confident about the customizations.
However, when you shorten the lease period from 10 years to three, it paints a very different picture for the property owner.
Instead of spreading the cost of improvements over a decade and paying $5 per year per square foot, the shorter lease guarantees the landlord only three years to pay for the renovations. Therefore, the office customization costs $16.67 per square foot per year, leaving the property owner with a profit of only $23.33 per square foot before mortgage and maintenance expenses.
It’s easy to see how the owner could end up losing money in that situation—especially if the tenant bails after three years and the renovated space doesn’t work for other potential tenants.
The result is that landlords will likely avoid offering buildouts and customization on shorter deals. If a business wants property improvements and a short-term lease, it will most likely have to pay for them.
The problems COVID-19 has caused commercial property investors to go beyond a hesitance to customize office space; these issues also influence how lenders approach loans.
Commercial real estate loans typically have seven to 10-year terms, after which a balloon payment for the remaining balance becomes due. These loans usually have amortization periods of about 20-25 years.
Many lenders hesitate to take this type of risk because commercial real estate is currently volatile, and tenants that back the property owner’s income stream choose shorter leases. There’s no telling if a lender will get their balloon payments at the end of the loan term or if stable tenants will back refinancing—so they’re more closely evaluating applications.
This, in turn, puts pressure on the investor to only offer lease terms that make sense and show a clear profit margin. And significant customizations are likely not part of the equation.
Here are a few critical observations about how all of this may play out:
We’re in a difficult period for businesses and investors, and the uncertainty is having a significant impact on the commercial real estate industry in many ways. For a read on some other vital issues, please check out our previous blogs:
If you’re struggling with the prospect of investing in or leasing commercial property during COVID-19, call Morris Southeast Group at 954.474.1776 for expert guidance. You can also contact Ken Morris directly by calling 954.240.4400 or via email at firstname.lastname@example.org.
In the rush to predict how an economy crippled by COVID will look, many experts have tossed around the shapes of letters to illustrate how an economic recovery will look. There is the gradual but steady upturn of a U, a V’s immediacy, and the yo-yo effect of a W.
The newest letter to be added to the alphabet soup is K. While it assumes that everyone starts at the same point, it depicts what has taken shape since the virus reached the United States—different trajectories traveling away from each other.
K represents the differences between Wall Street and Main Street, people who can work from home and many of those who can’t, and individuals with the liquid assets to survive or thrive in a recession and those without them.
The K-model can also be applied to commercial real estate, where each sector faces its own unique challenges and opportunities. Some will move upward while others will face a greater struggle during recovery—if they recover at all.
For example, here are a few sectors seen as winners:
Sadly, COVID has had a more substantial negative impact on some sectors. These areas look to have a tougher time bouncing back to pre-pandemic levels:
When looking at the K recovery model, there’s that point where the two trajectories begin their outward journeys. It’s here that some sectors may linger for the foreseeable future before picking a definitive course.
These examples, of course, are far from exhaustive. The crucial lesson of a K-shaped recovery and its impact on CRE is that different properties will have significantly different trajectories. Investors must closely evaluate an investment’s potential in the new environment.
More than likely, the economy will recover in phases. And there may be setbacks (depending on a future surge) and lags (especially in sectors that cater to underprivileged socio-economic communities). At the same time, other factors—consumer confidence, virus positivity rate, cost-control efforts from the corporate sector, the arrival of a vaccine, and a Presidential election—are influencing not only the speed and scope of the recovery but also the exact shape of the K.
As an investor, the reality is that any rebound, regardless of the letter, will take time. Therefore, it’s essential to diligently assess investments and property improvements and choose those that make sense. A regional mall project or an office skyscraper that requires significant capital investment, for example, likely wouldn’t be wise choices.
For assistance in determining how to proceed with an investment or to find the right property for your needs, please call Morris Southeast Group at 954.474.1776. You can also reach Ken Morris directly at 954.240.4400 or via email at email@example.com.
Consider it the essay that was heard ‘round the world. James Altucher, a former hedge-fund manager, author, and comedy club owner, penned his opinion that New York City was dead because of the fallout from the COVID-19 pandemic. In the piece, he laments the loss of business opportunities, cultural venues, and restaurants.
Naturally, that propelled a series of opposing opinions—most notably, from Jerry Seinfeld. Many of the rebuttals predicted a rosier future for NYC with a nod toward residents’ grit and determination. But these pieces seem to overlook some real-world economic problems. And many of these have been bubbling under the surface for decades.
Before we engrave the tombstone or send out re-birth announcements for New York, it may be wise to answer a basic question: If it can happen there, can it happen anywhere?
In many ways, COVID-19 decimated NYC. With one of the densest and largest urban populations in the world, the virus spread quickly and efficiently—and it was deadly. There were 19,000+ confirmed deaths, 4,400+ probable deaths, and thousands more in the boroughs and counties surrounding Manhattan.
Shutdown measures were swift and severe, and many—such as a darkened Broadway—have lingered despite lower case counts. Simultaneously, residents, reminiscent of those battling plagues of the past, fled the city to their Hamptons homes or their parent’s suburban tract houses. The rest of the nation followed NYC’s lead—and the longer the shutdown continued, the louder the non-virus-related questions became.
Some of what NYC is experiencing may have been inevitable; COVID just exacerbated some long-simmering crises and accelerated their impacts:
The problem with the current state of city affairs is there’s no rulebook. Because of the pandemic, people are behaving differently—and much of their new behavior does not reflect how they wish to live their lives. As a result, it’s difficult to predict how NYC and other cities can respond.
Until there’s a vaccine, it’s impossible to estimate a timeline of when business will get back to normal—or if it ever will. For example, the virus and remote working have forced office tenants to re-examine just how much space they actually need.
The closest example we have to an experiment in progress is Detroit. Perhaps no other city in the country exemplifies urban failure better than the Motor City. Once the crown jewel of American industry, Detroit has for years suffered under the weight of rampant unemployment, poverty, and enormous debt. In the five years after filing for bankruptcy, millennials moved in, investors took notice, and the downtown area boomed, earning the city a new nickname: “Comeback Capital of Urban America.”
Things, though, didn’t go according to plan. With development came higher rents for residential and office spaces, higher construction costs, and gentrification—all of which steered millennials away from the city while driving impoverished residents into greater despair. Then, COVID arrived. Just as in NYC, the virus capitalized on Detroit’s weaknesses.
Perhaps it has to do with the sunshine and palm trees, but South Florida cities and COVID are an anomaly. Despite being a COVID hotspot for the state since March, new construction and leases in South Florida have continued to move forward. In addition, the region has also seen its share of New Yorkers and other northern urban snow birders relocating to Florida’s warmer climate for the duration of their home states’ lockdowns, as well as millennials flocking to the suburbs.
This doesn’t mean, though, the region is not without its share of problems. Like other large metropolitan areas, South Florida has its own affordable housing crisis. Additionally, in 2017, Miami had the second-lowest median household income in the United States, as well as the second-highest percentage of people living in poverty.
Although these numbers improved slightly in 2018, COVID-related unemployment has undoubtedly made the numbers skyrocket. Complicating this is the Florida economy’s heavy reliance on tourism, which has caused some experts to predict the job market may suffer into late 2021 and beyond.
South Florida businesses and real estate may have been less impacted by the pandemic than NYC, but they share many fundamental challenges. A new way of working and evolving COVID measures and restrictions are changing priorities. Commercial properties such as office high-rises with a large footprint, for example, will have to adapt to the new normal—and some investments may not make it.
While COVID has clearly placed extreme burdens on large metropolitan areas, is it time to ring their death knell? Probably not.
There is a good reason to believe that cities will recover, although it remains unclear just how that recovery will actually look. Most certainly, things will be different. Technology will undoubtedly play a role, as will smaller office footprints.
A recovery for New York (and other major metropolises) will take leadership, vision, and work. At the same time, there is a need to address the underlying economic issues that made so many of our cities and people vulnerable, including wages, population density during a pandemic, and affordability.
For assistance determining how to proceed with an investment or to find the right investment property for your needs, please call Morris Southeast Group at 954.474.1776. You can also reach Ken Morris directly at 954.240.4400 or via email at firstname.lastname@example.org.
The economic impacts of COVID-19 won’t be fully measured for quite some time, but one thing is clear: many commercial real estate owners aren’t receiving rental payments from tenants.
Even as communities reopen, numerous restaurants, personal-service providers, and retailers don’t do enough business to pay their bills. Restaurants operating at 25% of capacity, for example, are seeing revenues well below normal, even though they are now technically open for business. In March, industry experts predicted that 2020 would see a loss of up to 75% of independent restaurants in the United States, representing five to seven million lost jobs and $225 billion in revenue.
Small businesses are unable to pay their bills across the country, leaving commercial real estate landlords to ask, “What about the rent?”
In the spring, as part of the Coronavirus Aid, Relief and Economic Security (CARES) Act, the federal government imposed a moratorium on foreclosures and evictions, keeping both homeowners and small businesses in their properties during the initial shutdown. But that moratorium expired in July.
In Florida, Governor Ron DeSantis extended the statewide moratorium to September 1st. But that extension only applied to residential tenants who have been “adversely affected by the COVID-19 emergency”—the order did not affect CRE rental payments.
Then, on August 8th, 2020, President Donald Trump signed four executive orders for coronavirus relief, including one that was positioned as preventing evictions. That executive order is widely seen as having no legal teeth, however. It merely recommends that federal agencies consider whether a moratorium on residential evictions is needed—it doesn’t actually prevent evictions of any kind.
And while Florida currently has no statewide order preventing commercial real estate evictions, both Miami-Dade and Broward Counties have enacted some moratoriums.
Broward’s “order prohibits the issuance of any writs of possession until normal court operations resume,” and “the sheriff’s office has suspended serving eviction notices during the COVID-19 pandemic.” Miami-Dade has “suspended [police department] enforcement of any eviction orders until the COVID-19 emergency expires.”
Broward County’s order is in place “until further notice,” and Miami-Dade County’s directive is in effect until “expiration of the emergency period”—which was extended on March 18th and remains ongoing.
All rental agreements are contracts, of course. And when contracts lose meaning, much of the foundation of our economy and society unravels.
Landlords are caught in the middle—between compassion for their tenants and the need to make their own mortgage, insurance, and property tax payments. While almost everyone in the CRE equation understands and empathizes with the unique economic burden COVID-19 has placed on businesses, it’s vital that contracts become enforceable again—and that evictions happen when they are absolutely necessary.
In the meantime, is it fair if landlords lose their investments? And what about tenants who may be experiencing temporary economic hardship?
The current situation calls for flexibility and a diligent eye on the longer-term implications of each tenant-landlord relationship. Landlords and tenants should keep open communication lines and review leases to see if any necessary accommodations can be reached as the economy reopens.
Starbucks, for example, has reached out to all of its commercial landlords to renegotiate rental payments.
“Effective June 1st and for at least a period of 12 consecutive months, Starbucks will require concessions to support modified operations and adjustments to lease terms and base rent structures,” said the letter distributed [in May] signed by Starbucks Chief Operating Officer Roz Brewer.
Chipotle Mexican Grill and Shake Shack have followed suit. Dunkin’ Donuts, Applebee’s, and Yum Brands, which includes Pizza Hut, KFC, and Taco Bell, are undertaking similar efforts, including tying terms to lease extensions.
It’s not out of the question to expect this trend to continue as various businesses—large and small—operate under government capacity restrictions and other limitations.
Many landlords hesitate to drop the amount for rental payments to accommodate tenants because “accounting rules still allow them to book income if rent is deferred, as long as it isn’t reduced. Temporary rent forgiveness or discounts would also reduce their property valuations, which could hurt an owner’s ability to get a loan.”
That said, landlords may be able to work out temporary deferments or other measures to keep some income flowing, tenants in business, and property values stable.
Again, landlords and tenants should keep the lines of communication open. If you are a landlord, tell your tenants not just to go dark and stop paying: “Keep us in the loop so we can help, and let us know what’s going on with your income stream.” Having those numbers will make it easier to approach your commercial lenders with renegotiations or forbearance requests.
Also, keep in mind: While landlords might work something out with bank lenders and insurance companies, commercial-backed mortgage securities (CMBS) are another matter. CMBS are a type of financing with no single “entity”—investors pull together into a security instrument, so there is no one to speak with about renegotiating terms.
Thus, if you have CMBS financing, tenants stop paying, and you can’t pay, there’s little you can do. The moment you are late with a payment, the financing goes into special servicing, and the property is in immediate jeopardy.
This creates a unique problem for CRE investors with this type of financing—and getting overdue rent payments or being able to evict non-paying tenants becomes even more critical.
The pandemic continues to contribute to disrupted business and high unemployment, which snowballs into even lower business revenues, among other consequences. All of these factors are affecting the ability of many commercial real estate tenants to pay their rent. The federal government is still working on a follow-up to the CARES Act that may provide some relief, but government assistance can only do so much. And it’s essential for CRE investors to closely monitor the national and local economic outlooks and stay adaptable.
In these most uncertain of times, a trusted advisor and property manager can be a valuable resource. At Morris Southeast Group, we’re closely watching how all of this plays out, and we’ll be sure to keep our readers and clients informed as the situation changes.
If you have questions about CRE investing strategies, property leasing needs, or property management services, call us at 954.474.1776. You can also reach Ken Morris directly at 954.240.4400 or via email at email@example.com.