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.