Displaying items by tag: commercial real estate

Is the U.S. in a recession? Whether the correct answer ultimately proves to be “yes,” “no,” or “not yet,” it’s an academic issue that’s not keeping us up at night.

There’s no doubt, though, we’re entering a period of economic slowdown in the commercial real estate market caused by:

• Inflation’s impact on consumer demand and, therefore, business activity.
• The series of Federal Reserve rate increases that are increasing the cost of lending, diminishing buying power, and reducing the number of qualified buyers for commercial real estate.

As we’ve seen for the past several years, Denver’s industrial real estate market is outpacing the office real estate market. That kind of divergence will continue, albeit with the industrial sector slowly flattening out and the office market slowly declining. The trends are marginally better in the suburbs and other prime locations compared to Denver’s city core.  

Office Workforce Issues Continue

Behind the office market data presented here are stories of companies struggling to bring employees back to the office and others who have decided to go to a fully remote or hybrid arrangement. They know all to well the tradeoffs between providing employee flexibility or enjoying significant cost savings, and potentially sacrificing company culture and productivity.

As long as a significant portion of white-collar workers prefer to work remotely and the labor market remains tight, the remote working situation won’t change significantly. A recession-induced reduction in white-collar office jobs will depress office space demand further still, although an economic slowdown may shift leverage back to the employer, who will likely seek to bring jobs back into the office.  

Given the declining occupancy rates in office buildings, more and more property owners will likely find themselves in a “must sell” or “must refinance” situation, which will cause a decline in asking prices due to the cost of debt going up with the increasing interest rates. Owners with a solid equity position will hang on and make necessary financial concessions to attract and retain tenants.

Industrial Commercial Real Estate Sector – Key Data Points

The 10% annual rent growth rate in Q2 for industrial space (now at $11.44 per sq. ft.) is remarkable and much of this increase is due to the lack of newer, vacant light industrial properties currently available in Metro Denver.

Another factor driving rents is the vacancy rate of 4.9%, which has tightened over the past 12 months and has now dropped to pre-pandemic levels after drifting slightly higher during that period.

Some observers believe the market sale price, currently $183 per sq. ft., will move even higher over the next 12 months, although we believe any prognostications like that probably are not fully accounting for the looming impacts of inflation and the economic downturn. This sector might cool marginally, along with pricing pressure.  

Office Commercial Real Estate Sector – Key Data Points

The relative strength of the suburban office real estate market is likely one key to the continued increase in sales prices for office space in the Denver region. The current average sale price of $254 per sq. ft. is up 5.4% over the last 12 months. Other conditions driving this figure include the fact that these office property owners simply can’t afford to discount their rental rates. There’s also the perception that office buildings still represent a reasonable investment with a market cap rate of 6.9%.

Vacancy rates will be the key indicator we’ll be watching in the office sector moving forward since the fundamental pricing principles of supply and demand can’t be ignored. The current 14.4% vacancy rate matches the rate in Q4 2021. The previous time it stood at that level in recent years was in 2005. Early indications are that the vacancy rate has plateaued, but, again, we don’t believe this estimate takes the upcoming economic upheaval fully into account.

Economic Cycles Rarely Align with Lease Expiration

In any market at any time, a seller, buyer, landlord, or tenant will be in a position of either an advantage or a disadvantage. The commercial real estate market is presently in a period of transition, and sometimes these parties have no better alternative but to act now, even though the timing might not be ideal for their purposes. 

If you can’t afford to wait for markets to move in your favor and you need to make a deal (due to an active 1031 Exchange or an upcoming lease expiration, for example), just remember there may be a silver lining to take advantage of or a strategy to limit the negative impact to your bottom line. 

We help our industrial and office commercial real estate clients make the best possible deal based upon the current market conditions.

If you’d like to dig deeper into this data or if you have questions about what all of this might mean for your commercial real estate investment plans or your tenancy situation, please contact us

Summary

The Metro Denver area is a good place to do business. We have a healthy business environment that leads many other geographic markets with regard to commercial construction and leasing activity, thanks to the strength of certain sectors and the general influx of companies to the area from higher cost coastal business centers.

Even so, the markets for industrial and office real estate here continue to move along two distinctly different trajectories. This is maybe most apparent when you consider the fact that there’s almost 9 times more industrial space than office space under construction in this region.

Additional data from Q1 2022 confirm that the demand for industrial commercial real estate space is still outstripping supply – and this disparity is continuing to drive rents and market sale prices to new record highs. The strong demand is due in large part to the need for logistics space and the continued, major growth of the life sciences sector in the Denver-Boulder corridor.

(Disclosure: Fountainhead Commercial Real Estate is currently representing the seller of one of the largest life-science commercial properties currently on the market in the Denver-Boulder corridor.) 

In contrast, the real estate market for office properties remains flat, due in large part to the continued delay in bringing office workers back to the workplace. Some researchers estimate that 20% of the nationwide workforce will permanently work from home, compared to 5% pre-pandemic. This will no doubt dampen the office real estate market for several years unless company work-from-home policies shift or until excess capacity is absorbed. In the meantime, office landlords are confronted with relatively high fixed costs and are forced hold firm on rent prices.

 Industrial Commercial Real Estate Sector – Key Data Points

In Q1 2022, commercial industrial vacancy rates reduced further to 5.5%, down 0.8 percentage points over the past 12 months. It appears this figure may represent the approximate floor for vacancy rate for the foreseeable future – the vacancy rate is not expected to climb much above 6% over the next several years.

Predictably, industrial real estate market rents continued to creep upward in early 2022, to $11.15 per sq. ft., up $0.84 over the last 12 months. This is a year-over-year 8.1% increase in market rents, and this annual rate of increase is projected to peak for the foreseeable future later this year at just over 9%! 

Office Commercial Real Estate Sector – Key Data Points

Although the vacancy rate in the office real estate sector continues to inch up (it’s now at 14.2%, an increase of 0.8 percentage points from 12 months ago), the rent rates are not dropping as one might expect in this office environment. This is likely due to relatively strong business activity in certain neighborhoods (e.g., Suburban Denver) and the fact that the region still has a strong ownership market with landlords not seeing a compelling reason to reduce rents and put themselves at financial risk. The average market rent per square foot is $28.76, up 1.3% from a year ago, and we expect this rate to steadily, but slightly increase in the immediate years ahead.

Office properties continue to provide a  strong investment yield (compared to STNL Retail or Industrial), with a market cap rate of 7.1% and sales prices up nearly 4% from this time last year to an average of $244 per sq. ft.

If You’re a Tenant Preparing to Negotiate Your Commercial Lease ...  

Even though the commercial office real estate market is lagging the industrial market, landlords in both sectors are anticipating a moderate-to-strong economy in the months and years ahead depending on how the current headwinds (i.e massive inflation, labor shortage, urban crime spike) impact businesses. They’re pricing and marketing their space accordingly. Industrial tenants, in particular, aren’t in the driver’s seat at this time.

If you’re approaching your tenancy lease renewal in 2022 or early 2023, considering making a move, or planning your new business initial lease, you’ll need to optimize your lease agreement in every way you can – the rental rates for sure, but also the lesser-known economic provisions that can also add up to big savings and the numerous non-financial contractual provisions that provide flexibility and options.

If you’d like to dig deeper into this data or if you have questions about what all of this might mean for your commercial real estate investment plans or your tenancy arrangements, please contact us.

Commercial real estate leases can be lengthy and dense. Prospective tenants assume that much of the content other than the financial terms is unchangeable “boilerplate” language. When reviewing the lease, commercial tenants look hard at the numbers and simply try to understand the rest. In fact, many non-financial provisions in a commercial real estate lease are negotiable.

In last month’s blog, we focused on the lesser-known economic-financial provisions in a commercial lease that can be negotiated to the tenant’s favor – things like amortizing supplemental tenant improvements, scaling back restoration requirements, and capping operational expenditure costs.

This month we’ll explore four of the many non-economic lease provisions you may not realize are actually negotiable. As we said last month: Your landlord is well-aware of these details and fine print ... and you should be too!

Landlord’s Right of Relocation

Almost all leases for commercial space in large, multi-tenant office buildings include a Right of Relocation provision that allows the landlord to relocate a tenant to a similar-sized space in the building if the landlord needs to make room for another, larger tenant’s expansion. In these cases, the landlord typically will reimburse the relocated tenant’s costs for moving equipment, furnishings, and materials.

If the relocation space is slightly larger, the tenant may end up with more space than they need and a higher rent payment ... unless they’ve negotiated a “Lesser Of” clause related to the Right of Relocation.

This negotiable lease language should state that if the relocated tenant’s new lease space is larger than their original space, the tenant’s total monthly rent payment will remain the same. However, if the new lease space is smaller than the original space, the tenant will pay rent that is equal to the current rental rate for the smaller square footage, thus reducing their total monthly rent payment.

Additionally, a tenant can negotiate this Right of Relocation provision to ensure:

• The new space has equivalent or better orientation regarding exterior views, visibility from the elevators, the floor (i.e., on the same floor or higher than the original space), overall layout, and more.
• The tenant is reimbursed/compensated for additional costs related to the move – for re-cabling, updating websites and letterhead, relocating a security system, and communicating the change of suite/address to tenant’s clients, for example.

Expansion and Contraction Options

When negotiating for new space, tenants should account for realistic, anticipated growth as well as the possibility of a future need to downsize. Depending on their risk tolerance and growth prospects, they should consider the following provisions:

An aggressive, “bullish” tenant may want a Must-Take clause that preserves specified adjacent space for future expansion. In this case, the tenant is contractually obligated to lease the Must Take space and begin paying rent (ideally at the same rate they’re paying for the original space) on a specified date, typically 6 or 24 months from the date of tenant’s occupancy. 

An optimistic but more cautious tenant may be more comfortable with a Right of First Refusal (also known as an ROFR) clause, which states that if another prospective tenant negotiates a lease for space adjacent to the tenant’s current suite, the existing tenant has the option (but not an obligation) to lease the space at that time, matching the terms of the letter of intent from that prospective tenant. 

A Right of First Refusal clause can also be negotiated to enable that tenant to obtain the same concessions for the ROFR space as the landlord offers the prospective tenant, including tenant improvement allowances and free rent periods, for example.

A less aggressive or less optimistic tenant, perhaps one who’s largely dependent on projects and renewable contracts, may feel more comfortable with a Termination Option that allows them to downsize or give up their lease space based on certain criteria or verifiable business performance metrics such as revenue, full-time employee count, and project/contract renewals. In these cases, landlords will likely insist that their unamortized out-of-pocket costs related to that lease be reimbursed and that the tenant pay a termination penalty.

Guaranty of Lease 

Landlords may require the principal owner(s) of a newer business (and especially any LLC that’s a pass-through entity for tax purposes) to sign a personal guarantee legally obligating the business owner(s) to cover their tenant’s lease obligations including:

• Total lease payments for entire lease term.
• Triple-Net obligations (property taxes, building insurance, and common area maintenance costs).
• Costs incurred by the landlord, such as real estate commissions, tenant improvement allowances, free rent, and moving allowances.

Guarantors, however, can seek to impose time limits on the duration of personal guarantees or cap the dollar value of their liability to only include unamortized out-of-pocket expenses incurred by landlord. Alternatively, tenants should also consider negotiating a larger-than-normal security deposit in lieu of a Guaranty of Lease.

Representations and Warranties

These provisions are generally included in lease agreements when a tenant is the sole occupant in a building (e.g., an industrial site or a stand-alone retail building) or in Triple-Net lease arrangements where the tenant is responsible to pay property taxes, maintenance costs, and building insurance. The new tenant can’t be certain that the previous tenant adequately addressed all building maintenance details and, therefore, the new tenant may be responsible for the consequences.

In these situations, the landlord may agree to include Representations and Warranties language whereby the landlord takes responsibility if maintenance of building’s mechanical systems were mismanaged by the previous tenant. This would include a prior tenant’s poor maintenance of the HVAC systems, for example, and the landlord would be responsible to confirm (represent) that the system is in good working order or agree to repair (warrant) these systems if the need arose during the term of the provision.

In some cases, a landlord will agree to a 6- to 18-month Representations and Warranties period, but it may be possible for the tenant to negotiate for 36 months depending on the condition of the property and current market conditions.   

Final Thought

These are just a few of the lesser-known, non-financial provisions commercial tenants should negotiate to provide a level of business certainty and to avoid possible headaches in the long run.  

If you’re preparing to negotiate a lease or a lease renewal, don’t gloss over the fine-print, non-financial provisions.  

Please give us a call – we’re ready to put these negotiating strategies to work for your business!

As a tenant representative, we obtain the best possible arrangements and terms for our clients in many respects during lease negotiations. This month we’ll focus on some of the lesser-known negotiable economic provisions in a commercial lease. Then in March we’ll explore various obscure non-economic lease provisions that can be negotiated to your advantage.

Your landlord is well-aware of these details and fine print ... and you should be too!

Certain economic considerations in a commercial lease are well-known and easy to identify. The rental rate, obviously, is a primary factor, along with provisions related to security deposits, tenant improvement allowances, and parking abatements.

But tenants shouldn’t stop there.

Our clients are often surprised to learn that many other provisions in their lease can be negotiated to significantly reduce their long-term costs – items that are open for discussion and not set in stone until the lease is signed.

Here are just a few:

Caps on operating expenditure costs. These provisions can help a tenant limit their financial exposure for certain controllable expenses – for example service contracts related to maintenance and snow removal or pass-through costs for capital expenses.

Holdover. This refers to situations in which a tenant chooses to remain in the space beyond the expiration of their lease term. Contracts typically allow the landlord to charge a premium in this case – often set at 200% of the prior monthly rental rate. It’s possible, though, to negotiate this down to 125% for the first month or two and then cap it at 150%. 

The tenant can also seek to contractually limit consequential damages if the landlord claims to incur additional costs (for example due to a delayed construction schedule or forfeited rent from a new tenant) when the tenant delays their exit.

Amortize additional tenant improvement allowance into the rent. In some cases, the tenant improvement allowance isn’t sufficient to cover the full cost of a construction buildout. Under this provision, the landlord would pay the additional construction costs and then amortize the expense (with interest) into the tenant’s rental payments over the length of the lease. In this way, the tenant won’t have to deal with a significant capital expense at the start of the lease term. 

Renewal provision. This provision prevents a tenant from being required to move out at the end of a lease term – the landlord must renew the tenant’s lease as long as the tenant meets specified moveout timelines. It’s even possible to require the landlord to provide additional tenant improvement allowances in this case, such as free rent, free parking, and more.

Restoration. Tenants can negotiate the restoration provision to where they won’t have to pay to return the premises back to its former condition after the lease expires. These restorations can be extremely expensive since they might involve removing walls, replacing ceiling grids, removing flooring, and reversing other improvements.

Termination option. This provision allows the tenant to end their lease without penalty before the actual lease expiration. It can be difficult to obtain this in 5-year leases, but landlords are more likely to agree to it in a 7- or 10-year lease.

Interruption of essential services. This allows a tenant to stop paying rent after a defined period of time if the landlord is unable to provide essential services to the premises, such as electricity, water, elevator service, and more.  

Moving/furniture allowances rolled over into additional free rent. In market conditions like we see currently, it may be possible to not only negotiate for the landlord to provide a lump sum allowance to pay for a new tenant’s relocation costs, but to have any remaining amount of that allowance applied to the cost of new furniture or even converted into additional free rent.

These are just a few of the lesser-known financial provisions tenants are able to negotiate. They can all add up to substantial savings over the life of the lease – and beyond.

If you’re preparing to negotiate a new lease, please give us a call. We’d be glad to put these strategies to work for you!

Summary

Over the past calendar year, economic conditions in Denver’s industrial and office markets were polar opposites.

Industrial space seemed to be snapped up nearly as quickly as it came online. It was quite the opposite in the office sector as 1.80 million net sq. ft. of space was vacated even while new properties came online.

Depending on whether a person was in the industrial or the office sector and whether they were a landlord or a tenant, these were either the best of times or the worst of times.

But there are hints in the 2021 Q4 data, and even stronger indications in the 2022 projections, that the current extreme conditions may ease in both markets over the next 12-24 months.

Industrial Sector

Nearly all the recent data for the industrial sector tells the story of supply fighting to keep up with demand.

Vacancy rates dropped from 6.0% to 5.5% in the past year. Not surprising, market rent per sq. ft. was up $0.59 for the 12-month period and $0.23 in the last quarter alone.

The annual rate of growth for rent reached 5.7% by the end of the year, an increase of 3 percentage points over year-end figures for 2020. This annual rate of increase is expected to spike in the first three quarters of 2022 before falling back to the mid-5% range by the end of the year.

In short, current directional trends in the industrial real estate market will continue in 2022, although rates of increase will moderate. The boom will become a low roar.

Office Space Sector

As mentioned, office tenants continued to vacate space through year-end 2021. This will continue, albeit at a steadily declining rate as we move through 2022. Vacancy rates increased by 1.8 percentage points in 2021 to 14.4%.

In spite of this oversupply (of both direct space and sublease space), many office landlords appeared unwilling to significantly reduce market rental rates. After declining slightly during much of 2021, rental rates strengthened again in the last half of the year, resulting in a year-over-year rental price increase of $0.13 per sq. ft., a 0.4% increase.

Sale prices for commercial office properties were steady throughout most of 2021 but bounced higher in Q3 and Q4 to $247 per sq. ft., up $10 per sq. ft. for the 2021 calendar year. This likely helped account for the steady rent rates in the face of declining demand.  

This recent data for the office market indicates the rebound will continue in 2022 as the strong tenant’s market of the past two years diminishes over the next 18 months.

Implications for Lease Negotiations

In spite of the disparity between the two markets, there’s one common takeaway. In both cases, landlords are taking a hard line on rental rates.

On the industrial side that’s due to the fact that supply and demand is on their side. And in the office market, it’s likely because the cost of newly constructed space remains high, the typical landlord’s current costs are fixed (such as long-term mortgage), and landlords don’t want to get locked into relatively low lease rates when they see better times ahead.

Given this inflexibility on rental rates, office and industrial tenants need to optimize their leases in other ways. There are, in fact, numerous other financial and nonfinancial provisions tenants can negotiate to their advantage.

Watch for our blogs over the next two months, where we’ll present some of the lesser-known negotiated terms that can improve a lease in spite of a landlord’s inflexibility on the rate. Feel free to give us a call if you’d like a sneak preview!

If you’d like to dig deeper into this data or if you have questions about what all of this might mean for your commercial real estate investment plans or your tenancy arrangements, please contact us.

Summary

Reviewing the current marketplace for commercial property in the Greater Denver region is a tale of two sectors. The data for each of the two primary segments, industrial and office, matches the narrative we’re all familiar with regarding the relative impact of the COVID pandemic on these two market segments and the status of the financial recovery in each.  

On one hand, the manufacture and distribution of consumer goods didn’t let up in 2020 or  YTD 2021, and these facilities today are continuing to try to catch up with pent-up demand. Significant increases in industrial real estate inventory and square feet under construction, though, have helped limit the increases in rent and sales prices. Without this infusion of new space, those numbers would likely be even higher.  

In contrast, many companies closed their offices or dramatically reduced employee office presence 2020 and 2021 – a situation that will continue for the near future and possibly longer. This is no doubt adding to the softening trends in office real estate rent growth and vacancy rates. In the next six months, companies will be making some hard decisions about bringing employees back to the office that could affect this market in 2022 and 2023.

Industrial Sector

The industrial sector real estate market remained relatively strong throughout the last 18 months, thanks in large part to the distribution sub-sector.

This slower but sure growth is reflected in the 3.3% rent increase observed over the last 12 months, back up to Q2 of 2020 levels, but well below the 5-6% range we saw in the prior seven years – and which we’ll likely see again shortly.  

The other data that jumps out here is the $153 sale price per sq. ft., an all-time high after a relatively large jump this quarter. It’s now at a level where we expect it to remain for the next 12 months. It will begin to creep up further after that as the recent expansion in surplus inventory is absorbed by industrial tenants and owner-occupants.

Office Sector

The office building investment market may take several years to recover from the COVID pandemic. Tenants will be at an advantage when negotiating economic terms for a new lease or office lease renewal.

Annual rental rates are down 1% as of this quarter. CoStar’s analysts predict these will remain in the red, at that level and lower, until breaking through into positive territory in Q1 of 2023. Rents won’t reach 2019 Q4 levels ($20.46/sq. ft.) until Q4 of 2024 by our calculations. In the face of this uncertainty, market cap rates will likely remain steady at 7.1%.

Another trend we’re watching closely is the office vacancy rate. This crept into double-digit territory in Q1 of 2020 and continued to rise slowly but steadily in the past year. Now standing at 14.3% across Denver-metro, the vacancy rate is expected to continue to climb and top out at around 17.5% in 2024.

If you’d like to dig deeper into this data or if you have questions about what all of this might mean for your commercial real estate investment plans or your tenancy arrangements, please contact us

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Not all commercial real estate properties have suffered from the impacts of the government shutting down certain businesses ostensibly due to COVID-19. In fact, industrial real estate in Denver is currently seeing record-breaking amounts of growth amid the pandemic. Unfortunately, the same can't be said for the city's office, retail, or hospitality markets.

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