This article appeared originally on Commercial Observer.
There’s no such thing as a free lunch, but there is such a thing as free rent.
A year into the COVID-19 pandemic, office and retail landlords in New York City are looking to lure tenants with a variety of incentives that include months to years of rent on the house, as well as money for tenant improvements. And, while most would prefer not to cut face rents, some landlords are increasingly flexible here as well.
Last month, for instance, law firm Ballon Stoll Bader & Nadler moved from their old offices at 729 Seventh Avenue to SL Green Realty’s 810 Seventh Avenue, where the firm took an 11-year lease on a 6,000-square-foot space, under terms that included a full year of free rent.
Particularly notable, said Nicholas Markel, a vice president at Cresa, the brokerage that negotiated the lease for the firm, was the fact that the space was immediately ready for occupancy.
“On a 10-year deal, 10 to 12 months of free rent is normal if you’re building the space from scratch, because it takes about four or five months to build,” he said. “But this space was pre-built and only needed minor modifications.”
Peter Riguardi, chairman and president of JLL’s New York tri-state region, said that of the million-plus square feet of transactions he has closed since the start of the pandemic, “all of them had increases in the free rent as a way to induce the occupiers to move forward on the transaction.”
Research suggests that there is something to this anecdotal evidence. The average tenant allowance for Manhattan office leases of at least five years was $101.58 a square foot in 2020, and the average volume of free rent was 11.7 months, according to Colliers International data. Those were both up from 2019’s $84.66 a foot and 10.5 months, and the highest since at least 2011. Colliers cautioned that a few deals can always skew these averages, no more so than in a year like 2020, when there were so few deals, and that sweeteners, such as TIs and free rent, are dependent on myriad factors. Still, brokers are living the reality in their day-to-day dealings.
Riguardi noted that in a market like the current one, where supply significantly outstrips demand, properties can sit vacant for extended periods. That can cut into owners’ bottom lines in a way that the leasing terms don’t ultimately reflect.
“People say, ‘OK, it’s a $60 rent with $100 in [tenant improvements] and a year’s free rent,’ but they don’t say, ‘Well, that space was on the market for a year, that space was on the market for six months,’” he said. “I’ve been involved in marketplaces, when spaces were on the market for a year or two of downtime, and what I think is happening now is landlords are conscious of this and are threatened by this, and so are more than happy to add free rent into a completed deal to help get it finished.”
After all, if a property is sitting empty, you aren’t taking in any rent, regardless, meaning that free rent — under current market conditions, anyway — actually is free, both for the tenant and landlord.
Tenant improvement dollars, on the other hand, are a more straightforward capital expense, but this is another area where landlords are offering incentives.
“Tenant installation dollars are on the rise,” Riguardi said. “Landlords are now offering a turnkey solution for tenants, where they will build the space for the tenants based on their plans, and for smaller tenants, they are doing a lot of pre-builds, so the space is already ready-built for them when they go and choose it — and I think both of those are going to be very significant for landlords to create velocity over the next couple of years.”
The goal is to avoid lowering face rents. That’s easier said than done, however.
“I don’t know how long [landlords] can really hang onto face rents when there is a flood of sublet space on the market dragging down average rents,” said Stephen Siegel, chairman of global brokerage at CBRE.
Office tenants added some 3.19 million square feet of sublease space to the Manhattan market in the fourth quarter of 2020, according to brokerage Colliers International. That meant that, by the start of 2021, available sublease space comprised nearly one-fourth of the market’s total availability. That’s the highest share since 2009.
Riguardi similarly suggested that despite their desire to avoid touching face rents, landlords will ultimately have to concede to the reality of the market.
“If you own a piece of real estate and you thought it was worth $100 a foot, and now it’s obviously worth $85 a foot, you’re going to have to change the face rent,” he said.
Maintaining face rents has also become less tenable for many landlords as the pandemic wears on, said Paul Amrich, vice chairman in the New York City advisory and transaction services group at CBRE.
He said that over the first nine months or so of the pandemic, landlords were focused on offering whatever concession they needed to, in terms of free rent or tenant improvements to avoid cutting rents. That dynamic has shifted of late, though, he said.
“What we’ve been seeing more recently,” Amrich said, “is that those concession packages were getting to levels where [landlords] didn’t want to have more out-of-pocket, and they didn’t want to wait any longer to get cash flow.
“For example, if your free rent and TI package added up to around two-and-a-half to three years of rent, and then you also have other costs of the deal like commissions and other things, you may be having to wait three or four years until you get one dollar of actual rental payment return on your investment in that lease,” he added. “And I don’t think landlords want to wait any longer.”
Of course, their ability to lower face rents depends on factors like how their debt is structured and how much equity they have in a property. A long-term, multigenerational owner with little to no debt on their building can move quickly to lower rents and grab tenants in a difficult market like the current one, Amrich noted.
On the opposite end of the spectrum, landlords with higher levels of debt and plans to sell in the relative near term may be more constrained in their ability to cut face rents. These owners, Amrich said, “are continuing to just increase the amount of concessions they are willing to throw at a deal to get a lease done.”
Amrich suggested that, for many tenants, free rent and TI allowances are actually more appealing than cuts in face rent anyway.
“A tenant probably prefers to load up the concessions up front because they can push out any sort of rental payment that much further, and, if there is more TI allowance, then they have more cash coming out of the landlord’s pocket on day one that … can mitigate any out-of-pocket costs coming directly from the tenant,” he said.
Michael Hirschfeld, a vice chairman at JLL, noted that in retail, rents had already been dropping for the two years prior to the pandemic.
“You saw rent drops in 2019 in most parts of New York City of 20 to 30 percent, and those were on top of a 2018 drop of 10 to 15 percent,” he said. “So, you were already pretty well off the highs to say the least.”
Hirschfeld said that for landlords and tenants signing new leases since the start of the pandemic, management of uncertainty and downside risk has been a key factor.
“You have a situation where you don’t have people back in their offices,” he said. “You don’t have tourism, domestic or international. You have many parts of town with extraordinarily limited footfall.”
This, obviously, has a negative impact on retail businesses. The question is, for how long will current conditions prevail?
“I have my opinion, you probably have your opinion, landlords have their opinion,” Hirschfeld said. “But I don’t really think that any of us can say. So, if you are doing a deal now, you really need to manage what the next 12 to 18 months look like.”
This uncertainty is moving landlords in the retail space to offer percentage rent deals, where a tenant’s payment is based on the volume of sales they do.
“Landlords who have the financial ability to be creative are willing to sit down and talk about percentage rent-only deals for the next two years,” Hirschfeld said. “And what that does is, it acknowledges to the tenant, ‘OK, you get it, you get that business is going to be a little bit challenging until all of this stuff comes back.’”
These deals do require “a bit more of an open book-type negotiation,” Hirschfeld said, “with the tenant really sharing with the landlord, ‘Here are our projections, here are our real costs, here is what our pro forma looks like.’”
It isn’t, obviously, an ideal scenario for a landlord, he noted. “Landlords, ultimately, don’t want percentage rents. Lenders can’t finance based on percentage rent. Because it’s a variable, it goes up and down.”
It’s an approach, though, that can help with leasing until the New York market regains its footing.
“It’s really a matter of navigating the next two to four years to get back to whatever the baseline is going to be,” Hirschfeld said.
And where might that baseline ultimately settle?
“I’m starting my 48th year in this business next week,” Hirschfeld said, “and I’m not sure I have an answer for that question.”