Tenants are from Venus

TENANTS ARE FROM VENUS AND LANDLORDS FROM MARS

For owners, properties underpinned by leases are core investments. Rental provides the income to service financing arrangements — be that interest on loans or dividends to equity investors. The business of landlords is all about property development, investment, marketing and management. Key to success is understanding fluctuations in property markets, with supply and demand imbalances caused by the ‘lumpiness’ and long lead times of producing new buildings. For tenants, property is a merely another ‘factor of production’ to support their business needs. These needs are seldom correlated to property market fluctuations. And understanding the complexities of property is seldom a core skill of tenants — it is merely another form of corporate infrastructure.

TENANT AND LANDLORD PERSPECTIVES

To understand the challenges of the relationships, it is useful to work through the contrasting perspectives of tenants and landlords in leasing arrangements. Both parties want to consummate the deal, but for fundamentally different reasons. Consider these different perspectives as set out below. For landlords and investors, perspectives are set by portfolio management principles focusing on maximising investment returns. Financial analysis tools of trade include net present value (NPV), internal rates of return (IRR), diversifying geography and property type to avoid non-systemic risks, weighted average lease expiry profiles and residual values assumptions, etc. Investors only care about property design factors, visual effect and operations in terms of how these aspects impact lettability, rental income and ultimately investment return.

Corporate real estate portfolio management principles focus on the productivity of the property as a resource. Financial analysis tools and approaches include cost minimisation, controlling operating expenses, Net Present Cost (NPC), rent as tax shield and financial accounting treatment (GAAP), capital and fitout expenditure depreciation over lease terms, minimisation of residual exit costs, minimisation of duration risk, and expansion and contraction options, etc. Users only care about property as it supports operations and the ability to make profits out of core business ventures operating from the properties.

LEASE NEGOTIATIONS

Lease terms, even five- and 10-year lease periods, seem to come up for renewal with regular frequency. All too often tenants find themselves having to engage with the property market, having to respond to a rent review and/or decide whether to exercise an option to renew. All too often tenants need to expand their portfolio of commercial offices or distribution centres to support their expanding business opportunities. These calendars of lease expiries, rent reviews and option dates are relentless and totally independent of the fluctuations of the property market cycles. Whether the market is surging or has stagnated temporarily, the reality of the market conditions has to be faced.

Lease negotiation dynamics and outcomes are critical to future long relationships. Landlords specialise in understanding and arbitraging their investments against these market fluctuations. Delighting in significant market rent increases in good years they are nevertheless protected by their own lease agreement devices in bad years — the ratchet clause. Rent never goes down.  This facilitates their financing arrangements and therefore landlords prefer long-term leases that underpin their assets and their liabilities — the agreed terms of their debt and equity providers. This is the focus of the landlords’ duration matching. Long leases with good risk attributes — such as good covenant tenants and no openended obligations — can supportlower investment yields and lower rental levels. Users as tenants attempt to focus on strategies to optimise the use of property as a factor of production. Duration matching for users is all about attempting to coincide business projections with lease terms.

But change in business is not always incremental and future needs not easy to project. Flexibility in lease arrangements in response to business fluctuations — to extend or contract the lease terms, to add additional floors or remove floors from lease commitments — are the tenants’ holy grail. But then the tenant has a decision paradox. This emerging need for flexibility contrasts with the ongoing desire for lower costs of occupancy of leased premises. Earnings growth projections continue to put pressures on reducing all recurrent costs — including property occupancy costs. And long-term leases usually have lower costs, but short-term leases offer more flexibility.

As one corporate real estate executive has commented: “Rather than negotiating a 10-year lease over 10 floors of a building, the best lease structure for this tenant would be 10 leases — one per floor — each of one year duration and each with nine one-year options, all at predetermined rental increases. This will provide maximum certainty and flexibility — but is unlikely to be acceptable to any landlord — but why not try it on?”

SERVICE LEVELS

Service levels in the industry continue to be a source of ongoing conflict between landlords and tenants. Landlords tend to forget that office tenants are the customers of the industry. Landlords are happy to provide services — but only as long as this does not cost any more than the budget. For tenants leasing is all about committing to pay a rental over an extended period of time for the use of accommodation and the associated bundle of support services. This includes airconditioning, lift services, toilet and sanitary services, as well as security, cleaning and other soft services.

But seldom, if ever, is there any form of service level agreement providing clear details of associated service levels that can be expected during the lease term. Lessee obligations feature largely in most landlord agreements with copious clauses, but hardly any mention of landlord obligations. Lessee recourse for interrupted or defective services and any mention of rent abatements are all ‘no go’ areas. Tenants rightly expect service levels across all aspects of leased accommodation to be in keeping with the nature and grade of the office premises. Any defective delivery of associated services directly affects the ability of the premises to provide the operating platform that is supposed to be delivered.

Be it key objectives, negotiating challenges or service levels, lease agreements are mutually beneficial to tenants and landlords albeit for different reasons. The similarity between longterm lease arrangements and marriages is often profound. And, as such, for these partnerships, as with marriages, the planets are not always aligned.