Due to the accelerating speed of change within and among companies, an acceleration enabled by and brought on by technology, the conventional view of the appropriate length of term of a commercial space lease must and will change.
Three main factors determine the length of time that a given business can or is willing to support a business plan of operation and thus maintain or hire staff to carry out the plan:
1. The ability of the firm to project revenue forward with an acceptable degree of accuracy.
2. How quickly the firm can alter its labor force and capital in the abandonment or modification of a current business plan to retool for an altered plan.
3. The speed of innovation and its consequent threat to a firm's business plan by a) the impact delivered by a firm's closest competitors and b) the impact delivered by a macroeconomic shift whether within an industry, a geographic area, or in a paradigm shift in business thinking.
None of these three factors is new. They have existed in varying form, within and outside the business world. For example, the respective strategic changes of the governments of France and England over the course of centuries of warfare would constantly change based on a) the ability or inability to deliver manpower in the form of armies to a variety of fronts; b) the ability to modify strategy, be it by approach or more typically by technological innovation to gain an upper hand, i.e. the Royal Navy; and c) the endless quest for allies, external to the direct conflict, but critically important in terms of access to capital and to ideas.
The examples of corporate "battles" if you will are far more numerous but based on these same factors. Consider the case of Wang. The firm began as a producer of sophisticated adding machines and advanced calculators. It remained a small but successful firm following this business plan for over a decade. And then An Wang created the word processor. Wang quadrupled in size in 2 years. Its competitors within the calculating field--IBM, HP, Texas Instruments--were knocked on their heels. And Wang, due to its ability to accurately forecast revenue, was able to maintain a business plan for several years that required tinkering but not a major shift of resources and capital. In doing so, complacency stepped in, and Wang found itself at a critical disadvantage in the second factor described above, the speed at which it could change business plans and retool to meet the new plan. And then IBM introduced the minicomputer. Wang was out of business within 8 years of that event. It did not attempt to build a minicomputer for 3 years and, when it did, IBM and a new player in the field, Digital Equipment, had already upped the ante by pounding through advance after advance. Wang's first minicomputer was 2 years out of date when it was brought to market.
Most firms can implement and execute an initial business plan. Few firms are able to optimally change the alignment of their resources to allow internal product change or, as demonstrated by the French and by Wang, to respond to the threat of competitive innovation.
As a commercial real estate broker, I deal with a critical component of the resource structure of a firm, assistance in providing working space in which firms carry out their business plans. And the real estate world is about to undergo an enormous shift in its own view of time.
There is no reason for a "standard" or "conventional" length of a real estate lease. The current 5 or 10-year default is at best a reflection of laziness and at worst a cause of misallocation of capital. It is artificial because it presumes that the time horizon of a business plan can be captured in a timeframe (the lease term) which has remained static for decades in a world where the length of the business plan has shrunken significantly.
In speaking to the vast majority of tenant clients, I have witnessed the shift during my own 27 year career. It was already out of date when I began as a broker in 1982. A minimum 5-year term was already too long for the conventional length of corporate insight. However, it was not radically out of line. General technological and communication changes, such as Wang's word processor or the IPhone, have enabled companies to respond to self-imposed, competitor imposed, or changes imposed by larger shifts in the macroeconomic atmosphere. But the real estate lease is still stuck in 1975.
This creates three distinct problems. The first and by far most important is that it sets the stage for individual business failure. The domino effect leading to this disaster begins when the firm’s need to shrink or expand, to accommodate a new business plan is restricted by the length of the lease term. The minimal protections granted by rights to sublease carry an implicit loss owing to lower price the market is willing to pay in a sublease where the layout, term, and lack of direct line of control to the Landlord are predetermined and unchangeable. Termination rights are no more than buyout rights. The price of freedom by way of termination often exceeds the ability of companies that simply want to adjust their space needs to pay. Unable to innovate and carrying an unmanageable rent burden, companies fail. And smaller companies will fail disproportionately.
The second problem is the consequent damage of tenant failure or default on the financial structure of the individuals or firms that provide the office space "asset"--landlords and lenders. Tenant default can create mortgage default which then generates an inhibition to new development.
The third component is the inefficient use of capital by tenants, landlords, and, as a result of the joint nature of the misuse, by our economy. For example, the damage of default is not limited to the specific loss of rent from the failure of a single tenant nor is it limited to the consequent diminution in building value of this particular loss of income. Tenant default leads to severe capital loss both in the write-off of what I will call "specific tenant improvement capital" and to the need to increase what I will call "forward improvement capital."
Let’s look at the first since it is the most obvious. Assume a landlord has paid for the construction necessary to accommodate the needs of a specific tenant, the “specific improvement capital.” Upon default, the landlord suffers a loss of income and a loss of unamortized improvements. Landlords may choose to record only a portion of the loss based on the so-called "reusability" of space, but trapped by their own 5 or 10 year conventional lease structure, this mode of thinking is not prudent nor realistic.
More than this, what is ignored is the increase in the aggregate cost of “forward improvement capital.” A default triggers an unexpected, and thus typically unplanned for, premature expenditure to secure a new tenant. Costs are both “hard”, such as the actual cost of reconstruction, and “soft” such as architectural fees and brokerage commissions. One could argue that forward capital would occur at some point in any case, even without lease default, simply because leases expire and tenants move. While this appears correct logically, it ignores the reality of the increased likelihood that a tenant will remain as a tenant beyond the expiration of an initial term simply because the tenant avoids its own expenditure of capital in a relocation. “A tenant at rest tends to remain at rest.” I apologize to Mr. Newton for this terrible paraphrase.
Let’s now look at the consequences of the artificial lease term. It prevents a company from adjusting its resources to fit a new business plan. This causes a reduction of income to the company because it is physically constrained from a realignment of resources to enable a new business plan. If severe, it causes a firm's demise and a loss of capital far greater than any real estate costs, i.e. capital paid for by a tenant within an office building. It can eliminate most if not all of the entire capital of a company. It then weaves it way through the financial markets by way of the landlord and lender who suffer the consequential damages of loss of rental income and capital and through the finances of other firms affected by the demise of the tenant in default, such as that tenant’s own suppliers and vendors.
The solution to this problem is simple. The length of the office term must no longer be based on a conventional and thus artificial period of time. It must be based on the function it serves, as a physical asset in which production occurs over the business plans of the tenant. It must also be based on the necessity for both the tenant and the landlord to properly recognize and account for the capital costs involved in the specific and forward improvements necessary for effective functioning of the commercial real estate market as an asset.
Below are the components of determination of rent.
Let:
Lt = The conventional lease term of today's real estate market, 5 or 10 years.
Lm = The length of a specific company's business plan.
Cs = The specific capital improvements necessary for a tenant's effective use of space.
Cf = The forward capital improvement necessary for a post occupancy refit.
H = The time that a Landlord plans to own a property.
Y = Landlord's yield or return on capital over the Landlord’s holding period (H).
I = Tenant's gross profit margin over the length of a single business plan.
R = Rent payable by a tenant to a Landlord over a lease term (Lt).
Given the above, Rent is defined as follows:
R = (Cs + Y) * Lt.
To solve the problems describe above, I submit the following realignment of definitions to our industry:
Allow Lt = Lm.
This simple adjustment replaces and repudiates the concept of a market-driven or capital-driven lease term. The proper length of term will now we determined by the user of the space who, at a price, can match business plan to lease plan.
I would posit the following theorem based on this adjustment:
By allowing lease term to match the business planning horizon, tenants will have the ability to maximize gross profit margin. Minimizing rent will no longer be the ultimate objective. By allowing the same, landlords will have the ability to maximize yield over holding periods by increasing the inherent value of space by decreasing the constraints now placed upon occupancy by term.
I will now proceed to my argument and my proof, humbly submitted.
Let’s review the individual components of cost and return, beginning with capital. In my proof, I will assume that capital costs include both direct and indirect costs incurred in the initial and subsequent leasing of commercial space.
Allowing for my proposal that Lm = Lt, there will be a shift in the benchmarking of a successful leasing outcome for a tenant, as follows:
The tenant's objective in an agreement to pay a specific rental over a specific term must be driven and measured entirely by effect of the outcome on the tenant’s gross profits margin.
The objective does not ignore the specific competitive market context, the office market, which will determine the “pure” rental component of Rent. But the outcome will no longer be a measurement against market. There will be no such phrase as an “above market” or “below market” transaction. The measurement of achievement will be strictly a measurement of enhancement of gross margin.
My assertion leads to my first elemental principle of the “successful tenant.”
The tenant that will achieve the highest rate of success will be the tenant best able to match a business plan to lease term, initial or altered.
This is the heart of the capital issue for the tenant. This argument is not an endorsement of a longer term. We oversimplify the cost of occupancy when we allow capital costs of occupancy to determine the length of term. Again, first consideration must be given to gross profit margin. For example, assume a tenant is capable of a two-year business plan. The Rent will be significantly higher than a tenant capable of a five-year plan and lower than a tenant capable of a short-term plan. But the Rent is not the measured objective. The tenant must analyze the marginal additional cost of higher rent to the marginal increase in gross profit margin. Capital depreciated over a short lease term adds cost but allows the freedom to match business plan to lease term.
It is perfectly reasonable for a tenant to pay $200.00 per square foot per year for two years while a tenant of identical size, capital requirement, location, and all other factors equal, pays $100.00 per square foot per year for 3 years. The differential is entirely due to the degree of importance and measurable value the first tenant attaches to the term as a direct determinant of gross profit margin.
Let us know consider the landlord. The landlord's objective, again set in a market context--the office market--is to achieve the highest yield (Y) over the preferred holding period, H. To the landlord, the objective of a rental negotiation is a measurement not against market but against desired yield, as follows:
Y = ((R * Lt) – C) / H
I propose the same realignment in the definition of term as I did in the analysis of the tenant perspective and objective.
Allow Lt = Lm.
Landlords that embrace this new philosophy must allow for the tenant to set the term according to the tenant's business plan. However, just as a given tenant will pay a higher or lesser amount based on the ability to increase gross profit margin by matching lease term to business plan, so too will the Landlord demand and receive a higher Rent on the margin to offset the marginal increase in capital costs due to changing periods of amortization. But by doing so, the Landlord does not simply match the return on a conventional term by charging for a lesser term. The price a tenant is willing to pay to lease space from a Landlord who embraces the concept that the business plan match the lease term will increase simply because the Landlord embraces the philosophy. This sounds horribly circular but, in many ways, the real estate leasing market is just that. The actions of a Landlord in one transaction affect the expectations of a tenant in the next transaction. It’s not unlike the 1970’s feel-good philosophy of “positive reinforcement.”
My assertion leads to my second elemental principle of the “successful landlord”:
The landlord that will achieve the highest rate of success will be the landlord best able to accommodate tenancies as determined by business plan of the tenant and successive business plans of forward tenants over a chosen holding period.
Because Cs is defined as the specific improvements dictated by a specific tenant, a tenant seeking a lesser term, will, at the margin, pay the landlord a higher rent to compensate for the higher yearly capital costs of a shortened capital amortization period. Landlords must stop making the argument that they "cannot do a three year deal because we can't amortize...." as a defense. This represents a failure to adapt in an economy whose time horizon of planning continues to shrink for all of the right reasons. And if a landlord's defense is to play the foil for the lender or other holder of beneficial rights or income from rent, then these recipients of return must also accept my case to allow Lt to equal Lm. If neither does, the real estate industry will find itself in a constant state of unnecessary capital write-offs, misallocation of capital, and consequent financial inhibition to develop new space, all brought on by unwillingness to accept current business management and mathematical fact, which I will demonstrate below.
In calculating capital costs, the landlord must not only account for the amortization of capital over the current term (Cs) but the necessity for additional capital thereafter (Cf). Therefore, I propose the following redefinition of the proper measurement of capital in a real estate lease.
The capital expenditure of a transaction is equal to the capital of the specific allowance as defined above AND the landlord's estimate of the forward capital of the following transaction. The variable that will ultimately be subject to scrutiny for success will measure return (pure rent) less all capital expended over the holding period.
In summary, I am proposing that the conventional lease term, artificially constructed and restrictive in allowing the tenant to match business plan with lease term be replaced by an approach to the lease driven by its underlying function--the business plan horizon of the occupant. Both parties will then pay or receive a premium for allowing flexibility, and neither party will look to "market" as an indicator of performance. The user, or tenant, will look to gross profit margin. The landlord will look to yield, or return, over the holding period.
Below is a mathematical “proof”, or more appropriately, example of my theory.
Assume capital cost for all Tenants at $40.00, and assume that all costs are paid for by the Landlord.
Assume all construction costs are fully amortized over the length of the lease term on a straight line basis without interest.
Assume that the "market" rent, as mutually negotiated by Landlord and Tenant, and not to be confused with Rent (R) as ultimately paid by a tenant, is $25.00 per square foot per year in both for both a one-year or two-year term.
Consider two tenants, the only difference between them being the marginal effect on Gross Profit Margin by an increase (or decrease) in the length of the term of a lease of space. Assume the gross profit at the beginning of the lease term to be examined is identical for both tenants at is identical at $1,000,000 per year. Assume that both require 20,000 square feet of space.
For "Tenant A", assume that each additional year of length in term decreases its Gross Profit Margin, as uniquely determined by Tenant A and derived from the foregone revenue or associated profit caused by Tenant A's inability to match the length its business plan, by 70% per year, or $700,000 per year.
Assume the marginal decrease for Tenant B at 25%, or $250,000 per year.
I will establish the method by which each Tenant will determine the appropriate lease term and amount of Rent each Tenant is willing to pay to secure the term. For simplicity, I will allow the option of either a one year or two year term.
Since the “market rent” is identical for both tenants, it is not a determinant of the term or the premium either Tenant will pay for its chosen term. In short, the decision is purely a capital decision.
The capital cost under a one year lease is: 20,000 x $40.00 = $800,000. For a two-year lease, the cost is $400,000. due to the ability of the Landlord to amortize the capital cost over a longer period.
Below is the logic and mathematics that will drive each Tenant’s decision on term and the amount of rent each will pay.
A one-year term will require Yearly Gross Rent of $1,050,000, of which $250,000 is considered “market rent” and $800,000 is considered “capital rent.”
A two-year term will require Yearly Gross Rent of $650,000, of which $250,000 is market rent and $400,000 capital rent.
Tenant A will choose to lease space for one year at $1,050,000 because the reduction in rent that would result in a two-year term ($400,000) is not sufficient to cover Tenant A’s risk of decrease in Gross Profit owing to the longer term ($700,000).
Tenant B will choose to lease space for two years at $650,000 because Tenant B’s risk of decrease in profit owing to a longer term ($250,000) is lower than the $400,000 in additional cost in a one-year lease. Tenant B can accept the risk for the low rent reward because of the lower correlation between length of lease and gross profit risk.
I will close by opening a door.
The elimination of the conventional lease term has the potential to ignite and create a new industry. The industry will be driven by tenants and landlords and involve all firms involved in design, construction, and the infrastructure of the working environment. The industry’s sole focus will be reusable construction. It is a new industry. It involves the creation of reusable space, NOT the renovation or refit of previously used space. Reusable construction is nothing less than the construction of the commercial building of the future. It will reflect the rapidity of change in business, allow for space to reflect optimal business planning, and allow landlords to achieve superior returns in meeting a very new world. The leaders in this new industry will redefine the commercial real estate property, by changing the very nature of our concepts of permanence.
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