When faced with hard economic times, markets react chaotically. In commercial real estate, landlords will often offer ever-increasing incentives to lease their buildings while trying to keep rates at break-even or better. Tenants try to take advantage of the weakness in the market by obtaining the lowest rates possible while getting high tenant improvement (TI) packages.
This is all fine and dandy and a normal course of business. That’s why we hear so much about free rent, broker incentives, and other “sweeteners” these days. Unfortunately, however, this chaotic behavior can take on a life of its own.
In our business this is absolutely true. A common example that we hear more and more is, “We would like to use any excess TI dollars to pay down rent.” This “incentive” has no benefit to the landlord or tenant; in fact, it harms both. The only beneficiaries are the brokers and the government.
Let me explain. A tenant’s broker will send out a request for proposal to a selection of buildings. In said proposal, the broker typically asks for the lowest rate possible, with enough TI to finish out the space as the tenant so chooses. The broker will often verbally tell the landlord that the tenant plans on making the space wonderful and will probably sink some of its own money into the finishes, in addition to the landlord’s contribution.
Sounds good right? Wrong! Because what usually happens a round or two later in the process is that the broker will ask if the tenant can use any excess TI dollars to pay rent (most of the time while requesting a higher TI package). What’s worse is that both the tenant and broker will make arguments as to why this is in everyone’s best interest.
Bullpucky, as my grandma used to say.
Let’s break this down step by step. Negotiations by their nature are contentious. Each side is trying to obtain the best deal possible. This often requires that those negotiating present their proposals in the best light while ignoring the shortfalls. The real trick to a successful negotiation is to do this while not angering the other side so much that they become obstinate or, worse yet, walk away. As a result, both sides develop creative ways of meeting their goals.
The offer of free rent is one such device. The idea is that the tenant will receive a better rate but the building will show a higher face rate which should allow it to refinance on favorable terms.
This isn’t quite as simple as anyone describes. The timing of the free rent versus when the refinancing occurs is just one of the variables a landlord has to factor; but any landlord who knows his/her property, should be able to handle these variables. But when a broker/tenant suggest the same be achieved by allowing TI to be used to pay rent, they are missing the ball big time.
Let’s say that, after the first round of negotiations, the tenant has an $18 rate with $40 in TI. But then the broker/tenant asks to use excess TI to pay down rent. Let me tell you what I hear: “I know I told you that I was going to need every penny of the $40 per square foot and then some, but, I was actually gilding the lily. I really need less than that but was setting you up.” The tenant/broker has now not only acknowledged their deceit—they want to further prosper from it. This is the equivalent of adding fuel to an already hot flame.
he broker/tenant will then go on to explain to the landlord how they are really just trying to help you out. “Since the deal penciled out for you, why do you care how it is spent. It is the same for you, the landlord. Furthermore, I’m just trying to help you keep your rates high while helping the tenant pay less.”
Let’s break down this falsehood in steps.
First of all, it is not the same to me. I fully expect that the TI will go into my building giving me more value in finishes, which in turn means I have to spend less down the road. If a tenant spends the TI on wood and granite finishes for example, when it comes time to re-lease the space, it should still be attractive and just in need of paint and carpet. Makes sense right? Therefore, the TI that gets spent on rent is of $0 residual value to me, the landlord, and makes a real difference to my bottom line.
The second problem with this proposal is that it makes the negotiation far more contentious. As I previously stated, I fully expect gamesmanship in negotiating. What I don’t expect is to be deceived and then asked for more. I don’t know anyone who would not react poorly to such a tactic. After all, this style of negotiating is so infamous it has its own descriptive phrase: “bait and switch”.
The third and perhaps most galling failure of this “incentive” is that it helps neither tenant or landlord. By keeping the rates where they are and allowing for the tenant to use excess TI dollars for rent abatement, the broker receives a disproportionately large commission and the government gets more tax dollars. The rate is actually less than it appears, but the landlord pays commissions on the effective rate not the actual lower rate achieved. This means that the landlord pays more for less, and the tenant receives less than an honest negotiation would have provided (presumably, the tenant would have had a lower rate had they negotiated a lower TI).
Furthermore, the landlord then has to pay taxes on the TI used as income. That tax, therefore gets passed on to the tenant, raising its operating expenses, and the landlord has to also pay taxes on the bottom line, which has now registered a gain as opposed to the pass it gets on free rent. \
In other words, both tenant and landlord lose, while the government and the broker gain.
One thing I want to be clear about is: I don’t think most brokers are purposely deceiving anyone. I know many brokers of various skill, and most are good, honest folk. Some have even acknowledged this “incentive.”
At a cursory glance, I can see why they think it is fair. It has been successfully negotiated with desperate landlords who know no better, and it is not the broker’s job to understand the tax ramifications of their actions.
However, now that I have spelled it out for y’all, I don’t expect to see this incentive anymore because one thing is for sure: I NEVER HAVE AND NEVER WILL NEGOTIATE AN INCENTIVE THAT HARMS BOTH MY PROSPECTIVE/CURRENT TENANT AND ME TO THE BENEFIT OF OTHERS!
Clearly, this is an issue I feel strongly about. I played with the wording for days. In the end, I let three tenant rep brokers read this. One felt it was a bit harshly worded, two thought it was right on, but all three agreed to the facts as I’ve laid them out.
Caleb Smith is president and owner of Spire Realty Group LP. Contact him at email@example.com.