When is a "Market" Deal Not a Market Deal?

Don't Anchor Expectations Based on the Deal Before Yours

The concept of a “market” deal has never been more misleading than it is today.  Traditionally, a “market” deal was the price/terms at which a willing buyer and a willing seller, without compulsion, would pay for a product or service.  For any product or service to be conducive to a market price determination, it must be a commodity – something that is homogenous and plentiful.  Thus, a certain car model, refrigerator or toaster can have a market price because consumers can buy the exact same thing in many places.  This dynamic creates a very efficient marketplace which necessarily narrows the price range within which a consumer will pay for the product or service.   A one-of-a-kind product or service, on the other hand, is more susceptible to wide variations in value perceptions and pricing as there is no substitute for the product or service and no direct means of comparison.

                Historically, commercial office rental rates have been quoted in terms of “market” classifications. Thus, brokerage firms regularly issue reports about a city or region’s “market” rental rates for Class A, Class B or Class C buildings, and brokers even speak of buildings in terms of their market rental rate (i.e., “this is a $35 building”).  In normal times, landlords and tenants have many options within any submarket or class of building and no one is compelled to act in any manner, thus, there is at least an argument that a “market” rate can be established.  That is not the case today, especially within the context of lease renewal transactions.

                Today, many tenants are afraid to make long term commitments to space because they are still unsure if their workers will ever come back to the office (and to what degree). Because they don’t know how much space they will need, many tenants are just standing pat or maybe just shedding some excess space.  Similarly, because of burdensome debt levels and tight credit markets, many landlords are hamstrung and cannot reduce their rents or offer the type of concessions they need to be truly competitive.  As a result, the rents and deal terms these landlords are offering are not reflective of how low they would be willing to go to attract new tenants (or how much they would offer in terms of tenant concession packages); they are reflective of their limited resources and unique debt levels/constraints.  Now, more than ever, renewal deals are reflecting the unique circumstances of the landlord and/or tenant, as opposed to what a willing tenant and willing landlord would agree to if not under compulsion.

In sum, commercial lease renewal deals are not reflective of a homogeneous marketplace with willing players and, consequently, the resultant deals should not be taken as defining a true “market.”

                Tenants who are uncertain about their future real estate needs and, therefore, unwilling to expend the money necessary to move have been paying material premiums to stay where they are for the short term. Should these deals dictate what a tenant who IS willing to move should pay for space in the same building?  What about a tenant who pays a $5/sf rent premium because the landlord allows them to shed 20% of their space a year early as part of a five-year renewal?  Does this rental rate establish the “market” rate for a new tenant?  In a situation where a tenant is truly captive to a building, but a landlord cannot afford to provide tenant improvement dollars or cannot lower its asking rate because the debt load can only be serviced at a premium rate, does this deal really reflect the relative value of the building compared to a similar building nearby where the landlord can be more competitive?

                To be sure, there have always been inefficiencies in the office market which call into question the validity of any concept of a true “market” – whether within an asset class, a submarket or even a building.  Every tenant is different, every landlord is different, and each asset is different.  Nevertheless, brokers have relied on the concept of “market” to help define the ending point for lease negotiations (an important tool when representing both sides in a negotiation) or establish building valuations.  However, with the combination today or (1) tight credit markets, (2) tremendous uncertainty with respect to future office space needs, and (3) growing numbers of commercial office buildings being under water (financially, not yet literally), the idea that every renewal deal should be relied upon as a basis for the next deal is silly.

                Tenants who have the freedom to choose different real estate outcomes today need to be extremely careful about anchoring their expectations on the deals done by those who came before them.  A lot of the renewal deals being done today are not reflective of what a tenant, without compulsion, would pay or what a landlord, without compulsion, would offer.  If you are not compelled to act, you are lucky and there should be some very good deals to be had.