Property Services

“It’s a tenant’s market”

Over the past few months I’ve dealt with a number of interesting matters that involved retailers who had worked themselves up into a lather about their impending lease expiry. In virtually all cases, the retailer was deeply concerned about their landlord potentially not offering them a new lease or asking for a massive increase in rent. Given the profitability of their business’ (and by extension their livelihood) could be seriously affected by the outcome of how the landlord was going to act, most of my clients were naturally very nervous about their situation, understandably so.

They sought my opinion as to what I thought was happening in the leasing market, so I thought I’d share my thoughts in this month’s blog.

In my view there is absolutely no doubt whatsoever that it is a tenant’s market at present ! Landlords are generally being more flexible than they have been for a long time, be they smaller private investors or large national property giants, most landlords across Australia are reducing rents and increasing incentives such as rent free periods and contributions to fit-out. I realise that this is a very broad statement and indeed every local market has it’s own nuances, however there is ample evidence to prove that this is the case. You only need to have read the news over the past twelve or so months to confirm that most landlords are “on sale” for the first time in two decades.

So why is this the case? Well firstly, retailing has been very sluggish as the local economy slows and unemployment continues to rise – official unemployment is hovering around 6%, however this is not the true level of unemployment when you take into consideration “underemployment”. The real figure is more like 11-13% and this is likely to deteriorate further as the mining boom winds down, government spending tightens and cessation of car manufacturing and other related industries takes ahold.

On top of this, some retail channels such as newsagency and pharmacy have been confronted with a myriad of structural changes, that have put enormous pressure on margins.

You might ask, why haven’t we seen lots of retailers closing their doors and high numbers of vacant shops appearing in large shopping centres? The answer to this is, the large landlords remember very clearly what happened during the last recession of the early 1990’s. At that time many of the larger shopping centre landlords struggled to keep a lid on vacancies, with most carrying 5-8% (or more) throughout the recession years. I can clearly remember when many of these large centres where carrying 10, 15 up to 20 vacant shops – they had a real smell of death about them. I know that sounds dramatic, but there is old rule in the shopping centre game, vacancies are akin to cancer, they spread like tumors and eat at revenue, negatively impacting profits and by extension, capital values. In the shopping centre industry, vacancies equate to sickness.

I believe the reason we are not seeing vacancy rates skyrocket in larger centres (thus far), is due to the fact that executives in senior leadership roles today within most large property companies are not letting this happen. Most of these executives were young centre managers and leasing executives 20-25 years ago, so their experiences of what occurred in the early 1990’s have been indelibly etched into their memories. They have obviously concluded that the only way to stop cancerous vacancy growth is to be flexible with commercial lease terms by reducing rents and increasing incentives in order to retain quality retailers and to attract new vibrant operators.

What about smaller private investors and syndicates, are they being more flexible? The answer to this is yes and no – some of these landlords are reducing rents and offering incentives, however they are not near as flexible as the larger landlords and are not dropping rents or offering incentives to the same levels. The reasons being that most of these property owners are already charging lower rents and unlike big landlords, have a lot more at risk personally and fewer resources to draw upon. This makes them very difficult to deal with, particularly when a retailer is seeking large decreases in rent – most are very reluctant to negotiate. Unfortunately for them, many of these smaller landlords have not been very flexible and this is reflected in the current vacancy rates in smaller neighbourhood shopping centres and high street shops, the majority of which are owned by smaller investors.

There is ample evidence of this in places like Bridge Road & Toorak Road, Melbourne and Oxford Street, Sydney. These were once thriving shopping precincts, however sadly today these high streets have dozens of vacant shops. Neighbourhood shopping centres, particularly those in regional locations are suffering heavily from tough economic conditions and this evident by the large number of vacant shops that plague many of the these malls.

So whilst tough retail conditions prevail, is there any good news? Well there is actually provided you do you homework and are prepared to think laterally. If you have a lease expiry impending, have an option to renew or simply wish to re-negotiate a fresh new lease, I suggest that you prepare for the negotiations at least 12 months beforehand, regardless of what your lease might say in terms of giving notice (in the case of an option).

Remembering it is a tenant’s market, you might even try to re-negotiate your existing lease to reduce the rent, even though you might have a number years remaining. Of course this is far more difficult to do than negotiating a lease at expiry. If you have an existing lease “on foot”, your landlord has absolutely no obligation whatsoever to reduce your rent and re-negotiate other commercial terms, however there are ways of doing this depending upon the individual circumstances.

When negotiating commercial lease terms in the current market it is very important that you put yourself in the landlord’s shoes and endeavour to understand their motivations. Generally speaking large corporate landlords many of which are property trusts, focus on maximising cash returns – capital borrowing costs are much lower than the average business person, so they are able to borrow large sums of capital relatively cheaply and are subsequently much more likely to offer cash incentives towards your fit-out. Generally speaking most of the large landlords don’t like giving away too much rent free as this impacts on cash yields.

In the current market it is not uncommon for large landlord’s to offer $50K, $100K or even $200K+ in contribution to fit-out, in order to attract new retailers, whereas they will generally not give away a lot of rent free. On the other hand smaller landlords are more reluctant to offer large capital contributions to fit-out, as capital is more expensive for them. Whilst cashflow is important, most smaller landlords prefer to offer longer rent free periods as their main form of incentive, although some do contribute to fit-out, however at a much lower level.

What about reducing rents? Well, whether you are dealing with a small or a large landlord, both are equally as reluctant to reduce rents, the main difference being it is a little more personal for smaller landlords who are typically unable offset rent reductions by increasing rents elsewhere within their portfolio, as their property holdings are a lot smaller.

At this point it is important to discuss how landlords view reductions in rent, I mean how does it affect them in terms of financial impact?

Based on the capitalisation method of valuing commercial property (please note I am not a certified valuer, so this is a very rough rule of thumb guide only), every one dollar in rent equates to approximately $9 – $14 in capital value, (sometimes more or less depending upon the cap rate applied). To illustrate this point, lets assume the cap rate is 10% meaning that for every $1 in rent that a retailer pays, this equates to $10 in capital value – if you were trying to negotiate a new lease and were currently paying $80,000pa, but decided to offer only $65,000pa, the landlord would stand to lose $15,000 pa in rent cash-flow. However from a capital value perspective the landlord would stand to lose a lot more, in fact they would lose $150,000 in capital value due to the multiplier effect noted above. In other words if your landlord agreed to the $15,000pa rent reduction and thereafter decided to sell the property, the effect of your individual rent reduction would be to reduce their sale price by a massive $150,000, so for a landlord (especially a smaller landlord), it’s not really a $15,000pa question, it’s actually a $150,000 question! This is really important to understand, because this is how a landlord thinks when considering rent reductions – yes it is a hit to cash-flow, but it has a bigger impact on property values.

So how do you tactically try to have your rent reduced in the case where your lease is due to expire – there is no one answer to this, however I subscribe to the theory that humankind’s motivation is dominated by the desire of gain and fear of loss. I believe the fear of loss is something that is tactically important in the current economic climate, given it is a “tenant’s market”.  As I stated earlier in this article, the retail leasing market is currently quite soft and I believe will weaken even further during 2014, so it is therefore very important to look at alternatives in terms of other sites you might be able to relocate to. I understand that this is not a straight forward proposition given the inherent regulatory controls that govern certain retail industries, however it is important that you do investigate what options might be available. When undertaking your search, I recommend you speak to other commercial real estate agents and shopping centre landlords to enquire as to what rents and incentives are on offer – as mentioned earlier in this article, prudent landlords are offering large incentive packages and attractive rents at present, so you owe it to yourself to see what might be possible. I refer to this as Plan B, in other words if negotiations with your current landlord break down due to them not offering you a new lease or not being flexible with the rent, you need a Plan B. In fact I normally recommend you look for at several alternate sites if possible, so Plan C if you will.

This approach has two main advantages, firstly it gives you greater bargaining power and confidence when dealing with your existing landlord and secondly if negotiations go south, you may have an opportunity of doing a better deal in another location with a different landlord.

I am not suggesting that you should automatically leave your current leased premises, I am merely suggesting that you should take the opportunity to re-evaluate your current location and ask yourself if this is the best site to be in or are there better alternatives – the last thing you want is to be held captive by your existing landlord.

Remember, there’s always demand for good retailers. Most prudent landlords would probably want to retain your usage and if they don’t, well then there are other options available, so be confident in knowing that it is indeed a tenant’s market, so take advantage of it while it lasts!