Landing Amazon, Google or General Electric and other corporate titans gives owners some certainty: these big corporate users tend to be credit-worthy tenants able to sign expensive, long-term leases. Leasing to one or two tenants is also a lot less management-intensive than leasing to many smaller tenants.
But this strategy may also be incredibly risky, particularly for investors who will have a harder time absorbing the body blows that come when there’s an economic downturn.
Let’s say you have a 200,000 square foot office building. A single corporate tenant would be nice, but what happens if that tenant goes bankrupt? Or if it gets bought out by a competitor that elects to consolidate offices, leaving your space vacant? Even in the scenario where the tenant fulfills their existing lease obligation but vacates at lease expiration, how likely is it that you’re able to fill that 200,000 square feet to another single tenant? It’s like deep sea fishing: some days are great, but often, you come up with nothing. Finding a 200,000 square foot user is difficult even in the best of markets.
There’s a good chance that space will be sitting vacant for a while. If the market crashes, you could be competing with 10 different building owners fishing in the same small pool of large, corporate tenants.
What’s more, these large, corporate tenants also show up with a long list of demands in hand. This is especially true during a downturn where the tenants hold more negotiating power. Tenant demands in such circumstances that we’ve seen here at Feldman Equities in return for a 10-15 year lease for 200,000 square feet have included such things as wanting:
- Their company name on the side of the building.
- Restrictions on allowing the landlord to lease to potential competitors (e.g. assuming that J.P. Morgan Bank is your tenant, they may insist on a clause in the lease that prohibits you from leasing to Bank of America).
- The right to pass the building naming rights on to sub-tenants.
- Four renewal options for five years apiece.
- The right to reduce, at any time, 25% of their space.
- Right of first refusal on all the vacancy in the building.
This laundry list can go on for pages and these onerous lease terms are often negotiated with high-profile and expensive attorneys who are tasked with milking every demand out of the landlord on their client’s behalf.
This is one of the challenges that office owners take on when leasing to few large tenants.
An alternative approach is to subdivide the property from the outset, leasing to many smaller tenants at different lease terms and lengths. For instance, that same 200,000 square-foot office building could easily accommodate 40+ tenants. Some may be as small as 1,000 square feet. Others may take 15,000 or 20,000 square feet of space. The key to success in office ownership and management is to ensure no single tenant has more than 20% of total leasable square footage at any given point in time.
To continue the fishing metaphor: Consider this approach to be more like bass fishing in a stocked pond with smaller fish, but much more frequent catches.
There are also other benefits to leasing to many smaller tenants. For one, the owner avoids the “house of cards” problem that is associated with the default risk from one large tenant. If a tenant goes out of business, or if a tenant falls behind on rent, the owner still has other income coming in from the other tenants to cover debt service. Moreover, when a tenant leaves, there are inherently more users out there looking for smaller spaces than there are 200,000+ SF spaces, making it easier to fill the vacancy. This means higher occupancy rates and less disruption to cash flow.
Leasing to multiple smaller office tenants also limits the individual bargaining power of any single tenant. The owner doesn’t have to worry about being held at gunpoint the way they could be in large lessee situation.
As a follow on, here at Feldman Equities, we like to diversify not only tenant size, but also tenant industry type. As many office users experienced during the dot-com crash, leasing to companies all concentrated within the same industry (e.g. start-up tech companies) can prove fatal. Instead, we try to find tenants across industry types: software, finance, e-commerce, insurance, biotech, robotics, professional services and more.
We also look to diversify lease lengths. One way to mitigate risk is to ensure that leases expire at different times. For example, some tenants will sign 3-year leases, others will sign 5-year leases, and some of the larger tenants will sign 10-year leases. We’re constantly analyzing lease terms to ensure that no major chunk of leases expires within the same time frame. This is yet another reason why we try to avoid one tenant taking more than 20% of rentable square footage at any given point in time.
This tenant diversification strategy isn’t for everyone. There will always be those drawn to the “sexy” allure of the large corporate user. However, in our experience, leasing to smaller tenants is the best way to keep buildings fully occupied, with consistent and predictable rental income. It’s how we have survived and thrived for over 35 years owning and operating some of the most prestigious office buildings in our region and how we intend to keep on doing so.
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