Will the Housing Slump Affect Commercial Real Estate?

The housing market continues to slump with no end in sight, and that has both immediate and potential long-term implications for commercial real estate.

For instance, when new home construction slows down drastically, all the support services for the housing industry pull back. These can include contractors, developers, lenders, title companies, architects, real estate agents, engineers, and so on. This can quickly cut the demand for commercial space.

Consumer spending power is another factor to watch. For years, home owners could count on increasing property values to back their cash out with new mortgages and home equity loans. Stagnant or dropping home prices restrict this source of spending, and that could eventually decrease economic activity and lessen the demand for commercial space.

Finally, there's the danger of subprime mortgages to be aware of. In the heyday of the housing boom, too many loans were made to people without the means to repay them, especially adjustable-rate mortgages that are now resetting at higher rates. Unable to get new financing or sell, tens of thousands of these subprime borrowers are losing their homes to foreclosure sales, which can depress local home prices further. But the greater danger is in the financial markets, where mortgages are combined into pools and sold as bonds. If the value of these bonds becomes questionable due to subprime problems, it can cause severe losses to investors trying to liquidate their positions. This could set off financial shockwaves that depress the whole economy further, again cutting demand for commercial space.

While less demand can mean lower lease rates for some tenants, a recession is not a desirable means to that end, and hopefully the housing markets will stabilize without causing significant economic slowdown.

Lock in a Renewal Option with Your Next Lease

It can be a costly mistake for a commercial tenant to wait until the end of its lease to start negotiating a renewal with a landlord. Market conditions could be such that rates have accelerated sharply. The landlord may also have other plans for the space and refuse to deal, forcing the tenant to incur the expense of a move.

Instead of waiting, it is far better to negotiate a renewal option into a lease. A renewal option gives the tenant the right to renew and sets the future renewal rent, or at least a formula to determine the rent. Once a tenant exercises the option, the landlord is typically limited in its ability to reject the renewal.

In crafting a renewal option, the method for calculating the renewal rent is key. The best renewal option for a tenant is one that avoids subjective interpretation and locks in an attractive fixed dollar amount for the next term's rent or limits the calculation to a percentage of the previous year's rent. Landlords, on the other hand, tend to want the renewal rent to be tied to the prevailing market rents, but defining "fair market" can be tricky: Is it arbitrarily set by the landlord? Is it comparable to the last several deals the landlord has done in the building? Or is it consistent with terms offered in similar buildings in the market? And even if a fair market rate can be determined by comparable transactions, how do you account for differences in location within the building, quality or value of build-out, or future escalations in rent? These are all questions that should be clearly addressed in a good renewal option clause.

The exercise date deadline and procedures for providing notice are also critical components to a renewal option. A landlord will typically require adequate notice before a tenant's expiration in order to preserve enough time to market the space should the tenant fail to exercise. And a tenant will want adequate time to respond to a proposed renewal if it is subject to the landlord's interpretation of fair market terms.

Finally, if the landlord and tenant cannot agree upon fair market, many renewal options incorporate an arbitration clause where a third party or several third parties (often appraisers or other real estate experts) offer opinions as to fair market terms.

While renewal option language may have no immediate impact on a tenant's occupancy cost, the long-term impact of a lease without a renewal option or a poorly written renewal option can be devastating to a tenant that does not want to relocate at lease expiration. Make sure your tenant representative understands the importance of renewal options before completing your next lease negotiation.

Landlords Challenged to Be More Green

More tenants in commercial buildings could see improved comfort and satisfaction with better building temperature control if their landlords accept the challenge of the world's largest commercial real estate trade organization to improve the energy efficiency of their buildings. And since a better indoor environment can mean greater productivity and lower absenteeism, these efforts to make buildings more green could help tenants' bottom lines.

The organization issuing the green challenge in July was the Building Owners and Managers Association International ("BOMA"). BOMA has 16,500 members who own or manage more than 9 billion square feet of commercial properties in North America and the world. BOMA estimates that energy consumption in commercial buildings accounts for 18% of U.S. greenhouse gas emissions. Taking ownership of that carbon footprint leads to the responsibility for finding ways to reduce it.

BOMA's energy-efficiency challenge starts with an overall goal of decreasing energy consumption in buildings 30% across portfolios by 2012. In order to work towards that goal, building owners are called upon to perform energy audits, benchmark energy performance and water usage, then implement strategies to improve energy efficiency. An example of those strategies is making sure a building's heating and cooling equipment is properly maintained and utilized.

Efforts such as BOMA's challenge to building owners indicate the growing commitment to green and sustainable practices in the commercial real estate industry. Tenants can take part by encouraging their existing landlords to be more green, or seeking out landlords who already are.