Prior to its 2001 bankruptcy, Enron was the seventh largest publicly traded company with a $70 billion market cap. It was considered by many to be one of the most credit worthy office tenants at the time. Enron’s headquarters was purchased by a group of banks in the 1990s for $285 million, then shortly after, leased to Enron. Following Enron’s bankruptcy, the building was sold for $55.5 million. For many, this serves as a cautionary tale of what can go wrong when a high-credit tenant turns out to be not as safe as the world previously thought.
But what if the example is not an outlier?
In the current economic downturn, this may be true. According to Bradley Mendelson vice chairman at real-estate brokerage, Colliers, “There’s no retail tenant who hasn’t contacted their landlord already [to get a reduction in rent].” Many large retail tenants are not paying rent at all including The Gap, Barnes & Noble, H&M, Nordstrom, GNC, and Mattress Firm. Those big names were among the 21 percent of the 135 major chains paying no rent or a small fraction of it in April.
There is obviously a value to a long-term lease with a great tenant. However, the insecurity of this assumption came into view during the COVID-19 outbreak as both credit and non-credit worthy tenants began asking for rent breaks.
Due to bankruptcies in strong economic downturns, a long term-lease leaves landlords with what some would describe as a one-sided contract, one that benefits the tenant and functionally creating a partnership without upside for a landlord. When a lease is signed and the market goes up
The situation is not unique to COVID-19. The same thing happened in the 2008 financial crisis. From the peak in 2006 to the lowest point during the financial crisis of 2018, the publicly traded REIT (real estate investment trust) market showed over a seventy percent drop in value. This is not to say that long term leases don’t hold value with creditworthy tenants or that short term leases or joint ventures (JVs) would save REITs in a financial downturn. Rather, it simply poses the question: Are we as an industry placing too high a value on long term leases given the possibility for a mass default?
While the long-term lease has been a staple of the industry for quite some time, other options exist and might become much more prevalent in a post COVID world.
Office space, co-working, and short term, pre-built office spaces make sense allowing landlords to keep up with market rate rents while giving tenants needed flexibility. This can be especially valuable to startups who are rarely able to estimate their employee headcount in twelve months let alone twelve years. Short term leases give tenants more flexibility, keep rent in-line with market valuations, and lower transaction costs compared to long term leases.
Below is an over-simplified hypothetical contrast of twenty year lease versus a five year lease. The chart assumes a flat three percent escalation per year, and that in both the five year lease and the twenty year lease, the landlord lost their tenant in 2008. It also assumes a fifty percent price cut for each year of renewal in the five year lease. This is to account for some levels of transaction costs and tenant improvements. At below market rates, the landlord does not get fair market value, and at above market, the tenant may default or renegotiate. The final result is a six percent increase in gross revenues for a five year lease.
Note: Actual transaction costs can vary wildly, along with vacancy rates. Nothing here is meant to be anything beyond a hypothetical model.
|Year||Market Rent||20 Year Lease||5 Year Lease||Notes/ Assumptions|
|2008||$50||$0||$0||Market downturn/ Empty Space|
|2009||$55||$0||$55||Empty for 20 year lease: Empty half year for 5 year lease|
|2014||$80||$67.53||$40.00||50% Revenue for renewal year|
|2020||$110||$80.63||$55.00||50% revenue for renewal year|
Investing in tenants
One company taking an ownership stake in its tenants is Brookfield Properties. They have set up a $5 billion fund to invest in retail tenants. This gives them a big piece of the upside. According to the WSJ, an investment will not be a requirement to lease from Brookfield, but it will present a viable option to align interest.
The ideal situation would be that Brookfield would take a minority stake in the next Apple. In May of 2001, Apple opened its first retail store in Tyson’s Corner Virginia. At the time, Apple was trading for roughly $1.50 per share. Today it trades at around $300 a share. If Apple had paid $50k in rent with stock, the current value would be roughly $10 million today.
The rise of flexible office space
Landlords don’t have to directly engage in a short-term leasing prospect. Large coworking companies and flexible leasing companies are engaging in management deals that add profit sharing and flexibility without a landlord needing to take on an operational role.
This can add a level of flexibility to a portfolio without causing a major disruption or needing to lease a space every five years. In a large building, changing five percent of the space from traditional office leasing to a flexible office space with conference rooms and meeting areas can add value to the remaining 95 percent while generating revenue on the space that is flexible.
The largest problem with short-term leases, JVs, and profit share models is that banks are less likely to provide financing for them. To banks, long-term leases still make the most sense and are the most reliable way to determine future revenue streams. The lending process drives deals. From construction to leasing to operations, for large changes to occur, banks would first need to be comfortable with alternative deal structures.
There is going to need to be an overhaul of how landlords handle retail space. Too many previously credit worthy retail tenants are going under or renegotiating. I don’t believe that this is the end of long-term leases. However, I think that landlords who utilize long term leases in addition to short-term, joint-ventures, flexible spaces and management deals can use the diversification to insulate some of the downside in a bad market and share in some of the potential upside in a great market.