CorporateInsight October 2003

Over the past year or two, institutional owners have experienced increased vacancies throughout their portfolios. The recession, reduced tenant demand and oversupply of new product have caused a glut of vacant industrial space, even in markets that have performed well through downturns in the economy. The results are pressure on owners' returns and the opportunity for industrial tenants of size and credit to negotiate based upon the owners' cash flow and not on market. In a challenged economic environment, this is a more natural way to develop a lease structure.

Large industrial users in particular have benefited from this approach as they recognize the relationship between a long-term lease for the owner and reduced occupancy costs for the tenant. Proactive owners of large industrial space are recognizing the risks they face as tenants that are approaching lease expiration begin to evaluate moves to newer, more functional facilities, often for lease at rates below the rates being paid for older, less functional facilities at the back end of their lease terms.

There is a way to bridge that gap and to create a win/win for tenants and owners: the classic restructure. As a large industrial tenant (generally more than 50,000 sf) approaches one to three years from its lease expiration, the owner begins to evaluate the probability of that tenant renewing. From a cash-flow standpoint, the owner will begin to budget for the costs associated with replacing a tenant that might vacate. Those costs include the downtime or vacancy period between a tenant's lease expiration and the commencement of the term for a new tenant, the tenant improvements required to re-lease the vacant space and the commissions required to pay brokers and to attract new tenants.

Each of these costs has an impact on cash flow. If the owner can mitigate his risk and exposure (i.e. eliminate some or all of the costs associated with the potential vacancy) then he can preserve cash flow and exceed his budgeted expectations from a return-on-investment standpoint.

Likewise, a tenant has the opportunity to reduce occupancy costs even with two or three years of remaining lease term, by trading term for rent reduction or a tenant improvement allowance. By negotiating on the estimated costs an owner will incur if there is a large vacancy, a substantial industrial tenant can achieve a rent structure that is below market.

The restructure works like this. First, aggregate the value of the potential downtime or vacancy (i.e. how much rent/income is lost for every month the landlord has a vacancy?), then evaluate the potential tenant improvements that the owner will pay to replace the tenant. By computing the net present value of these potential costs and amortizing that value as a rent credit against the market rent, you achieve a transaction predicated on the owner's cash flow.

There are other factors that can impact the potential savings as well, such as the owner's other vacancy exposure and his plan to refinance or sell the asset and future development pipeline. Each of these potential risks can be mitigated by helping an owner preserve cash flow through the renewal or restructure of the larger, higher credit tenant leases in the portfolio.

In the end, the owner can maintain positive cash flow without interruption, and the tenant is able to achieve a lease transaction that truly takes into account the benefit the tenant provides to the owner's bottom line. Simply put, the owner secures a tenant for a term beyond expectations and the tenant achieves a rent savings in exchange for its long-term commitment.

Jonathan Kingsley is executive vice president and managing director of Grubb & Ellis' Miami office.

References to market data included in this article are obtained from Grubb & Ellis' research analysts who routinely track local and national trends in the office market. Click here to find out more about Grubb & Ellis's research.