Problems for Landlords Arising from Ever Increasing Tenant Improvements
Tenant improvement costs have been rising across the country, according to a report released by Real Capital Markets in June of 2019. The driving force behind much of the growth is increased labor and material cost, which makes it hard for landlords to escape. It coincides with significant new office supply in primary markets like New York and San Francisco, along with significant upgrades to Class B office assets across the country.
The capital that landlords, institutions, and developers extend is largely being serviced by rising rents, but a rift is forming. Tenant credit has broadly deteriorated since 2010 (see our article in National Real Estate Investor due in large part to increased demand from lower credit quality tenants that have relied on private capital including venture capital and private equity to fund growth. These tenants have driven much of the recent growth in rents across the country, but they are highly susceptible to disruption should the economy deteriorate. This could make servicing debt on specific assets more challenging, especially with the higher tenant improvements, in an economic downturn.
Landlords should not fault themselves, for this is simply what the market dictated. However, there are steps landlords can take to minimize the pain that many of these tenants could pose should they become distressed. The first step is identifying high risk tenants. Once identified, landlords need to demand higher security to cover losses and downtime. Many CFOs are beginning to enact fiscal policies that conserve cash for the anticipated downturn, which may make requesting security more challenging. It is important for landlords not to lose sight of their exposure and to push for sufficient security. At TRA we have seen significant, non market based security posted on deals with substantial build outs.
The second step is to modify build outs for risky tenants so they are as reusable as possible. Tenants with weak operations or highly leveraged balance sheets should not necessarily be granted significant, custom buildouts unless they are willing to post substantial security or pay for buildouts directly above a base level.
TRA has successfully advised clients on structuring dynamic lease security on many deals like this across the country, and we can support you too. Reach out to us to find out how we can help.