Pressing the “Snooze Button” on Lowering Office Rents
Understanding the relationship between owners and lenders, distress, and the dynamics of CRE loans
Each week, we break down a major real estate news story, explaining what it means and why it matters. Great for people who want to better understand the real estate industry.
From the March 26th WSJ article: The Office Market Is in Turmoil. So Why Are Rents More Expensive?
This week’s article addresses a surprising dynamic: while occupancy in US office buildings has been falling month-over-month for the past three years, rents are still going up… why?
The answer lies in understanding the relationship between office landlords and lenders, and the funny way the market values office buildings.
We’ll use a few of the characters from our Fundamentals of CRE course and a fictional scenario to explain:
Let’s say Elevated Properties buys an office building in 2019.
They get a loan from Bells Margo, and part of the loan docs say “Elevated cannot offer rents below $40 per foot” to make sure the value of the building does not fall (in case they have to sell the building unexpectedly and get their money out).
Now, fast forward five years to 2024.
Building occupancy is down 50% thanks to hybrid and remote work trends. And per the loan docs, Elevated can’t drop its rents below $40 per foot to attract new tenants.
So instead they keep the rents higher and offer tenants a combination of two incentives:
Free rent. A certain number of months free for every year of the lease term. So if I get “2 months free for every 1 year in the term”, and I sign a 6 year lease, I won’t pay rent to Elevated for the first year. Elevated uses this to keep the face value of the rent up, while lowering the overall cost over the term to the tenant by almost 20%.
Tenant improvement allowances. Commonly referred to as “TI” and given to tenants to build out and furnish their spaces. For example, Elevated might give me “$20 per foot for every year I sign”. So if I sign a 6 year lease and my space is 10k square feet, Elevated will give me an extra $1.2mm to build it out.
Elevated does this with the hopes that they can keep the rent – and in turn the value of the building – high, while they wait for office market demand to return.
But what if demand never returns??
This scenario represents the great conundrum of the US office market today… landlords and lenders “pressing snooze” on reality by keeping rents up and pretending the values of their buildings haven't changed – while they pray office demand returns so they can sell and get out alive.
But time is running out. Loans on US office buildings are now coming due – $2.2T (yes, trillion!) over the next three years. And, spoiler alert, office demand isn’t returning to 2019 numbers.
Soon landlords and lenders will be forced to sell hundreds of millions of square feet of unwanted office space at huge losses. Their stock prices will fall. Lots of investors will lose lots of money. Some regional banks will fail, and people will lose more money. And the office market will go into a complete tailspin.
And then, prices will reset… and we’ll rebuild. Get your 🍿popcorn ready!
—Paul Stanton
 | A guest post by
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Office tenants prefer high face rates and concessions to lower rents and having the build out space on their own dime. Even when landlord's mark up their cost of capital, is still cheaper than the WACC of most companies to borrow through the landlord and amortize the cost into the rent than finance the TI dollars themselves.
I’ve never heard of a lender on an office building stipulating a minimum rent in the loan documents. Maybe it happens, but I think it’s the exception not the rule.
The free rent game has been around for decades, and most appraisers - and investors - look at effective rents not face rents.
My guess is it’s more about pricing psychology - and maybe in 10 years it helps to have a higher face rent when renewing the lease.