"At one time, MTV was hip, and suddenly it became outdated." - Prince
This article addresses the question of whether long-standing and generally accepted commercial lease norms are now outdated, given changing tenant requirements.
Commercial tenant requirements have become less predictable
“Making the landlord and the tenant the same person has certain advantages as the tenant pays no rent, while the landlord does a little work.” - Gilbert K. Chesterton
The essence of economics 101 is how the interaction between supply and demand affects prices. When economics 101 is applied to lease negotiations, it explains why the primary focus is the incentive on offer from the landlord, having regard to the level of vacancies in the market. High vacancies increase the incentive on offer, thereby reducing the cost for the tenant, while low vacancies reduce the incentive on offer, thereby increasing the income for the landlord.
Far less attention is given to other aspects of the leasing arrangement, such as risk, flexibility, obligations, and guarantees, notwithstanding that the landing point on these matters is critical for both the landlord and the tenant. The pandemic highlighted just how important these provisions are as landlord revenue was largely protected from the impact of lockdowns whilst the tenant's lease obligations continued despite impaired utilisation of the leased premises. The fact is that lease norms that provide strong landlord protections were established when business cycles were longer and accommodation requirements were more predictable. In this context, commercial tenants sought stable tenancy arrangements, and this aligned with the property investor's need for risk-free passive income to support asset valuations.
The challenge is that business cycles are getting shorter, business models are continually being updated, and accommodation requirements are becoming less predictable. These changes call for updated lease norms whereby lease provisions are more supportive of tenant enterprise in good times and bad with regard to evolving business requirements and accommodation needs. This will require property investors to develop new leasing models that protect and promote tenant enterprise in changing circumstances and that have regard for the tenant's need for more flexible accommodation arrangements, with landlords assuming more risk. Enduring tenancy will require ongoing alignment of occupancy costs and risks with changing business needs.
Supply-side change
"Landlords grow rich in their sleep." - John Stuart Mill
Accelerated change is also being experienced on the supply side as property investors respond to the challenges posed by the shift to online shopping in the retail sector, the associated demand for distribution centres in the industrial sector, and the WFH trend in the office market. The office market is also impacted by the growing emphasis on building efficiency and sustainability, which impacts tenant demand. On the other hand, lease norms have been slow to change as existing norms transfer ownership risks to the tenant and protect risk-free, escalating income.
Looking forward
"Successful investing is about managing risk, not avoiding it." - Benjamin Graham
Lease negotiations are driven by economics 101 with a transactional focus on the level of the incentive on offer. This perpetuates a situation where limited attention is given to the need for change to outdated lease norms that restrict tenant enterprise. It is noticeable that the innovation in financial markets has yet to be widely applied to the commercial real estate sector, and existing lease norms are highly protective of passive, risk-free income for landlords. We think that innovative investment solutions are overdue, with the potential for new commercial lease models whereby a landlord assumes more risk in the leasing arrangement in return for participation in tenant success. This type of arrangement aligns the interests of landlord and tenant in a way that promotes tenant enterprise and entrepreneurial effort. It is well worth considering what impact more flexible lease norms would have on economic activity. At the end of the day, it is tenant enterprise that fuels economic activity, not commercial real estate valuations.
Who is LPC, and how do we help futureproof your accommodation arrangements?
LPC is a conflict-free advisor to commercial tenants across Australia and New Zealand. We facilitate strategic review of accommodation strategies, represent occupiers to secure best-fit accommodation arrangements, provide lease management services to multi-site occupiers, and oversee client fit-out and relocation.
Contact us to help with your accommodation strategy review.
