Not a Landlords’ Market Yet, but They’re Knocking at the Door

Office and industrial tenants in Los Angeles find themselves grappling with a new set of issues in today’s lease negotiations as power shifts toward landlords in a tightening market.

Some owners are not only raising rents, they are cutting back on property improvements that were common a few years ago, while demanding tenants assume more risk for environmental problems that might occur. Tenants, meanwhile, are asking landlords to assume responsibility for potentially disastrous Y2K glitches.

Lawyers, brokers and landlords agree that the lack of new construction, lessons learned during the recession and other factors have put an entirely different face on today’s lease negotiations when compared with those of previous real estate booms.

Probably the biggest difference from previous cycles is the emergence of real estate investment trusts as major property owners, said real estate attorney Bob Andreani. REITs are less inclined than traditional landlords to invest heavily in such up-front leasing costs as customized space for tenants.

“That means tenants end up having to finance more of their own improvements,” said Andreani, a partner in the Los Angeles office of Arter & Hadden.

Managers of REITs also negotiate harder for gradual, yearly increases in rent, while private owners are more inclined to settle for once-customary flat rates for the first few years of a lease, followed by a price jump in later years.

“REITs are under great pressure to show quarter-by-quarter, year-by-year increases in funds from operations [a measurement comparable to net income],” Andreani said. “Since they really can’t show those increases as much anymore by buying property, they really have to squeeze it out of the rents.”

But REITs can’t always get their way, said Jeff Nickell, a vice president in the Pasadena office of Menlo Park, Calif.-based Spieker Properties, a real estate investment trust.

“We have to temper our desire to please Wall Street with what the [tenant] market wants us to do,” Nickell said. He also believes that Southern California--even the popular Westside--is less tilted in favor of landlords than some people believe.

“It’s not at all like the very strong landlords’ market in Northern California,” he said. “We feel that if we push too hard on a deal, the tenant still has other choices [of spaces to rent]. We might be headed toward a landlords’ market, but I don’t think we’re there yet.”

Another difference in the current cycle, according to Andreani, is that landlords are scrutinizing tenant credit ratings more carefully. Landlords often insist that start-up companies or those with weak credit ratings post letters of credit or make other arrangements to ensure that the landlord will be reimbursed for tenant improvements, brokers’ commissions and other costs if the tenant defaults on the lease.

“The landlord’s up-front costs can amount to millions of dollars on a big lease,” Andreani said. The growing pressure to protect against such losses is partly the result of a lesson learned from the recession, when many tenants went bankrupt and defaulted on their leases.

“Landlords used to accept personal guarantees for these up-front costs, but they found out that most of these personal guarantees weren’t very valuable. They weren’t worth the amount of time and money it took to pursue them,” Andreani said.

One response has been to require financially weak tenants to post surety bonds, said market observer Jeff Woolf, an office broker with Lee & Associates in Los Angeles. By buying an annually renewable surety bond, a tenant doesn’t have to come up with the huge, lump sum of a cash deposit or a letter of credit. The tenant typically pays 1% to 2% of the face value of the bond per year.

Woolf pointed out that there’s nothing new about the push-and-pull between landlords and tenants, with power shifting along with supply and demand. But this cycle is unlike the one before it, he said.

“It’s much different now. Development in this part of this decade is very disciplined. There are still lots of buildable sites in Los Angeles, but the capital markets aren’t willing to risk the money [for construction] the way they did in the last cycle,” Woolf said.

Woolf said the lack of new development means more tenants are renewing their leases rather than moving to new space. That’s in part because tenants don’t have the alternative spaces to choose from that they had during the previous cycle, when new office buildings were popping up often.

“In the 1980s, the tenant just said, ‘If you don’t give me what I want, I’m going to the new spec building next door.’ Now there is no new spec building next door,” Woolf said.

Another new issue in this real estate cycle is potential computer-related problems at the end of the millennium. “Lots of things can go wrong in an office building if there’s a year 2000 crash,” Andreani said.

Utilities might be shut off, access to the building could be denied, the elevators could shut down, fire and life safety systems could fail, and phones and other communications systems could cease to work if the landlord hasn’t secured his property.

Landlords, however are probably free of liability for tenants’ Y2K problems because of standard clauses that protect them.

“Most leases will say that no matter what the landlord does wrong, the tenant has to give 30 days’ notice to the landlord of a problem and give the landlord a month to fix it,” Andreani said. “A building could conceivably be dark and inaccessible to the tenant for a month because of a Y2K shutdown, and there would be nothing the tenant could do about it.”

Sophisticated tenants today are negotiating leases in which they don’t have to pay rent if the building is shut down because of a Y2K failure. Some also are negotiating requirements that the landlord must compensate them for lost business if it results from the landlord’s failure to address Y2K problems. Some tenants also are asking for the right to terminate the lease if they are prevented from using their space for a designated period of time.

Not all new leases hold the landlord responsible for solving Y2K problems, however. In single-tenant buildings, Andreani said, the landlord and tenant are often agreeing that Y2K compliance is the tenant’s responsibility.

An industrial broker with Grubb & Ellis, Jim Center, said this is especially true in industrial buildings, where the tenant often controls most of what goes on. In the industrial neighborhoods where Center works most--the San Gabriel Valley and East Los Angeles--conditions clearly favor landlords.

Industry observers agree that conditions will probably continue to tilt in favor of building owners unless the economy sours. That means landlords are winning negotiations on a number of points that tenants were accustomed to winning during the recession.

For example, landlords now are insisting that tenant improvement dollars be spent almost exclusively on the structure of the building, refusing to fund the cost of furniture and equipment that they might have paid for at one time.

In today’s market, broker Woolf said, time is the only leverage most tenants have.

“If you start your site search or your renegotiations of an existing lease too late in the game, you’re in a lot of trouble because you don’t give yourself any options. The space that you thought you could jump into down the street probably doesn’t exist anymore,” Woolf said.