Market Factors Create an Opportunity for “Blend and Extend”

by CoyDavidson on October 8, 2009

Houston Office Market CBD

The result: an immediately reduced rental rate

If you have been following the latest developments in the commercial office space market you are reading headlines such as “Office Rents Dive as Vacancies Rise” and “Office Space Vacancies reach Multi-year Highs” and it is no surprise office market fundamentals have deteriorated substantially during the current economic recession.

In Houston, we were one of the last markets around the country to feel the pain, but the Houston office market has now experienced 3 consecutive quarters of negative space absorption.

While the economy may have bottomed out and is beginning a recovery, there seems to be consensus among many leading economists that we will not see office job growth for at least another 12 months and with a not so positive outlook for oil and natural gas prices over the next year, it may get worse in Houston before it gets better. I don’t expect to see any significant improvement in the Houston office market until 2011.

The relationship between a business and a landlord is defined by long-term lease arrangements, which often lack the inherent flexibility required for an enterprise to achieve its mission. Office tenants with lease expirations coming up currently have a window of opportunity (see related post: “The Opportunity to Reduce Occupancy Costs is Now”) to strike attractive deals with Houston area Landlords. However what about tenants who signed longer leases before the decline, when the office market was at its peak and do not have lease maturities in the next 12 to18 months.

Despite the long-term nature of a lease contract, tenants sometimes have the ability to realign their lease terms according to their business needs, even when several years remain on the lease. Through a transaction concept known as a “Blend-and-Extend Lease”, tenants can use the allure of an early renewal to renegotiate a lease, often injecting advantageous new terms such as lower rents and additional capital improvements.

For example, higher vacancy rates in many markets motivate landlords to consider blend-and-extend transactions to ensure that:

  • Their buildings are full of credit-worthy tenants.
  • They don’t incur the risk and costs associated with having to re-market and lease space.

In the context of a falling market, tenants can look at things from the landlord’s perspective and identify a positive rationale for the owner to go along. Perhaps having your firm extend by a few years will eliminate some upcoming risk in their portfolio that you might leave or they face an upcoming loan maturity on their asset in which having credit worthy tenants with long term commitments improves their position with lenders.

Many progressive landlords are now pursuing proactive methods to accommodate early lease renewals for tenants with more than one year remaining on their current lease term. Previously thriving companies’ ability to post a profit during our current challenging economy can be severely impacted by the burdensome office space costs that were negotiated during the economic boom.

The willingness of a landlord to partner with the company’s retooled business plan is essential to reducing the tenant’s lease load, a major component to restoring most tenants’ profitability. And if there’s one simple business principle we were reminded of the past couple of years, it is that without profits, most businesses won’t be around to pay the rent.

Blend-and-extend transactions allow a tenant to combine costs associated with the existing lease with lower current market rates over an extended new period.

The result: an immediately reduced rental rate

Executing a blend-and-extend, however, can be very challenging and depends heavily on timing and reading the market. How do you know market conditions are right? How do you convince a landlord to go along? When is the right time to bring it up? It all depends on the situation.

If your company has the ability to consider a building as a long-term facility, and cost reduction is paramount, consider a blend-and-extend transaction.

The financial mechanics of a blend-and-extend are relatively simple to understand. Let’s imagine a 20,000-square-foot company has two and a half years left on its office lease, and is paying $30 per square foot, in a market where the rental rate for a new lease has dropped to $25. Using simple math, if that tenant extended its lease for an additional two and a half years at $25 then the new average, or blended, rental rate would be $27.50 and a new rental schedule can be negotiated accordingly to fit both the tenant and Landlord’s objectives. Perhaps the Landlord will find a new rate of $27.50 for the next five years acceptable or decrease the rent to $25.00 for two and a half years and increase back to $30.00 in remaining two and a half years. In this example, the tenant would be experiencing an immediate rent reduction of $50,000 to $100,000 per year.

There are numerous variations of how a blend and extend may be negotiated. It could be that excess space is given back to the landlord, or the landlord provides tenant improvement dollars to reconfigure your space, or any combination of the above.

Negotiated by a seasoned creative professional, this transaction structure can give you the leverage to increase flexibility, lower costs and make your real estate perform at its peak. As in most business transactions, it boils down to a numbers game. Both parties will need to have similar-looking crystal balls, and that can be challenging. Nevertheless, favorable terms and nuances critical to both parties are all achievable with “forward thinking” and reasonable parties.

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