Episode #4 - Renewals
The Industrial Advisors take a look at real estate renewals and explore what success looks like for the tenant at the end of the renewal process.
Bill Condon: Welcome to our podcast again. Today's topic is lease renewals and what the right process looks like and what success looks like for tenants at the end of the renewal process. So Matt, why don't we jump right in and why don't we start by talking about what you think it takes to achieve a good renewal.
Matt McGregor: Yeah. First of all, it's a topic that's not talked about enough because there's way more renewals done, right, than new deals, relocations, expansions. Renewals are the number one volume in transactions in industrial real estate.
Bill Condon: Absolutely.
Matt McGregor: Yeah. The first thing I'll say, I loved a book called Outliers by Malcolm Gladwell and the concept of that book, I know it's a New York Times bestseller, a lot of people read it. For those of you that didn't read it, the big concept in the book was 10,000 hours, which is what Malcolm Gladwell defined as becoming an expert in something. And it's interesting with lease renewals because so many people attempt to do them on their own. I mean, we run into it all the time, right?
Bill Condon: We sure do. Yeah.
Matt McGregor: Very few people would would say, "Gosh, I'm going to relocate on my own and do this." But they just kind of take renewals a little bit for granted.
Bill Condon: They think it's just easy.
Matt McGregor: Right, absolutely.
Bill Condon: [inaudible] let's just sign and let's keep going, right.
Matt McGregor: Yeah. And really when you roll into 10,000 hours, what does that mean? In the book, it shows what a true level of expert in anything is. And the comparison, or the example, a couple of them, was Bill Gates, his access to supercomputers in high school compared to other schools. So it was not by chance that he ended up running the largest computer company in the history of the world. It was because he had access to 10,000 hours of supercomputing that nobody else did in the country, right?
Bill Condon: That's right.
Matt McGregor: And then the second example was professional hockey. And it compared the amount of hours that youth had. I guess ice time is a big issue and very hard to get. And so it showed, it ran a statistic, a study, showing the amount of hours that kids had on ice time and it equated to becoming an expert, right? You're not going to become an expert skater if you can't get on the ice. So the same thing is true in renewals and you and I do 50 or 60 of these a year as our team?
Bill Condon: Yeah.
Matt McGregor: And so when you equate that to hours, collectively our team is spending four, five thousand hours a year dealing with renewals.
Bill Condon: Yeah, and I will say it's interesting because when you look at lease renewals and you look at it over the last, you know, since we got in the business, which has been about 15 years now, although there still are many companies that look at renewals and do them on their own, over the past 15 years I would say that number has gone down.
Matt McGregor: No question.
Bill Condon: And today, in particular with the larger tenants, they've become more sophisticated and understand the value that brokers really bring to the renewal process. I mean, we've done a study, and we can dive into it and a little bit, but we did a study on tenants that renew on their own and tenants that renew with brokers, and on average it's about a 22% savings when tenants hire a broker on a renewal compared to when they do it on their own.
Matt McGregor: And obviously that percentage fluctuates with the quality of the broker. You, for example, get like 200% savings, correct?
Bill Condon: Correct, correct. Yeah. And you're close to that. Like 190. But yeah, yeah.
Matt McGregor: That's right. That's right. Just a quick story because so many people and for different reasons, you want to go do the renewal on their own. They just think it's easy, right? And again, we're doing 50, 60 of these a year, and not to knock a CEO, not to sound arrogant, or a real estate director, but they're doing, if they're a one location place, they're doing one every five or 10 years. And even if they have multiple, they're still doing a few a year, right, versus 50 to 60 of a good professional, a good professional, national brokerage team. And I can't tell you how many times we've run into cases where they started the process and then didn't like where it was going, then called us. That's like the worst, right?
Bill Condon: Yeah, right.
Matt McGregor: One example, a couple of years ago we did a 350,000 foot renewal where it was one of those classic stories where the landlord approached the tenant about a year and a half before their lease was up, obviously, probably to avoid them getting consultants and offered them a deal, made it sounded like it was a wonderful deal. They got all the way to signature out on an amendment when they called us and said, "Hey, just making sure, is this a good deal?" And we looked at it. You remember? I mean, it was horrific, right?
Bill Condon: Right.
Matt McGregor: And we immediately were engaged when we walked our client through the situation and showed them comparably what that deal really looked like. And he was like, "Oh my gosh." And we then called the landlord and landlord of course flipped out, didn't want us involved and said, "We're not paying a fee and we're not changing anything." And what did he say? They got, what, two weeks to sign it or the deal's off the table?
Bill Condon: Yeah, sign it in two weeks, or yeah, deal's off the table, I think was the line there.
Matt McGregor: Yeah. And there wasn't a lot of leverage to be made, but we sat down with them, went over our strategy checklist, which we use on new deals and renewals. And it's about a 32 step process of evaluation. And the number one thing you got to do is create leverage, right?
Bill Condon: Absolutely.
Matt McGregor: And we did. In that particular case, there wasn't a perfect building. The landlord knew it. The landlord certainly had a broker behind them. Not that the tenant knew that, right? But the broker was feeding them information, saying, "Hey, there's no like properties. They're screwed, right? Their move cost is $1.2 million, whatever it was, they're not going anywhere. Let's hammer them." And in the end we did create that value. We found an alternative solution. It really had to do with material handling and cubic storage capacity that was able to reduce their footprint, right, and so that we could fit actually in a smaller building for material handling upgrades. And the landlord was going to cover a lot of those costs to attract them to the new building. And in the end we went back to the landlord, exposed that, because we were willing to move at that point. So we created a dynamic that wasn't preferred but we were willing to do other than that ugly deal that was on the table and in the end we got eight months of free rent, an 18% reduction in rent, more TIs, and we got paid, right?
Bill Condon: Yeah. I mean, to your point, Matt, it's about finding the leverage. I mean, I remember a few years ago we represented a company, over 600,000 square feet needed to be in one building. There were no options in the market to go deliver them-
Matt McGregor: I remember that.
Bill Condon: one building.
Matt McGregor: None.
Bill Condon: And-
Matt McGregor: And the landlord let us know that.
Bill Condon: The landlord let us know that they knew that, and-
Matt McGregor: Oh, and by the way, that was another one where they had already started the renewal process-
Bill Condon: Without a broker, right.
Matt McGregor: [crosstalk] again. And for those clients that are listening, please don't put your broker in that situation. Start where you want to finish.
Bill Condon: Exactly. Start early on. And so we were able to find out through some research that they had a loan coming due and there was no way they were going to be able to re-up that loan without securing that tenant. And so, we were able to leverage that into a phenomenal deal for the tenant, great savings for the tenant and a good long-term deal there for them. So again, it really is about finding leverage. I was talking to an owner a couple weeks ago who owns a couple of buildings down there. He runs a business, so owning the real estate is kind of on the side for him. And he did a direct deal with the tenant that was in the space on a renewal and felt really good about it because they did it direct and achieved above market rate. So it really is important for tenants to early on hire a professional, and do it the right way.
Matt McGregor: That's right. And you gave a good example because that one was not a real estate play comparison. The landlord already knew that there weren't comparable buildings, right?
Bill Condon: Right.
Matt McGregor: You did a great job of going out and finding that they had, that was a, I think, a 2.1 million square foot park. They were 650,000 feet of it, so like 30 whatever percent that is. No way is their financial partner going to secure and advance that loan with that kind of a pending vacancy.
Bill Condon: That's right. I'm glad you brought it up because the economics of a renewal are one thing, right? But there's so much more to it that brokers can help with, right? You dive into the triple net expenses, the HVAC, the roof, and how that language reads and so the rate factor's a part of it, but there's a lot more important factors, and having a broker on your side will help with that.
Matt McGregor: That's right. And good point on the roof and other parts of it. Because the other thing is, you may have an inherited lease negotiated by somebody else or negotiated in a different economic period. Again, maybe the company did it themselves, didn't have leverage, and what does that lease look like today, right? A good consultant broker can help you go through that. Hey, look, getting a couple of months of free rent, a little bit off the shell rate is one component, but certainly not the only component, and making sure, for example, does that building need a roof next year that's a $2 million roof? Does it need HVAC systems? Who's paying for that? Who's paying for all the CapEx? What are the conditions? Those leases now average almost 49 pages, right?
Bill Condon: Mm-hmm (affirmative). They sure do.
Matt McGregor: There is a lot in there that you have to compare to the current market situations. How do your renewal options look? How does your expansion options look? And we've seen too many times when adjacent uses now are impacting quiet enjoyment, right? What about odor? Right? There's so many factors in a lease that need to be evaluated during a renewal and that's just the lease. Then you set that aside and go "how does the labor market affect you now?" Maybe the company has been there 20 years, right, and the market's moved. How do those demographics, how does the labor affected, how does drayage, inbound and outbound freight? As we know, real estate is typically four to six percent of a distribution fulfillment company's overall cost structure. It's the logistics and transportation is the majority, right?
Bill Condon: Yeah. Yeah. A factor that recently came up on my end, I was representing a company who I've represented for years and they were coming up on a renewal. They were also getting ready to sell the company. Well, the way the previous lease read was that they were not allowed, the renewal right did not carry forward if they ever sold the company. And so obviously the new buyer of the company wanted to stay in the park and have that renewal right. And so we were able to negotiate that in. But little things like that matter and sometimes they get skipped over if you don't have someone looking out for you on your side.
Matt McGregor: That's right. And so often, I think people think that brokers are going to come in and hurt the relationship. Look, I'm not, and I know you're not saying that a good brokerage team always adds value. We have clients that we represent globally where there are situations that I've seen that they say, "Gosh, we've had a relationship with this landlord." How many times have you heard that? Yeah, we're best friends, right? You're really not, but you're friends, and a broker's job is not to come in and upset that situation. It's not our job to come in and just start punching people, right?
Bill Condon: That's right.
Matt McGregor: It's our job to make sure that both parties understand the market and that our tenant, okay, and we got to be aggressive, is getting a deal that's going to stand up against the competitors and over time, and you're going to look back and look at that lease and know that that was a good lease. And our job is not to come in and just pound on the landlord. But there are times that, and I'd say usually in tertiary markets on small deals where maybe a large company acquired a company and that guy that sold his business remains being the landlord and there are no options and it's in the middle, you know, tertiary market of Kansas city, we're not going to add value, but we come in and advise anyway. But maybe we're not part of the deal. A good tenant, we're just going to take care of them in that situation. We're probably going to upset that 82 year old landlord that's never seen a broker before. Right?
Bill Condon: Right. And I will say too, as the markets have become more and more institutional, they recognize that sophisticated tenants have brokers, right? And those building owners typically have a fee built in already, right, for the tenant's representative and their own representative, because more often than not they have their own brokers representing them. So as a tenant you definitely want to have your own representation as well.
Matt McGregor: And that's a great point. So a lot of those times, you and I know behind the scenes what's really going on when the tenant thinks, "Oh, it's just me and my buddy landlord doing this deal." Well, no, it's not, okay? Your buddy landlord is representing an institution and/or an organization behind him that's trying to maximize their best interest. Going to you and not wanting to... There's a reason why they get mad initially when a broker gets involved because the deal's not going to be as sweet for them, right? And so they're not showing you that. But what's happening on the backside is they're talking to their consultant, they're talking to their broker, saying, "What's their options?" Okay? "What else are they looking at? What's their move costs?" Right? And they're trying to maximize their best interest. Having a good consulting brokerage team on the tenant side is not in their best interest.
Matt McGregor: And I think the easiest way to diffuse it, so many of the tenants, once they start that process and have a relationship with the landlord, they don't know how to convert that and put us in front of them without saying, "I don't trust you." Right? And I think the best way we've seen that being done is saying, "Hey, Mr. landlord, I need to introduce you to, you know, Bill Condon, Matt McGregor, Colliers," or whoever it is, "It's a mandate of our company and our board of directors to make sure that we're doing our fiduciary. It's a policy that we have to engage this team to make sure that we're getting a fair market rate."
Bill Condon: Absolutely. And I think, as we've talked about, all of the quality institutional landlords recognize that sophisticated tenants have brokers, right?
Matt McGregor: Exactly.
Bill Condon: Oftentimes you'll run into it when it is a private owner in a different market, and that's when you really need to play that card. And rightfully so, because it saves the company money. It saves them not only from a rate standpoint but from some of the other issues we've already talked about throughout a lease, that are extremely important in addition to rate.
Matt McGregor: That's right. And it's interesting, again going back to that expertise in 10,000 hours and really knowing what you're doing on these deals, because at the end of the year when we look back on any market and you look at comps, what's the ones that jump out at you?
Bill Condon: The ones that are not represented. Yeah, yeah.
Matt McGregor: Yeah, I mean they're usually, to your point, 22% higher. You're like, "What happened here?" Well, let me guess, right? And it's just because they don't understand all those ins and outs. They don't know when the debt is due on the building, and is that a leverage point, right? And then finally on renewals, I think a big, big point is the functionality of the building versus what else is out there and what else has been developed in the meantime. I mean, nobody wants to move if they don't have to. But the question is, this is maybe the largest transaction some companies will do, a single transaction, right, is a renewal. So really understanding and going through the processes, if you were going to move, even if you say there's a 0% chance, to go through the the checks and through go through, we have what we call our strategy document. We won't go over it, that's whole nother podcast. But it's really a 32 point check system of going through and understanding "how does this facility fit our needs in today's advanced supply chain world?"
Matt McGregor: And comparing that to everything else in the market, even if it's a 0% chance. At least when you that renewal, a lease addendum, and/or renegotiate a lease, you know 100%, just as if you moved, that this was the right deal for your company in today's world.
Bill Condon: And so much goes into it too. And term's another important one, right?
Matt McGregor: Yes.
Bill Condon: Oftentimes you'll have a tenant that says, "You know what? I'm going to do a 10 year term or a seven year term or five just because it feels right." Well, we have stats and we look into it and depending on what market we're in, sometimes it does make sense to do a long-term deal. But sometimes it makes sense to do a shorter term deal, right?
Matt McGregor: Termination option.
Bill Condon: Depending on the flexibility that the tenant needs, depending on their growth plans, right? So, so much goes into it from a term standpoint too, that it's really important to not just get hung up in, "Hey, I'm going to do another five year deal, just because that's what I did last time." Right?
Matt McGregor: That's right. Well, once again, we appreciate everybody joining us on today's podcast. We're going to go get busy today doing some renewals.
Bill Condon: Yeah, that's right, that's right.
Matt McGregor: So, appreciate it.
Bill Condon: Thanks guys.