Episode #5 - Lease Trends and Hotspots
The Industrial Advisors sit down with John McDowall, an attorney with Fikso Kretschmer Smith Dixon Ormseth to discuss lease trends and hotspots in the market.
Bill Condon: Welcome to the show everybody. Today we have our friend John McDowall, who is an attorney with FKSDO. Prior to that, John was with Carney Badley Spellman in Seattle, for over twenty-two years. There he was on the board of directors for nine years. He chaired the firm's business group, and co-chaired the firms real estate group. John has won multiple awards in the industry. He has been named by the Washington Super Lawyers magazine, and Super Lawyers Business Edition, as one of the top attorneys in Washington State from 2013 through 2019. Matt and I have had the opportunity to work with John on multiple transactions and we think, he's really as good as it gets in the industry, and so we wanted to bring him on and have him shed some light and talk about some of the trends that he's seeing in leases, that tenants should be aware of. John, thank you for joining us. Why don't we start with that? Why don't we just start out by talking, maybe you could talk a little bit about some trends you're seeing in some of the triple net leases right now.
John McDowall: Yeah, you bet. Thanks for that kind introduction. I feel you were reading a fiction novel there for a minute, but I appreciate it. It's always great working with you guys. Thanks for having me on your podcast. I guess to summarize it, depends a little bit what market you're in. We're obviously in the Seattle market, where it's a very vibrant real estate market. A tighter market for tenants, kind of a landlord's market here, with some exceptions, depending on where you are. I know that's not the way it is around the Country in some pockets, but speed is very important in this market. Some of the trends that we see are driven by that. Also, because the market's so popular, there's just more dollars from more sources around the country and around the globe, frankly, institutional owners and similar owners who are buying properties in Seattle, and that's who we're dealing with in the leasing market. Some of the trends we see are driven by the way that institutional owners think.
John McDowall: I think most of my comments, I'll couch them from a tenant perspective. I probably represent landlords about a third of the time, and tenants probably about two-thirds of the time. Most of my comments will be couched more from what we're seeing from a tenant perspective because often time the out of town institutional owners have their lawyers in New York or Chicago or Los Angeles, whom we're dealing with, and we get hired to represent the tenants here. Slow permitting, or difficult permitting processes is one trend that we see. We see it in a couple of different ways. One, all the planning departments are just very busy here. Many of the industrial users, and some of my comments today will apply to office type leases, but most of them are going to apply to industrial type leases.
John McDowall: Many of the industrial users have some sort of ancillary manufacturing use, it's not just warehousing. That sometimes requires some extra level of permitting. It could also entail some extra level of federal licensure or state licensure for whatever the particular use is. That sometimes slows it down. The other thing is that if we're... Of course, we're often dealing with large users who are taking one hundred thousand square feet, maybe two hundred thousand square feet, for their warehouse, manufacturing use, logistics type clients, who just need a lot of space. But, sometimes when we're demising space, or when we're dividing up space, there are issues if you're dividing up a warehouse that's been there for years and all of a sudden there's no access ramp there in the space that they're going to be occupying. We have an ADA issue, right? That could slow things down. So there's a lot of issues like that, that can slow things down that we just see more and more. That's just a function of the market being very vibrant and the permitting folks being very busy.
Matt McGregor: I think you make a great point of that. I think across the Nation and especially in busy cities like Seattle, that's a huge issue with not only the permit slowdown because the amount of construction projects going on, but also the lack of TI companies and construction companies that can do the projects. So that brings us to an interesting topic that we've struggled with a lot lately, which is, what is the exact definition of rent commencement date? A lot of firms want to set that date out. What happens if the space isn't ready? How do you resolve that in a lease?
John McDowall: It's really a matter of negotiation and you just have to be very specific about it. Usually you're going to have a Lease Commencement date. Which is when you sign the lease and there may be certain activities that start, such as tenant build out. Oftentimes the landlord is doing the work, but tenant may be doing some work. The landlord wants two things. One, they want all obligations to be binding from the moment that the tenant starts even thinking about entering the space. Number two, they want certainty. They want the tenant to sign on the dotted line so that they can focus on that and they know they're not wondering who their backup tenant might be in the space and they can focus on other deals. So you're going to have the lease commencement date, but then you're going to have a rent commencement date that's going to be often tied to your delivery date and always tied to your delivery date and then the question is going to be, do you have a free rent period or a rent abatement period? Which you often do.
John McDowall: Even though it's a landlord's market, there's oftentimes still some rental abatement, whether it's only a month or up to four or five, six months, depending on the location. So you're tying the rental abatement to the rent commencement date and you really have to be very specific about what your schedule is. Sometimes there's some landlord work and tenant work. The parties just have to sit down and talk to their contractors and say, "Here is what's realistic, here's when we can get in there." That goes to the point you were making. Everybody wants the best contractor out there, the best general contractors want the best trades and subs, and it's hard for all of us to find them because they're just all so busy right now and the costs are going up and the tariffs are not helping that. You just have to be very specific on those dates and spend a particular amount of time on that. As early as the term sheet stage, not just [crosstalk]
Bill Condon: Yeah, I was going to say the commencement date in a lot of these core markets is becoming a bigger and bigger issue, right?
John McDowall: For sure.
Bill Condon: Because you look at, for example, Southern California, New Jersey, Seattle, these are landlord markets right now and there's competition for deals and so landlords are oftentimes trying to push for a hard commencement date and tenants really have to look at that and say, "Is this a good business decision? How badly do we need this building? What are the other options that are out there?" Because oftentimes they're in a competitive situation and need to take down a building and need to commit to a hard commencement date. So doing a lot of that work upfront, making sure that they're comfortable with that date. Is extremely important.
Matt McGregor: That's right. We've seen several times in these hot markets where the tenants actually has burned through all of their free rent and on into their rent period. They haven't occupied the building yet because their lease was not negotiated correctly. So, that's obviously a key mistake on tenants. John, in the last couple of years in these tighter markets, what other key mistakes are you seeing tenants make in negotiating triple net lease?
John McDowall: Actually, on this last topic, I'll touch on that one. The tenant wants to have some remedy if it is late and if it's the landlord's fault. For whatever reason, the landlord hasn't delivered the shell on core. If you don't have a rental abatement right, if the landlord's delivery is late. What we usually push for is there's a grace period of fifteen, twenty, thirty days and then you want to have a rental abatement right. If it extends ninety, one hundred and twenty days or more, you want to be able to terminate that lease because you've got to take your business somewhere. Not all landlords will agree to the termination right. They push back hard on that one. That's a mistake. Not having those type of rights. Others I would say is not being aware of the age of the building, and what upgrades could be coming from a landlord's perspective, and what is really a capital repair that generally landlords pay for, and sometimes they get to pass through. Sometimes they don't. Depends on who has more leverage in the deal.
John McDowall: Again, landlords tend to have more leverage in this market, but if you have an older building where there's going to be HVAC units that need to be replaced, tenants need to be cognizant of that. If you have a ten year lease and a replacement of HVAC units happens in year eight, you don't want to pay for the full cost of that. So tenants need to make sure that they're, and this is quite standard in the industry and in most markets, if not all markets, landlords should be amortizing that cost based on either a gap standard or IRS standards, so that it's based on the useful life of whatever improvement it is, whether it's the HVAC units, a roof replacement.
John McDowall: So that if that has a fifteen year useful life, that should be amortized over 15 years, and the tenant should only pay two years of that, their last two years of the lease. Now obviously if they renew for ten years or five years, whatever, they would pay a part of that. That's another area where tenants I see make mistakes and not catch something like that. That could be a significant expense for a tenant.
Matt McGregor: For sure. That's a great point because not everybody's leasing a brand new building and it's sometimes as simple as the tenant demanding or requesting a property condition report. Maybe that roof needs to be replaced next year and it's one million dollars.
John McDowall: The HVAC systems could be twenty-five years old.
Matt McGregor: Several of the systems can be shot and as soon as you sign that lease, right? The tenant is on the hook for most of those, whether directly if it's inside the walls or indirectly as a pastor on the triple net.
John McDowall: Correct? Correct. And kind of on this issue, a similar but different mistake that I see tenants sometimes make, and this demonstrates a trend that I also see in this market with more institutional owners. Many of the industrial buildings that you guys place your tenants in, or you represent landlords. Some of them are just old buildings that were built in the fifties, sixties, and some of them were owned by a family or two brothers. And then eventually they decide who's the next generation that's going to own this. We're getting all these offers. These brokers are coming to us. Of course everybody loves brokers coming to them. Right?
Matt McGregor: That's right.
Bill Condon: Of course.
John McDowall: But after a while they say, let's sell. And the Institutional's come in and they look at this lease from 1984 from the George Orwell era I guess, and say, well who does leases that are 10 pages anymore? And there are many things that they want to upgrade in the lease. Insurance provisions, surrender provisions, a lot of different things, and some of that could have impacts on exactly the issue that you were just talking about, Matt. Who is responsible for the walls? Who's responsible for a crack in the floor?
John McDowall: So tenants need to pay particular attention to that and oftentimes you don't, because it's an extension. You say, okay, we're doing five more years here, but in the last two years the building has changed hands and now you're dealing with a large institutional owner who wants to upgrade their leases because they're doing it around the country. And I don't blame them one bit for doing it. That's proper risk management from their standpoint. But tenants need to say, you need to do this in the term sheet process. On renewals, you're usually just thinking, what's our term? What's our price? Are we doing a couple of improvements? There's not much more you usually think about on those, but you need to think about that type of issue, particularly if your landlord has changed in the last few years.
Bill Condon: That's a good point because certainly here and again in a lot of the core markets across the country, it is definitely a trend where those markets are becoming more and more institutional. The old days of the five to ten page leases are turning into sixty to seventy page leases with a lot more substance to them. Even more important to look at in detail, at those particular leases. You mentioned the term sheet, so we call it letter of intent. One of the things that we try and do is really put a substantial letter of intent together for our tenants, that outlines a lot of those lease provisions. We do that early on because there's still competition at the table. The goal is to really try and avoid that lease blowing up at leases. So negotiating a lot of those terms up front while there's still leverage there for the tenant. What are some ideas and tips that you might have for tenants as... To avoid getting leases blown up at the actual lease stage?
John McDowall: You can spend a little more time on the term sheet, for sure. I think you really need to spend some time thinking about what do the next five years look like? How might we change? How might we need to expand? How might we be acquired? What other aspects of our business might we try to expand? What areas might we try to get into? This doesn't happen as much with industrial users. Manufacturing users. Happens a little bit more in the office context, particularly with startup type clients, but still be thinking about that. Then I think spend more time on the term sheet. I've seen Colliers do this often and I've seen a couple of other brokerage houses do it, where you guys have a pretty good, some people would say, well, this seems like overkill, but you have a term sheet that really tracks all the issues, and then you track them by version as well.
John McDowall: During the course of the negotiations that might drag out a couple of months so that you can see you've gone back and forth three or four times and we end up on that term sheet with three or four or five columns. But it helps you really track all those issues and really be thinking about it.
John McDowall: I think the tenants should trust the process that the brokers know that you guys put in front of him. I think that's actually a really good process because that generally simplifies the issues when it comes to at the time of the lease. The goal really, there's an old saying if I have more time I'd write a shorter letter. The perfect lease is probably not the ten pager from 1984, nor is it the, believe it or not. I was doing a deal recently where we had about an eighty pager and I was dealing with an attorney in the Midwest, very pleasant to deal with, and it was a large industrial developer that everyone would recognize. We were laughing about the length of lease and she said, well their particular equity partner on this, they have an even longer lease, that was like one hundred and twenty pages.
John McDowall: The goal is to get to a good thirty, forty, page lease that is just an efficient lease and there's not that much back and forth once the attorneys get involved. Because, we all know things can slow down when attorneys get involved and our goal is to try not to inhibit the deal from happening.
Matt McGregor: That's a great point. And John, one thing we love about working with you is your demeanor. I don't want to stereotype attorneys because you can stereotype brokers just as easily, but we've been on too many calls where you get one or two attorneys with a big ego that needs to win on every point, and it just changes the dynamic of that call. And it seems to happen when you have more people on the call cause one or more person feels like they're on a stage. We've had so many deals blow up because one person's just needs to win big, big ego. What do you do in those situations? Because I've been on so many calls with you where I don't see that you just, you do something and you wave your magic wand and calm everybody down. But any stories there of big egos and what do you do to avoid that?
John McDowall: I think number one, you just talk to people. You try to talk to them on business terms and say, here's what's important to us. What's important to you? Number one. Number two, you always remember that when you guys come to us, when a client comes to us with an LOI, or when a broker calls us into a deal, the fact that there's an LOI or term sheet, means that you guys want to do a deal. So always remember that. We always keep that in mind and try to always be working toward that. And then we try to focus on the big issues that are really important. And a good example of this, a long time Seattle landlord who probably owns at least two million square feet around in the industrial area South of Seattle. I got called in by a broker that you guys do deals with often, you know him well, because the attorney who was involved, had just redline the heck out of his 18 page lease that he's had for years.
John McDowall: He said, I just don't change much of this stuff. So the broker and I got on a call with the tenant, with the client, and just talked about what's important. I gave him a few views on the lease. So I suggested, why don't we get on a call with that landlord, all of us, and let's just be professional. Let's be assertive about what's important to us, but let's be professional. We got on the call with this guy and we previewed him a little bit and said, there's eight or 10 issues we'd like to talk to you about. I think he gave us six or seven of them because we just talked him through. There were a couple of where we, he said, no, I've had that request twenty-five times if I've had it once in the last year and I just don't do that.
John McDowall: But he was very reasonable. It really came back to number one, talking to people and number two, talking about what's important to the tenant and why, and understanding why things were particularly important to him. I think the other thing that you can do is when attorneys, and although I advocated a good term sheet with some detail as you guys often do, when attorneys get involved, you can have way too many versions of a document. I had one recently where we went through eight turns on a term sheet, and this was a large publicly traded company as our sub tenant. We ended up with twenty-four versions of the lease and the landlord consent, because it was a sublease. That should not happen. What attorneys should try to do is if we've got a good term sheet is from a tenant standpoint, do a solid red line of the landlord's lease and then the landlord will probably give you at least a third, maybe half of what you're asking for.
John McDowall: Then rather than doing more rounds of red lines, just come up with a good issues list, send it over to the landlord often through the brokers, and say, why don't we do a call to talk about these twelve issues? Then there might be one more round of red lines because the landlord might say, okay I get your point on six of those issues, I'm going to tweak it a bit. But try to streamline that process. A couple of examples when we're redlining a lease, tenants ought to have audit rights on operating expenses. But rather than present a five paragraph audit provision that is very detailed that I like, I just ask the landlord and usually large institutional landlords, there's very savvy and sophisticated. They're used to this issue, they probably have their preferred language. So we say we would like audit rights, please present your language.
John McDowall: Same on renewal rights, option renewal rights. They often have the process whether it's a baseball process or how you define the market for setting renewal rents. So in those circumstances we just flag the issue and say we want this, we could present language, but landlord you probably have language. So give us your language and then can we talk about that? So those are ways that we try to streamline the process and get the deal done. Because like I said, you guys come to us because you want to do a deal. That's why you have a letter of intent.
Bill Condon: It's a really good point. By the time you get involved, that you make... You have a landlord that wants to do a deal. You have a tenant that wants to do a deal. You certainly have the brokers that they want to get the deal done too. So it's not about winning section 19.2 in the lease agreement. It's about coming to an agreement on a fair document that works for both parties, and moving forward in a positive light. It's a good approach.
John McDowall: You've got to check your ego at the door. Most of us are sports fans and, of course, in Seattle we're Seahawks fans so of course, we hate the Patriots. But I was-
Bill Condon: Who doesn't?
John McDowall: Right. But Tom Brady's a heck of a player, but he's always humble. I was watching something where he was talking to, I think the Ohio state quarterback who's with the Redskins now.
Bill Condon: Yeah.
John McDowall: Dwayne Haskins. And after the game, Tom Brady went to him and said, man, Ohio state beats Michigan all the time. Michigan being Tom Brady, his Alma mater, and all he wanted to talk about was the other guy and nothing about himself, even though he's won six Superbowl's. You're not going to get too many Tom Brady's negotiating leases.
Bill Condon: You're like the Tom Brady.
Matt McGregor: Calming effect.
John McDowall: I'm going to lose a few friends over that. But you always have to just be understated and be the offensive lineman that just does his job and let the clients do their deal.
Matt McGregor: John, we want to thank you for joining us today. We really enjoy working with you. We're going to put your contact information in our podcast notes. To all the tenants out there, remember to hire the right broker, hire the right attorney, and we'll avoid a lot of these pitfalls.
Matt McGregor: Thanks, John.
John McDowall: You're welcome. Thanks for having me guys.