Intersection Point

The trends in logistics are changing. Fulfillment centers around the globe are adapting to better suit customer demands. We’re seeing more automation and robotics, more office improvements, more levels of complexity, more security and more employee workplace amenities among others.  In short, businesses are expecting more. And they want more now.

Leasing new property is an important part of expanding or streamlining operations. Whether it’s done to expand into a new market or make business easier for staff members or external customers, leasing decisions have always been an important logistics challenge. But while a landlord’s main customer is the tenant, the capital structure of distribution buildings is critically important.

Lenders, equity investors, Real Estate Investment Trusts (REITs) and pension funds are also a major part of the picture. The days of individuals owning buildings for income and appreciation are over. Commercial real estate ownership is now dominated by institutional real estate investors. The investors raise capital from insurance companies, pension fund advisors, university endowments, private individuals, real estate private equity firms and sovereign wealth funds. In fact, the Top 100 global institutional real estate investors firms own more than $2.1 trillion of valued real estate with nearly 47 percent of that total being invested in U.S. properties.

So what does this change to institutional real estate ownership mean to the tenant? And how does that compare to what it means to the landlord?

Selection Process

The typical real estate process starts with the corporate occupier identifying land sites that suit the operational needs of the project.

Once properties are selected, the competing real estate developers will work with a potential tenant to create a proposal to build a facility that meets the operational goals of the tenant. These developers will then make a lease proposal based on their costs and what they think a market rent is. Typically the tenant goes through a process to determine the right combination of site, building features and rent. Corporate occupiers then choose the developer and sign a lease and eventually occupy the building.

Before we discuss the changes in this process, we will define “cap rate,” a basic term measuring return on investment. A cap rate is defined as the annual net rent divided by the cost or value of the property. For example, an income of $100 in a building valued at $1,000 yields a cap rate of 10 percent.

When real estate investors held properties long term, the most important variable was the difference between the rent and the mortgage payment. Now that developers sell their property, the most important variable is the difference between the cap rate on the cost of the property and the cap rate that an investor will pay for the property.

In the simple example above, if an investor can live with a five percent return, then the $100 of rent yields a value of $2,000 and the owner can sell the property for a big profit.

This concept is known as the cap rate on cost versus the cap rate on sale. When the cap rate on cost is greater than the cap rate on sale, the investor can flip the property to an investor and make a profit.

In today’s market investors are looking for a five percent cap rate. Developers want to lease a property for a six percent cap rate and realize a profit when they sell the building. In the $100 annual rent example above, the investor has a six percent cap rate meaning his cost is $1,667. When he sells at a five percent cap rate or $2,000, the profit is $337.

Most companies only think about the rent. We think it’s critically important that the corporation understand the landlord’s capital structure.

Logistical Issues

From a logistics perspective, these real estate markets are perpetually inefficient. And these inefficiencies create opportunities for those looking to use that space. While some portions of real estate information may be transparent, some very important data points are not. Those include:

+ The landlord’s business plan;

+ Whether the landlord plans to hold or sell the property;

+ The nature of the landlord’s capital stock in the property;

+ The development yield spreads and how those affect short and long-term costs.

Understanding these “hidden” data aspects is the key to tenants establishing a better rental rate. By understanding the capital markets side of the equation and understanding the owner’s perspective, potential tenants can determine rates that satisfy both parties and eliminate obscurity.

First off, tenants should look to use an “open book” process for construction budgets and profit spreads. This allows both sides to have access to the same information, leading to more consistent costs and establishes trust between parties for a successful long-term business relationship.

Using detailed numbers related to the property, tenants should look to negotiate the spread between cap and cost and cap and sale to ensure the final amount are within those parameters with less cost uncertainty.

Tenants should also look to negotiate a share of sale profits so that if the property changes hands, the tenant will still be vested in the future of that property. Quite simply, if you control the land, you control the process and can ensure that the management of the property remains in a place that favors the tenant.

By negotiating a suitable rent price using these strategies, tenants not only are establishing a cost savings, but are creating a solution that frees up revenue for other aspects of business, but creates certainty in the future of a property and establishes a positive relationship with the landlord and their interests as well.