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Most property owners believe that return on investment (ROI) is the most important factor when managing commercial property. Since ROI is determined by the net income of a property, the natural conclusion is to set rental rates as high as possible and reduce expenses to their lowest common denominator, yielding a higher net income in any given year. While this approach generally supports short-term investments, does ROI in any given year produce the best results for the long-term ownership of commercial property?
Unlike residential property, where leases are typically signed for a one-year term, commercial lease terms are normally much longer and often run from five to 20 years. The relationship between landlord and tenant, therefore, becomes an important factor in producing long-term gains. Tenants create their own image and style in commercial space, whether the use is office, retail or industrial. The ability for tenants to create an environment that is attractive to them and their customers is paramount in tenant retention. This relationship is created at the time of the initial lease term and is based upon the rental rate, the method of calculating future increases, the cost of improvements and the general condition of the building in which the premises are located.
There are two approaches to owning and leasing commercial property. One approach says that if you do not have vacancy, you probably are not charging high enough rents. The alternative approach calculates the average cost of vacancy, ascertains the rental prices of competitive property and charges a rate that will produce long-term revenues for owners.
The difference between these two approaches was substantially evident during the 2008 financial crisis and the long-term recession that followed. Commercial real estate brokers intensively solicited tenants to change locations with the bait of dropping rental rates into properties with significant vacancies. Sensing a weakness in the market, many tenants moved into buildings that offered handsome concessions and teaser rental rates. Some tenants even continued paying on the space they vacated until the expiration of that lease with the expectation that they would save money in the overall deal.
As commercial property managers with long-term experience in the marketplace, we have always employed the second approach in an effort to create long-lasting relationships with tenants. During the recession, our buildings stayed at a 95% occupancy rate despite the fact that some of our tenants experienced business failures. Our only concession at the time was to waive consumer price index (CPI) increases for two years during the worst of the crises. The result was that our buildings continued to provide owners with a steady income stream despite a major rupture in the market.
How do revolving vacancies impact ROI? They lower the return despite higher rental rates. The cost of vacancy can be significant. Loss of rental income, the cost of remodeling, commissions and rental concessions all come directly from the owner’s pocket. A stable, long-term tenant at a lower rental rate actually produces greater returns over the long term.
Managers should be aware that the following values are critical to producing a longer tenancy and adding to the owner’s bottom line:
1. Integrity: Treat all owners and tenants with respect and service. They are the lifeblood of our industry. Approach all negotiations with fairness and mutual benefit in mind. To the owner, current financial statements, accurate billings, facilities reports and all aspects of the business relies on the integrity of the management firm. Honest and forthright communication regarding lease proposals and maintenance concerns is what owners most rely upon with their managers.
2. Customer service: Think of a long-term tenant as a partner for a term. As managers, try to become a valuable asset to your tenants’ business operations. Perform general maintenance functions, minor improvements and day-to-day services like changing lightbulbs. For owners, timely, accurate and reconciled financial reporting and honest dealings are essential.
3. Efficiency: Personnel should respond to most non-emergency requests within 24 hours. Owners should be able to expect instant responses to their queries and concerns. Our firm manages approximately 500,000 square feet of space in three states with five employees. This efficiency can only be obtained with the application of the latest technology — cloud computing, ACH payments and collections, utility efficiency and most other functions all depend upon the use of cost-efficient technology.
4. Communication: Communication with tenants and owners is paramount in maintaining a good relationship. Scheduling maintenance functions, entering spaces after hours, providing public safety announcements and timely billings create good working relationships. Communicating with owners about long-term maintenance and leasing issues prevents unpleasant surprises.
Is the highest ROI determined by the highest rental rate? I think not.