The Vacancy Mystery? Why Commercial Rent Doesn’t Just Drop

Have you ever walked past a commercial real estate building and wondered about the vacant space that never gets filled for years? Or thought what is wrong with the owner, why don't they just drop the rent? Surely, something is better than nothing.

Well, you're not alone. As a teenager, we used to go to Pizza Chalet a few times a month, and I used to see this vacant space every time. My mind would race with ideas for businesses that could fit right in there, filling that space with life. Back then, the solution seemed straightforward: just lower the rent and the void would disappear. But it never rented.

Fast forward to today, and with a few more years later, a few more pizza plus a little bit of commercial real estate experience under my belt. I can share with you the mystery of why they may not just drop the rent and how it can be a benefit to you as an investor or if you're a tenant looking to fill some space.

Commercial vs. Residential Real Estate: A few differences

Let me set the table for a quick review on how commercial and residential real estate differ in a few ways.

1. How Properties are Valued:

 - Commercial: Valued based on potential income. If the rent drops, the sale price can too.

 - Residential: Usually bought by folks who plan to live there. Potential rents might not majorly affect their buying decision.

2. The Ripple Effect of Lowering Rent:

- In commercial spaces, if you reduce rent for one tenant, existing tenants might want the same deal. Imagine you have three stores. Two are paying $2000 each. If you rent the third for $1000, the first two will likely want to renegotiate and get the same rate. This means instead of potentially earning $6000, you'd get $3000. This can also decrease the property's perceived value. The value could be worth $1,000,000 and then by dropping those rents it's now worth $500,000. So you collected $1,000 more in rent a month but lost $500,000 in value. No Bueno I'll explain more in the next section of cap rate and income approach

3. Nature of Leases & Costs:

 - Commercial: These properties come with high operating costs. Reducing rent might not cover these expenses. Plus, leases span many years, making landlords patient for the right tenant. Instead of reducing rent, they might offer other incentives while maintaining the property's overall rental rate.

 - Residential: Shorter lease terms and less complexity. Rent adjustments can be more flexible.

4. Tenant Targeting & Market Dynamics:

 - Commercial: Owners often seek specific tenant types, like those from booming sectors. They'd rather wait for the right fit than settle. The ups and downs of the commercial real estate market, along with legal intricacies tied to leases, also factor into keeping rents stable. Think about it maybe you don't want some illicit business next to a kids pizza parlor.

Remember, in the world of real estate, decisions often go beyond just immediate vacancies. Whether it's a house or a business space, there's a strategy at play, driven by market trends, financial goals, and long-term visions.

WHY THEY DON'T LOWER RENTS: INCOME APPROACH

I briefly talked about it above but the income approach is mostly used as to value commercial real estate and thus the somewhat confusing term of the Capitalization (Cap) Rate

• What it is and why it matters: The Cap Rate is a formula used in CRE to determine a property's potential return on investment. It’s essentially the ratio of a property's annual net income to its purchase price. A crucial tool for investors, it gives a snapshot of a property's profitability.

• How it's used to determine CRE value: The higher the Cap Rate, the higher the risk but potentially higher the returns. When buying CRE, investors often use this rate to gauge if the price aligns with the income the property can generate.

The Domino Effect of Lowering Rents

• Scenario: Let's say a building earns $25 per square foot in rent. If the rent drops to $15 per square foot, that's a significant decrease in potential income.

• Impact: If the building's value was originally based on earning that $25/ft (leading to a valuation of, say, $5 million), dropping the rent can seriously devalue the property. In our example, the building's value could plummet to $3.5 million.

In essence, the income a property generates (or is expected to) directly influences its value in the commercial sector. Adjusting rents can have cascading effects on valuation, financing, and overall investment strategy.

WHY THEY DON'T LOWER RENTS: BANK APPROVAL

How Loan Agreements Affect Rent Decisions

• The clauses that bind owners: When property owners take out a loan, they don’t just get handed a check and sent on their way. The bank typically includes clauses in the loan agreement which might stipulate conditions on rental rates or even on changing them. This ensures that the bank’s investment (the loan they provided) is safeguarded by the property’s potential income.

• Example: Imagine a property owner named Jane. She takes out a loan to buy a commercial building. The bank, seeing the building's potential to earn, say, $30/ft, might stipulate in the loan agreement that Jane can't rent for less than $25/ft. If she does, she could be in breach of her loan terms.

The Role of Banks in CRE Decisions

• Their interest in maintaining property values: Banks want to ensure the money they lend can be recouped. If the CRE property serves as collateral, its value must be maintained. If rent drops and the building's value plummets, the bank's chances of recouping their loan in case of a default decreases.

• Consequences for owners who deviate from loan agreements: Going against the loan agreement can lead to penalties, higher interest rates, or even foreclosure in drastic cases. For our owner Jane, renting out for too low might not just upset her tenants or devalue her building – it could put her in hot water with her bank.

Of course there are times in which the bank will be more accommodating to these factors. But there are times when they want to play hardball. For instance, let me give you a real world example the bank loan has a really low interest rate but interest rates are much higher than they were a couple years ago. Do you think the bank wants to keep making 2.5% interest. Heck no, so they will start looking for ways to get you to refinance that property into new interest rates or get you to pay off the loan. If you violate their loan terms they would be often times very happy to force you into a bad situation.

WHY THEY DON'T LOWER RENTS: WRAPPING UP & HOW TO TAKE ADVANTAGE

Why Every Dollar Counts More in CRE

• Factors that make CRE more sensitive to rent changes: Commercial real estate, with its longer lease terms and income-driven valuation, feels the impact of rental adjustments more acutely. A slight decrease in rent can translate to a sizeable dip in property value, based on the income valuation model. This makes every rental dollar especially vital in CRE.

• Comparison with residential properties: While a vacant house can still fetch a good price (because people might buy to live in it), a vacant commercial space signifies lost potential income. Residential values often hinge more on location, size, and amenities, while commercial values are tightly bound to income potential.

The Potential and Opportunities

• INVESTOR OPPORTUNITIES: An empty commercial space can represent opportunity. For investors, such vacancies can offer value, especially with a fitting tenant or vision in mind. Securing a key tenant can not only boost a building's worth but, in some cases, triple its value instantly. Often, under-rented properties may overlook maintenance, presenting further value-add and income growth prospects for investors.

• TENANT OPPORTUNITIES:If you're eyeing a vacant property as a potential tenant, recognize the owner's limitations while noting their potential eagerness to lease. Leverage customized rental agreements to your advantage: consider longer lease durations, negotiate for more free rent at a higher rate, or seek substantial tenant improvement allowances. For example, signing a $25/ft lease for three years with 12 months free effectively reduces the annual cost to around $15/ft. Explore options like short-term leases, as seen with seasonal businesses. Use the property's rental nuances as negotiation leverage.

Hope that gives you a slice of insight into how the empty place next to the pizza place might be left vacant for years.

-Jake