Tenants Walk a Fine Line as They Gain the Upper Hand

Landlord-tenant relationships are shifting rapidly as commercial real estate regains its footing in the wake of the COVID-19 crisis⁠—and in a “complete 180” of pre-pandemic norms, tenants now appear to hold the bulk of negotiating power. 

“In the past five or six years, landlords have had all the negotiating power so they were able to be relatively bullish on what their renewal rates are, their terms, and prices they could set,” said Trepp’s Lonnie Hendry in a recent analysis. “This dynamic has changed in many cases throughout the pandemic. Now, it has done a complete 180, to where it is in the tenants’ favor.”

The current market is rich in two important variables: sublease space and supply constraints. The sublease market is currently bifurcated, “meaning you may have contract rent (per the contract today) but this may not be reflective of market rent in the open and exposed environment,” Hendry says. That means that if market rent is lessened by a glut of sublease space, the market gets reset to the new rental rate when those leases roll.

Total North American sublease space hit 147 million square feet earlier this summer, and across the 90 North American markets tracked by Cushman & Wakefield, office sublease space is up 76 percent year-over-year and up 99% since the beginning of the pandemic in Q1 2020. 

What’s more, “we are very supply-constrained given the supply chain impact,” he says. “So, if you have to re-tenant a large space, your tenant improvement costs will be astronomical compared to market norms⁠—if you can even find the labor to perform them.”

For operators and landlords, that translates into immediate rent decreases.

“It will certainly be interesting to see how these changes play out in the long run, but in the interim, there may be some confusion to participants,” Hendry says. “You may have a clear bifurcation tenant market, and the way resolution will be handled will likely be different depending on deals.”

And for tenants, that calculus requires a delicate balance.

“If you are an established company in an established market, you may not necessarily want to go with the lowest cost provider because if that landlord goes to bankruptcy or the building goes into default, that can negatively impact your business as a whole,” he says. “At the same time, however, you don’t want to overpay just because of an owner’s brand recognition or operating experience in a particular market if you can get a competitive deal that offers you a similar utility at a lower cost.”