Forget Remote Work, Concessions Are Real Downers for Office

What are the big problems for commercial real estate/? Higher interest rates if you’re trying to refinance, of course. That seems to be the most obvious. Next up, skyrocketing operating expenses. Insurance, utilities, payroll and benefits, and repairs and maintenance have seen drastic growth.

What gets less attention but could take a larger bite out of NOI? Concessions, as Moody’s notes specifically about office properties. It’s almost invisible. There are no tax authorities, Federal Reserve, vendors or employees, or anyone or anything else requiring a certain revenue share. Instead, the mechanism is negotiation with a great deal of opacity. Two parties push their interests and weigh the options of a deal or saying no and walking away.

The basic conditions are set by figures like what percentages of employees work from home and how much space each will need. As a separate Moody’s report said, there will likely be an ultimate decline in vacancy rates to between 12% and 14%.

The amount of space the average one will need has dropped from around 190 square feet to less than 160 square feet, about an 18% decline, largely due to remote work. Moody’s has said that as time moves on, other technically “full” and yet underutilized office spaces will be further reduced. It may be that occupiers will need more than they initially think, and landlords will have to reasonably and rationally push back. That still means the interaction of perception and negotiation.

The interaction tumbles into concessions. How much can the occupier get and how much space does it require in practice? How badly does a landlord need that particular tenant? What does the remainder of the rent roll look like and how soon will significant portions of space come up for lease renewal?

That is why “concessions as a mechanism to attract and retain tenants and ultimately reap the financial benefits associated with higher occupancy rates” become such a difficult subject. Free-rent periods, rent reductions, and tenant improvement allowances all represent landlords making less. These are the results of individual situations, not largely predictable broader market conditions.

According to Moody’s, asking rents on average are 26.8% higher than effective ones. “Said differently, concessions imply that effective rents are discounted 21.1%,” the research group wrote. It’s a 21.1% revenue haircut. In comparison, an extra hundred basis points of interest or 5% more in overall operational expenses seems low.

But as a third Moody’s report points out, concessions are more complex. There is a benefit to the landlord in locking tenants into longer-term leases. However, tenants will have the advantage in negotiations for the foreseeable future.