HEARTLAND SNAPSHOT, FEBRUARY 2009

Cleveland Office Market

A year ago, Cleveland stood at the threshold of a commercial real estate construction boom. Today, it is a boom interrupted. Landlords and tenants alike are under pressure. Huge blocks of space unexpectedly coming back on the market are creating nightmares for building owners, while tenants are looking at the expense side of the ledger for ways to reduce costs. Since real estate is typically a top two or three expense line, it is a necessary place to seek values.

Over the last 36 months, Northeast Ohio, including downtown Cleveland and its suburbs, has attracted out-of-town institutional landlords. They were attracted by the relative value in comparison to first-tier cities like Chicago and New York, which had encountered multiple sales of assets based on access to cheap debt and escalating rents. These landlords are now encountering new territory with increasing vacancy and decreasing rents.

The challenging market presents opportunities for tenants. With the difficult economy, many will try to cut costs, some will look to renegotiate or trade up to better space, while others will focus on the long horizon and try to trade term length for better fixed pricing. Commercial tenants, especially anchor and large tenants that are within 18 months to 30 months of their lease expiration, should be evaluating the market now in order to lock-in favorable lease terms. New leases may deliver actual savings and/or a better location with more building amenities.

Due to the fact that commercial mortgages mature every 5 years to 10 years, and the current debt environment is as illiquid as any time in recent history, the underwriting of debt has become even more focused on the tenants in a real estate asset. Should a landlord lose an anchor tenant in this current environment, future financing could become impossible. Tenants in this situation need to understand both their value and the risk associated with a building going back to the possession of the lender.

It doesn’t have to be a zero sum game. In a unique way, this newly found tenant power might also help building owners. Free rent, moving allowances, caps on pass-through expenses, tenant improvements, and a number of other incentives are all on the table. Many of these are no-cost tradeoffs for future lease term commitments, which enhance and stabilize the landlord’s current cash flow.

Regardless, whether planning to stay in place or move, tenants are in a strong position to test the market. A long-term commitment has tremendous value to the building owner. Tenants will be underwriting the building’s cash flow, which will help provide the financial base that lenders require. Even if a building owner is not about to refinance, tenants still have leverage since owners know that other landlords are seeking users.

The key is to know what to ask for, understand what owners are willing and able to negotiate and, most importantly, assess their ability to deliver. Some building owners are well-capitalized and have sufficient cash flow to support commitments, while others don’t have the financial ability to deliver.

This requires due diligence on the part of tenants — something that was not as common just 18 months ago, but is imperative now. Potential users must research the landlord’s finances to be sure that it can perform. This includes checking with banks and lenders, obtaining letters of reference and assurances that the landlord has access to capital and is able to deliver on all of the lease terms. The last thing a company wants is to be committed to a distressed property.

Opportunities exist for tenants to lock in advantageous lease terms and conditions that will pay dividends for the life of the lease. Companies owe it to themselves to review the lease in order to assess how it can gain the most value. Most importantly, tenants should hire a professional to assist with the strategy, due diligence, and execution of what could be a complicated but rewarding process.

— Brian Conroy is a vice president with UGL Equis and is co-office head of the firm’s Cleveland office.

©2009 France Publications, Inc. Duplication or reproduction of this article not permitted without authorization from France Publications, Inc. For information on reprints of this article contact Barbara Sherer at (630) 554-6054.