How One Denver Deal May Illustrate a Growing Trend
In the ever-evolving tug-of-war between office tenants and property owners, conventional wisdom would suggest that tenants currently have the most leverage.
As property owners contend with hybrid work arrangements that depress office utilization and rising interest rates that cut into net operating income, it would seem that tenants have an opportunity to capitalize on their landlords’ woes. But how are tenants taking advantage of this moment in time? And what concessions are property owners willing to make to keep a tenant in place?
To answer those questions, LoopNet spoke with Howard Schmidt, vice president of Avison Young in the firm’s downtown Denver office. Schmidt detailed one recent transaction to illustrate what seems to be a growing trend in downtown Denver that may have implications for office markets throughout the U.S.
From Red Hot to Lukewarm
According to Schmidt, before the beginning of the pandemic, downtown Denver was “probably one of the hottest office markets in the country.” At the beginning of 2020, Denver’s direct office vacancy rate was less than 10%; but by the end of the first quarter of 2023, it exceeded 15%. That represents a more than 50% increase in just three years, according to data from CoStar Group, the publisher of LoopNet.
And many estimates of Denver’s vacancy rate exceed those figures. Schmidt estimated that, if sublease space is considered, totally vacancy could approach 22%.
Market statistics like that set the stage for tenants to achieve favorable terms and concessions. And, according to Schmidt, a common pattern has emerged in downtown Denver with regard to how tenants are applying that increased leverage.
Less Space, Longer Term
“If you’ve got an existing tenant in your building, you do everything you can to not let them leave.”
Howard Schmidt, vice president, Avison Young
Schmidt focused on one recent transaction as an example. To speak somewhat freely about the deal, Schmidt declined to name the tenant, landlord or property in question.
Here’s what we do know: the tenant was a law firm occupying approximately 50,000 square feet in one of the largest Class A properties in downtown Denver. While they weren’t the most sizeable tenant in the building —they represented approximately 7% of the property’s total space, based on Schmidt’s estimation — “they’re not a small fry,” in his words.
Schmidt said that the property in question had been “bleeding tenants the last two, three years.” And while direct vacancy at the building wasn’t necessarily substantial, there was “quite a bit” of sublease space available.
Meanwhile, the law firm in this tale found that, as a result of hybrid work policies, it was utilizing only about two-thirds of its 50,000 square feet of space. So, with about two and a half years remaining on their lease, they asked Schmidt to begin discussions with the landlord about surrendering a portion of their space in exchange for agreeing to an extension of their lease term.
Now, this is not a new tactic in the world of office leasing. A subset of the “blend and extend,” strategy, tenants have been renegotiating rental rates and/or surrendering space in exchange for a longer lease term for decades. Nonetheless, the amount of space that Schmidt’s client surrendered, coupled with the other terms they were able to achieve, was notable.
Specifically: two years ahead of their lease expiration, Schmidt’s client arranged to return approximately 15,000 square feet of space, with no penalty. In exchange, they agreed to a seven-year term extension for their remaining 35,000 square feet of space and a modest increase in their rental rate.
Further, the law firm obtained free rent (while Schmidt wouldn’t say precisely how much free rent, he noted that the going rate in the Denver market is approximately one month free for each year of term extension), free parking for a portion of their lease term and an approximately $10 per square foot tenant improvement allowance.
According to Schmidt, that last concession is particularly significant. That’s because the tenant’s space was built out relatively recently and doesn’t require much renovation, and any unused portion of the tenant improvement allowance can be applied towards additional rent abatement.
All of this might seem fairly generous, but Schmidt said that he’s completed or is in the process of completing several similar transactions in Denver that feature comparable terms. “There’s kind of a rule of thumb right now for a lot of landlords: if you’ve got an existing tenant in your building, you do everything you can to not let them leave the building,” Schmidt said.
What Tenants Should Know
“What we’ve been seeing lately is that some of these groups are downsizing too much.”
Howard Schmidt, vice president, Avison Young
If a tenant is interested in replicating these results, Schmidt advised that there are a couple of things they should bear in mind. Firstly, the wherewithal of the property owner is a significant factor in these discussions.
“It depends on if a building is in receivership,” Schmidt said. Receivership occurs when the owner of a building has defaulted on their loan, and management of the property is transferred from the borrower to a neutral third-party, known as a receiver. “That’s a little trickier, because [in that scenario] cash flow is king. They don’t want to give free rent because they need that consistent cash flow to keep coming in.”
Even in that situation, though, Schmidt said he’s developed some tactics that have proven to be beneficial. For instance, rather than obtaining the entire free rent period at the beginning of the lease, some landlords are more willing to offer one month of free rent per year for the life of the lease.
Schmidt also observed that, in general, a bit of a role reversal has occurred in this aspect of the tenant-landlord relationship. Whereas it used to be the landlord that was focused on the financial health of a prospective tenant, now tenants are scrutinizing the financial condition of their current or potential landlord.
“The tenants now are asking, ‘What does your loan look like?’” Schmidt explained. “We’re talking with asset managers and saying, ‘Explain the building situation to us before we get too far down the road here.’”
Additionally, Schmidt said that while some companies are definitely in a position to surrender a large portion of their space, not all of them are.
“A lot of these companies feel like they have to downsize because that’s what they read in the paper,” Schmidt said. “But what we’ve been seeing lately is that some of these groups are downsizing too much. And they come back and say, ‘Whoa, we gave back too much space. We’re not 50% of [our prior footprint] we’re more like 70% or 80%.’ And that’s something we’re starting to see more and more of because more employees are going back to the office.”
Daniel Schmergel is the Managing Editor of LoopNet. He has worked in the commercial real estate industry for more than 15 years, serving in a variety of marketing, content and communications roles for companies that include Newmark Knight Frank and Cushman & Wakefield. He has also previously held positions as an adjunct professor, music critic and editor-in-chief of an online arts and culture publication.