How Strong is the Landlord of your Commercial Office Building?

I’m not suggesting you find out how much he or she can bench press!   With the economy still weak, Denver office vacancy rates continuing to increase, and commercial credit markets still tight, the real question is: What is the financial strength of your Landlord or Landlord entity (corporation, LLC, etc.)?  Although the official second quarter results are not yet available, year-to-date figures predict another quarter of negative office space absorption in the Metro-Denver area.  This would make the fourth straight quarter of negative absorption (i.e. increasing office vacancy rates) in the Metro-Denver market.

A Landlord’s financial strength is important not only to existing Tenants in a given building, but also to prospective office Tenants evaluating various building options for a new office lease.

Traditionally, the Landlord has been concerned about the financial strength of its prospective and current Tenants; in today’s economy, Tenants have many reasons to have the same concerns about their Landlords.

Compared to commercial purchase transactions, where the Buyer and Seller eventually part company, a commercial office lease establishes an ongoing business relationship between Landlord and Tenant that may extend for five, seven or even ten years.  During this period, the Tenant has numerous responsibilities, the most important being to pay rent in a timely manner.  But the Landlord also has numerous ongoing responsibilities, including managing the building in a professional manner, handing all required routine and emergency maintenance, paying property taxes, providing insurance coverage, providing heating, cooling and utility services, janitorial services, and numerous other tasks.

If a Landlord is financially stressed (perhaps because it purchased the building at a high price as was common over the last few years), and the building’s vacancy rates have increased (thereby reducing its cash flows), the building services and maintenance may suffer.

A financially strong Landlord can handle the reduced cash flows that higher vacancy rates create.  However, a financially weak Landlord may find itself making choices – like deferring maintenance or required capital improvements – so that it can make its monthly mortgage payments.

Such a scenario will impact existing Tenants, but what about prospective Tenants?  Many office leases require a Landlord to provide some level of tenant finish allowance – typically $X /RSF – or a “turnkey build-out” to make modifications to a prospective Tenant’s space.  In some situations, the space is being built out from “shell condition” and the Landlord allowance could be as high as $40.00 – $50.00 per RSF.  In either case, the required design and construction can take significant time, sometimes several months to complete the required work.

Prospective Tenant’s should use caution and exercise some level of due diligence to determine if the Landlord has the financial strength to deliver the office space it promised – by being capable of hiring and paying the architects, engineers and contractors necessary to deliver the space.

Tenants should exercise even greater caution if a Landlord is providing them with a tenant finish allowance after the Tenant hires the architects, engineers and contractors to build-out the space. If there are questions about the Landlord’s financial resources, a Tenant might require the Landlord to establish a Letter of Credit to guarantee payment for the work.

In the ongoing relationship created by an office lease, a Landlord’s financial problems can create all manner of problems, issues and headaches for its Tenants.  In these uncertain times, many Tenants will prefer to commit to a Lease with a financially strong Landlord versus one that this weak or questionable, even if the Lease rate is slightly higher.  In any event, caution and reasonable due diligence regarding a Landlord’s financial strength is warranted!

Image Credit: Jason Lengstorf | Wikimedia