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The Misapplication Of Comp Data In Commercial Real Estate

By David Marino

In many real estate transactions, buyers and sellers assess the market value of a property using market comparables, or “comps,” of similar recently sold properties. Within residential real estate, comps are powerful indicators of market value since sales can be accurately compared (“comped”) with similar properties based on square footage, condition, age and other features like the number of bedrooms, view, property size and other attributes.

Additionally, dozens of applicable and publicly recorded transactions typically close each month allowing buyers and sellers, with their respective brokers, to look to the immediate market area to understand current values and trends.

Over time, this methodology has spilled into commercial real estate and is often applied to how landlords and tenants negotiate lease renewals and renewal options—or even consider what a tenant should pay in an active lease negotiation. However, I find this application of lease comps completely favors the landlord and puts the business owners at a massive disadvantage. The tradition of applying comps to commercial real estate leasing is yet another method and custom that was created by building owners, for building owners.

Disadvantages To Tenants Of Comps In Commercial Lease Negotiations

First, comps in commercial real estate transactions are not “comparable” at all. It’s not just the price a tenant pays, but also the length of the term and other concessions around signage, parking, tenant improvements, rent increases and a host of other often unreported variables. Rather, I witness landlords and brokers usually pick and choose what comps they want to report given the case they want to make, none of which are publicly recorded.

Second, the negotiations themselves are tremendously variable depending on whether the tenant was represented by an independent broker or represented by the landlord’s broker as a dual agent, the tenant’s credit, what subleases or other options were available to that tenant at the time or whether the tenant even went to the market to understand their value and alternatives.

Lease outcomes are highly inconsistent based on whether they were arm’s length (in my experience, a tenant who negotiates directly with a landlord or landlord’s broker generally has the worst market outcome), how the tenant approached the market (if they did at all) and the agency, competency, potential manipulations and conflicts of the brokers involved.

The Flawed Logic Of Using Comps For Future Market Prices

For business leaders drawn into using comps to set future market prices, the outcome is that a comp signed last month had business terms negotiated in a market dynamic set four to six months ago.

For example, consider a tenant today with a lease expiring in the first half of 2025 who is negotiating a new lease, renewal or renewal option that’s looking at comparables today; they are looking at comps from market conditions set in late 2023 or early 2024, which is a more expensive market than today’s or tomorrow’s.

What asset class would you pay a price for nine to 12 months from now based on pricing that was set four to six months ago? It sounds ridiculous, yet every day, some tenant somewhere exercises a renewal option based on this same contradiction or gets convinced by a broker that a lease proposal is reasonable based on that same logic. In today’s market for office, wet lab research and industrial leases, market prices and terms in most metro areas are rapidly becoming more tenant-favorable, but many landlords and brokers convince tenants that looking at past lease comps is a reasonable way to price future rents.

The Pitfalls Of Renewal Options Based On Past Comps

Consider the overpayments made by tenants who’ve signed lease renewals by exercising lease “renewal options.” I have heard hundreds of times where tenants say something along the lines of, “I signed a lease with two five-year renewal options,” as if they have some kind of future preferential right or leverage, when in fact, it couldn’t be further from the case. Renewal options generally must be exercised at least eight to nine months in advance of the expiration date, and often when larger lease transactions, a full year in advance.

Imagine that you’re moving into your option window in the coming months. If you go to the market and press what landlords are willing to do through the balance of the year (as their debt matures and their occupancy continues to erode or as the real risk of you moving increases), you will get a completely different end result than exercising your formal renewal option that ultimately relies on lease comps.

The Misapplication Of Comp Data In Commercial Real Estate Article

The Changing Market Dynamics

The reality is that from now to the end of 2025, I predict that most office, biotech wet lab and industrial leasing markets are likely to lose 10% to 20% of their value as we see more office building foreclosures across the country and continued distress in these spaces resulting from overdevelopment and softening demand. Tenants falling prey to this landlord-developed and broker-supported standard of commercial conduct are looking at future pricing in the rearview mirror versus through the windshield.

Unfortunately, I see too many business owners and executive management teams gamed in the commercial real estate industry to apply very sound residential real estate comp methods to the commercial real estate industry completely out of context.

Recommendations For Business Owners And Executives

I recommend that business owners and executives who have leases expiring during any cycle of the market, particularly over the next two to four years in what will likely become one of the softest commercial real estate markets in recorded history, go to market on the proper critical path (which is shorter today given the abundance of subleases and built out space) and not exercise renewal options or look at comps for guidance on values.

The goal is to understand what your current and alternative landlords are willing to offer versus being held as a captive in a process where what you pay in the future is what others paid in the past.

 

David Marino is senior executive vice president of Hughes Marino, a global corporate real estate advisory firm that specializes in representing tenants and buyers. Contact David at 1-844-662-6635 or david@hughesmarino.com to learn more.



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