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Why Rising Rents Are Not Bad for Tenants

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    NEWSLETTERS

    Due diligence is the best bet when renting a property or renting one out.

    As pure tenant-only brokers, we like soft real estate markets where supply outstrips demand. Generally speaking, in these types of markets, tenants hold the upper hand and can exert their leverage to secure aggressive lease deals. While it is certainly nice to be able to take advantage of weak market conditions, a sustained down market is not healthy for the region or for tenants in the long term.

    Philadelphia and the surrounding suburbs have suffered from a relatively flat rental market over the past 20 years. Because supply has generally outstripped demand, rents have not grown over time. As the cost of constructing new buildings has increased over time (even in a relatively low inflation environment), landlords need higher rental rates to justify the higher costs of new buildings. Unless and until “market” rental rates for existing buildings reach “replacement cost” rents (i.e., the level that a developer needs to obtain to justify the investment in new buildings), developers will not start new projects. Thus, there have been very few speculative commercial office building projects in our region outside of the Keystone Opportunity Zones (which have both State and local tax incentives which help offset the higher rental costs).

    Assume for example that a suburban office building costs $300/sf to build. Further assume that, in order for the landlord to achieve his required hurdle rate of return for this investment, he needs to achieve a 9 percent lease constant (the factor, applied to the cost, that results in the required rate of return after taking account of the landlord’s cost of capital and applicable amortization periods). This would require a NNN rent of $27/sf (i.e., $300/sf x .09). Adding operating expenses and taxes (assuming there is no tax abatement for new construction) of, let’s say, $8.50/sf would yield a “replacement cost” starting gross rent of $35.50/sf. If and to the extent rents for existing Class A buildings in the surrounding areas are $29/sf, it may be hard for a tenant to justify paying a $6.50/sf premium for a new building unless it had unique requirements that could not be accommodated in the existing building inventory. If, however, market rents for existing Class A buildings in the area approached $35/sf gross, developers would be able to justify the investment of new dollars and tenants could justify paying a small premium for a newer product. Read more about this story on PBJ.com.

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