For most of the 1960-2010 period, commercial tenants could receive a strong benefit by committing themselves to long-term leases. Unless you were dealing with the obvious coastal markets where stock-like returns from real estate is taken for granted, commercial landlords prized the income security that came with a tenant covenanting to stay on the premises for three, five, or even ten years.
From the tenant’s point of view, the advantage of long-term leases was the certainty of rent obligations as well as the discount that could be received by paying lower monthly rents.
The landlord’s advantage was that it would not have to deal with vacancies and the high transaction costs associated with tenant turnover.
In the past few years, however, commercial tenants have struggled to secure the traditional discounts associated with long-term leasing commitments and, in some instances, landlords have outright refused to consider extending long-term leases to tenants that seek them. This is historically unusual and without precedent in the modern American real estate markets.
What is happening?
As commercial real estate landlords have become more sophisticated, they have learned that the rent they receive for a property can, in one circumstance, be higher than the fair market rental value for the property.
What I mean by this is that a commercial tenant receives a strong advantage from its customer base knowing where it is located. Having customers know that your pizza joint is located at the corner of 8th and Market Street is important for the retention and growth of business development. For an established business, maintaining the same location is paramount. Therefore, an established commercial tenant may be willing to pay 10%, 20%, or even 30% more than fair market value rent to maintain such premises as the benefits of maintaining the same location at the time of lease renewal is superior to the alternative of changing locations to premises with lower rents but a greater loss to the difficulty of reorienting the customer base.
I am aware of the historical moments when commercial landlords have taken advantage of year-to-year tenants. For instance, when Sam Walton was operating a Benjamin Franklin five-and-dome store to the point it was generating $500,000 per year in sales, he was forced to close up shop when his landlord demanded to triple rent. After that, he vowed to own the premises for all future operations, and owned the real estate on the Wal-Marts that he subsequently developed.
The distinguishing characteristic between Sam Walton’s situation and the current commercial leasing environment is that Walton failed to avail himself of the opportunity to sign a long-term lease for his Ben Franklin stores whereas the commercial landlords of today are either outright refusing to grant multi-year leases or only extend multi-year leases that carry significant increases in rent (essentially meaning that tenants receive none of the traditional benefits but all of the traditional negatives associated with signing long-term leases).
This shift does affect how I analyze micro-cap stocks. Those $10 million market cap companies that trade over-the-counter might only have three or four customer-facing locations, and the cost structure on the rental expense side is now subject to significant disruption. Large-cap businesses are not nearly as affected as many outright own their real estate or deal with the same landlord in such bulk transactions that the balance of power has not shifted in the way that we are now seeing at the individual level.
For the individual investor trying to put together a collection of assets for his family’s portfolios, it means that commercial real estate investment trusts are especially worthy of investment consideration.
I recently began looking at the balance sheet of Brandywine Realty Trust (BDN), an owner of commercial real estate in the Philadelphia, Washington D.C., and Austin real estate markets.
In their annual report, they are bragging about all of their 8% and 12% annual rental increases at various office buildings in their own portfolio. That is significant information about how commercial landlords now behave in boom cycles compared to the past (in boom years like 1998 and 1999, commercial landlords still offered steep discounts to tenants that signed long-term leases as they contemplated a bust in the offing and wanted the benefit of a locked-in tenant at a fixed rent).
The range of future outcomes for an investment like Brandywine Realty Trust is now extreme. If American small businesses continue to grow and experience no meaningful bust within the next five to ten years, Brandywine could be a 13-18% annual compounded. It is maximizing its pricing power during boom times to that significant of an extent–there is no “slack” in its business model.
On the other hand, if a recession appears in the offing, it has a lot of short-term leases on the books so it may see its rental income fall quickly. If someone told me that a recession would occur in 2020, I would expect Brandywine’s stock price to fairly cut in half.
If you had a strong macro-economic conviction that the United States is going to boom and boom some more over the medium term, the REITs in the commercial real estate market would be a good place to look. If you look to the nearly tenth year in a row of economic improvements as a historical anomaly and expect some type of reversion, I would not direct future investments into this class of the real estate market.
My own preference is to make investments that prosper in boom cycles and hold up steady in recessions (like McCormick, which rules the salt and pepper markets and has 40% of the American spice market) so I have not personally felt compelled to move towards commercial real estate investments.
This is a publicly available version of an article shared with The Conservative Income Investor’s Patreon followers on May 27, 2018.