Pricing a Renewal Against a Credit Tenant's Threat to Leave
You manage a 250,000 sq ft Class B office building. Tenant Y occupies 45,000 sq ft (18% of the building) under a lease expiring in 10 months at $31/sq ft gross. Market rent is $27/sq ft gross, and the building currently runs 82% occupancy. The tenant's broker signals Y will renew only at $26/sq ft with $25/sq ft of TI and 8 months free rent, or it will relocate to a newer building offering $28/sq ft with a $40/sq ft TI package. Re-leasing the space if Y leaves would cost $35/sq ft TI, 10 months downtime, and 6% leasing commissions, and would drop occupancy to 64% - likely triggering a loan covenant at 65% occupancy. The owner's hold period is 3 years.
1. Compare the net effective cost of renewing versus re-leasing, and assess the covenant risk.
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Renewal economics (per sq ft): rent $26 vs market $27; TI $25; free rent 8 months ≈ $26 × 8/12 ≈ $17.3. Net effective rent over, say, a 5-yr term: total rent $26×5 = $130, minus TI $25, minus free rent $17.3 = $87.7 over 5 yrs ≈ $17.5/sq ft/yr net effective.
Re-lease economics: market $27, but TI $35, downtime 10 months (lost rent ≈ $27 × 10/12 ≈ $22.5), commissions 6% of $27×5 ≈ $8.1, plus free rent. Net effective over 5 yrs ≈ (27×5 − 35 − 22.5 − 8.1 − free rent) / 5 ≈ (135 − 65.6 − free rent)/5 ≈ **$12-13/sq ft/yr** - materially worse, and that ignores the risk the space sits vacant longer.
Covenant: losing Y drops occupancy to ~64%, breaching the 65% covenant - a loan-level event that can trigger cash management or default. That risk alone likely outweighs the rent concession.
So renewal is cheaper on net effective rent and avoids covenant breach.
2. The owner says "don't give away the store - hold at $28." How do you advise, and what counter should you make?
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The owner's instinct is understandable but ignores the asymmetric downside: holding at $28 risks losing an 18% tenant in an 82%-occupied Class B building, triggering a covenant breach and a re-leasing cost that is far worse than the concession. The $2/sq ft rent gap ($90k/yr on 45,000 sq ft) is small relative to the covenant and downtime exposure.
Counter-proposal to the tenant:
- Accept $26-27 base but tie free rent to a longer term (e.g., 7 years) and a TI allowance paid on completion/occupancy, not upfront.
- Reduce free rent to 5-6 months in exchange for a slightly higher starting rent or earlier commencement.
- Add a renewal option at market and a recapture/co-tenancy-style protection so the owner isn't trapped.
- Require a credit enhancement (parent guarantee or letter of credit) given the concession.
Advise the owner: the goal is to protect occupancy and the loan covenant while minimizing give; a structured renewal at ~$26.50 with reduced free rent is better than gambling on a $28 hold.