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. Last Updated: 07/27/2016

Effective Rent Index Compares Costs of Cities

NEW YORK -- In the late 1980s, Julien J. Studley, the chairman of the brokerage firm that bears his name, noticed an unusual development: Even though demand for office space was weak and landlords were clamoring for tenants, the asking rents for properties kept rising. "For two years the market fell, but rents seemed to keep increasing,'' he said.

But the seeming paradox was easily explained. Although the asking rent figures were bumping up, building owners were giving larger and larger concessions packages f periods of free rent and contributions to the cost of interior construction f to attract tenants.

The result was that the effective rent that tenants were paying was declining f as it should in a soft market.

But some owners, Studley said, had an interest in maintaining the fiction that the market was still strong and rents increasing so that they could complete financing arrangements that let them pull most or all of their investment out of a property. "A lot of lenders who did not look closely enough at these deals ended up taking back the buildings'' when owners could not cover their debt payments, Studley said.

Something of a reverse happens in rising markets. Landlords typically prefer to shrink the concessions package, rather than scare tenants off with big increases in asking rent, although the effective rents reflect the shift in the supply-demand equation.

But while the asking rent figure does not tell the whole story, Studley said, it is the only easily available number in a highly fragmented and competitive business. Real estate has no equivalent of a stock market, where prices are determined continuously in an open market and are widely disseminated to all who are interested.

So, Studley said, he decided to compile what he called an effective rent index, one that would reflect concessions packages as well as expenses that tenants incur, such as the cost of electricity. The idea was to give a clearer year-to-year comparison of what was happening to rents and to provide an easy comparison between the central business districts in a dozen major cities.

The report found that midtown Manhattan is the most expensive market in the country for tenants, but that high costs hold down landlords' income. Rents for tenants in downtown Manhattan and New Jersey are close, but again higher costs in New York mean landlords there keep a lower portion of their rents than do building owners in New Jersey.

Although others may challenge his results and methodology, the Studley effective rent report represents an interesting attempt to cut through the complexity and clutter that make it hard to get a clear picture of what is happening in important commercial real estate markets.

"The only information that's available is asking rents,'' Studley said. "Now you can take the asking rent and apply a discount, but the discount changes, so that is unreliable as well. In some market conditions, the taking rent exceeds the asking rent.'' That means that the demand for space in certain locations is so great that tenants bid the rent above what the landlord originally asked.

Although Studley's firm usually represents tenants, he said it is important to understand what a landlord actually has in his pocket after paying operating expenses, taxes on a property, concessions and commissions, but before debt service. Because financial structures are complex and vary from property to property, they would make year-to-year and city-to-city comparisons difficult and unreliable.

Also excluded is the so-called loss factor, the difference between the amount of space a tenant is paying for under the lease and the amount he can actually use. This is part of the twilight zone of real estate, in which steel and concrete buildings change in size as they are remeasured. "Buildings in New York grow larger as they age f like people,'' Studley observed.

The result of this figuring leads to two separate indexes, the tenant effective rent and the landlord effective rent. The tenant effective rent is the estimate by the Studley firm of what a tenant actually pays after concessions are amortized over the length of the lease.

The landlord effective rent is the estimate of what a building owner has after paying the costs, although some costs, like electrical power, are passed on to the tenant. "We are developing a figure for a free and clear cash flow,'' said Mark Stewart, a managing director at the Studley company that compiles the report.

Because owning property is largely a fixed-cost operation, seemingly modest increases in rental income, which is customarily stated in dollars per square foot per year, can produce big changes in the owner's income. "If you have a $32 a square foot, operating expenses, taxes and so forth will typically consume $26 a foot, leaving the owner with $6 a foot in income,'' Studley said. "But if the rent increases to $38 a foot, he doubles his income.''

According to the Studley company's figures, the landlord effective rent in downtown Manhattan increased from a slender 78 cents a square meter to $1.24 a square meter from the end of 1997 to the end of 1998. This increase was caused both because the tenant effective rents increased somewhat f from $2.30 a square meter to $2.82 a square meter f and because concessions decreased, from $6.93 a square meter in 1997 to $5.40 a square meter the following year. The concessions are a one-time expense to the landlord and are amortized over an assumed 10-year lease in making the calculations.

Meanwhile, operating costs and taxes were rising, so that landlords' cash flow rose 46 cents a square meter, even though the tenants' effective rent had increased 53 cents a square meter.

The story in midtown was somewhat different. The concessions package remained constant at $4.95 a square meter while the tenant effective rent increased from $3.91 a square meter to $4.24. Although that represented an increase of 33 cents a square meter, landlords got only an increase of 30 cents a square meter, once again as a result of higher operating expenses and taxes.

Across the river in New Jersey, concessions stayed the same, at $1.80 a square meter, while tenant effective rents increased 11 cents a square meter, from $2.57 a square meter to $2.68. But landlords got only an increase of 8 cents a square meter because of higher operating and electricity costs.

A big part of any concessions package is a period of free rent, which was originally thought of as the time a tenant could not use the space while its offices were being constructed. In periods of slack demand, landlords will extend this period from a few months to years as an incentive.

Studley said this type of concession has special appeal for tenants, particularly in tough economic times. "Tenants look at transactions on a discounted cash flow basis,'' he said. "The dollars up front are the most important to them. Owners are more willing to take up-front costs than tenants.''