Three Reasons Retail Landlords Might Undercharge – And What to Do About It
Are retail property owners leaving money on the table? It’s not uncommon to find retail tenants paying below-market rents across Montana, says commercial real estate expert Connor McMahon. And it is not just money lost in rent today – undercharging can have significant impacts on the value of a retail asset in the longer term, too.
There are a few common reasons that can result in undercharging for retail space.
Family businesses are one example, says McMahon. Either the space has been leased to relatives for a sweetheart deal or the asset has been passed down from one generation to the next, without the new owners having sufficient leasing knowledge. In these cases, the assets might either have stagnated rents or simply be undermanaged.
Another common scenario is a long-term lease written for economic conditions that no longer exist. McMahon points to long leases signed during the Great Recession. “If a landlord signed a lease in 2009 when the market was pretty unstable, they might have offered very favorable terms just to get the building leased up. Fast forward to 2021, and those terms are pretty out of sync with the market.”
Poor management is a likely culprit as well. Property managers who might be more familiar with residential property, or even something like offices or industrial assets, may not understand the nature of retail property. Writing and negotiating leases for retail properties can be a niche science, says McMahon. Finding the right broker and property manager is crucial to maximizing returns on your investment.
Why Does It Matter?
If a retail landlord finds they are undercharging for rent, so what?
In the short term, it means reduced revenues. But it’s the longer-term impacts that are more concerning. If ownership decides to sell the asset, the Net Operating Income (NOI) is lower than it should be. Lower NOI can negatively impact sale price, often creating unfavorable negotiating conditions.
While there are ways to demonstrate future NOI on your asset, having to caveat the sale price isn’t optimal. Marketing a property with a demonstrably strong NOI can generate more quality offers.
Beyond building revenues, an undervalued property can also start attracting tenants seeking a deal. That’s especially true if they know that existing tenants are paying under-market rents. Businesses looking for reduced rental rates might be struggling – and thus may not be a safe bet for longer-term tenants.
McMahon says there are options for building owners who have underperforming assets. A property management audit can identify weak spots and set up strategic improvement plans. Working with a broker to update your leases, including rent escalations in the agreement, can start to chip away at revenue shortfalls. Owners may opt to buy out leases from tenants if the terms are suitable for both parties. It’s not the right solution for every relationship, he says. “But some tenants may want to relocate and are happy to accept the buyout.”
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