Long-term or short-term: what’s the best tenancy mix?
As a commercial property landlord, what’s the best and most financially rewarding tenancy mix?
Is it better to have the majority of your building’s tenants on long-term leases, short-term leases, or a combination of both?
A new report from commercial agency CBRE answers that very question, by modelling more than 70,000 potential tenancy scenarios, using historical data from Australia’s six main CBD office markets.
And the results might surprise you. Here’s what they found:
Short-term a sure winner
Logic might tell you that signing up tenants to long-term agreements will deliver the highest returns, simply because you’ll have the tenant in place for longer, with less opportunities for vacancy.
But CBRE’s research shows that overall returns, which take in income as well as capital growth, are highest when the proportion of short-term tenants within a building is higher.
According to the report’s author, CBRE associate director Bradley Speers, to achieve the highest returns more than half of a building’s tenants should be on short-term leases of five years or less.
“For optimal total returns an office building should have 55% short-lease tenants and the remainder as long-lease tenants, on lease terms of five years and seven years respectively,” Speers says in the report.
“Our modelling proves quantitatively that having a higher proportion of short-lease tenants generates higher total returns,” the report says.
Speers says that short-term leases also provide greater incentive for tenants to stay, as they’re often able to secure more space within the building as their business grows.
“A further, qualitative benefit is that this type of strategy is more accommodative for tenants, providing them with greater opportunity to grow or contract their footprint,” he says
“Landlords could benefit by tenants becoming stickier due to a track record of having their occupational requirements satisfied.”
Capital growth the key
As with residential real estate, the greatest returns are most often achieved through growth in the building’s value.
So while long-term leases attract a greater average income, the report suggests that capital growth is stronger in buildings with more short-term leases.
Speers says the modelling found that buildings with a higher proportion of short-lease tenants would appreciate in value faster than ones with more long-term tenants.
“Average capital growth at the extremes was 3.4% for (buildings with) 0% short-lease tenants and 4.9% for 100% short-lease tenants,” he says.
Our modelling proves quantitatively that having a higher proportion of short-lease tenants generates higher total returns
Speers adds that CBRE’s modelling assumes that long-term leases cause a significant hit in the rate of a building’s capital growth when they near the end of the leasing term.
“Scenarios with long-lease terms from 10 to 12 years at year 10 in the DCF (discountd cash flow) have very short WALEs (weighted average lease expiries) and are about to incur substantial hits to income through vacancy and re-letting. Collectively these factors negatively impact terminal yield, terminal value and total return.”
“Investors pay lower yields for these type of long WALE buildings, presumably because they back themselves to successfully resolve the re-leasing risk prior to expiry. Our modelling assumes that all tenants vacate at expiry and thus demonstrates the downside when tenants don’t renew.”
Defining the right mix
“The absolute optimal scenario in terms of total return is five-year short-lease and seven-year long-lease; within this set, scenarios with 55% short-lease tenants on average delivered the highest total return (10.33%) in the 72,576 scenarios,” Speers says.
He adds that having only long-term tenants, while seen as a positive by many investors, more heavily impacted the overall return, due to factors such as rent incentives, vacancy and changes in the yield over the life of the lease.
“Scenarios with a higher proportion of long-lease tenants with 12-year terms delivered the lowest returns. This is because these scenarios started with higher WALEs (and lower yields) and were the most adversely impacted by yield shift from start yield to terminal yield. These scenarios also delivered the weakest capital growth.”