The effect of commercial lease structures on landlord-tenant leasing behaviours and experiences (Gross lease vs. net lease) Dulani Halvitigala, Deborah Levy, Laurence Murphy The University of Auckland New Zealand

Commercial property lease structures  Commercial leases  Should be responsive to the requirements of both landlords & tenants (Jaffe and Yang, 1997)  Landlords’ and tenants’ different lease objectives can cause tension in the operation of leases (Crosby et al., 2006)  Landlords attempt to enforce strongly pro-landlord lease forms by being inflexible towards tenant requirements (Crosby et al., 2006; Crosby et al., 2003; Dunn, 2003; Lizieri et al., 1997; Saltz, 1990)  Importance of in-depth understanding of commercial leases  Diversity of lease structures in the market (Parker and Robinson, 2000)  Different leases shift the risks and opportunities between the landlord & tenant (Rowland, 2000)

Related commercial leasing literature  Largely focused on financial characteristics of leases and the effect of various lease covenants on investment returns (Adair et al., 1994; Hamilton et al., 2006; Turner and Thomas, 2001a, Turner and Thomas, 2001b)  Evaluation of alternative lease structures are dominated by financial-qualitative aspects of leases (Metawa, 1995)  Behaviour of market participants determines the nature of property market operations (Daly et al., 2003; Diaz III, 2000; Diaz III, 1999; Hardin III, 1999; Levy and Henry, 2003)  The application of behavioural interpretations in property literature is limited to property valuation issues (Leishman and Watkins, 2004; Roberts and Henneberry, 2007)  Little attention is given to understanding the impact of different lease forms on the behaviours and experiences of key market agents in leasing

Purpose of study Research aim Research questions Do landlords and tenants have different perceptions of gross & net lease structures? Are there any differences in the behaviours and experiences of landlords and tenants under gross & net leases? What are the key issues confronting them under gross & net leases? Do lease structures have any impact on the financial and non-financial characteristics of leases? Examine the effect of different lease structures on landlord- tenant behaviours and experiences (Gross versus net leases)

Research focus  Significant leasing environment in New Zealand  Auckland (commercial capital) – mainly net, private sector dominated  Wellington (political capital) – mainly gross, public sector dominated (41%)  Lease structures examined  Gross lease – landlord pays directly for OPEX without separate charge to the tenant  Net lease – tenant to pay all or portion of the landlord’s property expenses  Property sector examined  Prime office sector in New Zealand  Study sample  Landlords – New Zealand’s listed property trust sector  Tenants – Major tenants of the properties owned by NZLPTs (in Auckland & Wellington)

Research methodology – Landlords  Survey sample – NZ Listed Property Trusts  Total portfolio value – NZ$7.377 billion, Market capitalization – NZ$3.6 billion  Data collection method – in-depth interviews  Interview participants – 6 portfolio managers attached to the top 3 NZLPTs IntervieweeJob Title Value of the portfolio managed ($m) Total NLA managed (m 2 ) Type of office properties owned 1National Commercial Portfolio Manager ,968Prime quality 2Wellington Portfolio Manager ,046Prime 3Auckland Portfolio Manager ,889Prime 4General Manager ,810Prime + Secondary 5National Asset Manager ,028Prime + Secondary 6Asset Manager ,598Mainly Prime

Research methodology – Major tenants Tenant survey – Major tenants of LPTs Data CollectionResponse rateNature of tenantsData analysis 236 surveys sent Auckland – 137 Wellington returned Overall – 38% Pubic – 23 International – 19 NZ national – 23 Statistical analysis Semi-structured, in-depth interviews Data CollectionParticipant profilesOutput 4 public sector tenants 4 private sector tenants National property manager – 1 General manager (property & operations) – 2 Director, corporate services – 2 Senior property managers – 3 Probe and explore the survey findings in more depth Conclusion – Integration of the findings of the two approaches

Findings - Tenant perceptions of leases  Preferred lease type – gross lease  Current lease types – mainly gross even in Auckland  Priority – certainty in the TOC. Financially constrained by budgetary requirements  Strong negotiation power  Act together under the direction of State Services Commission & the Treasury in leasing activities  Preferred lease type – net lease  Current lease types – mainly net, some gross leases in Wellington  Changes in attitudes – in favour of net lease due to bad experience with gross lease  Priority – quality of the premises than the TOC  International tenants are more resistant to gross leases than NZ tenants  Familiarity with net leases overseas Public sector tenantsPrivate sector tenants  Significantly varied with their business sector

Reasons for tenants’ lease preferences  Simplicity  Certainty of the total occupancy costs  Risks of OPEX increases are landlords’  Property management is the landlord’s responsibility  Gives more time to concentrate on their own businesses  Applies more discipline to landlords towards OPEX  More responsive and proactive landlords as the costs can be recovered  Landlord can change the management style or the OPEX to meet tenant requirements  Easier to maintain the premises to the standard tenants desire  Better maintained and better quality accommodation  More tenant involvement with the management of the property Public tenants – gross leasePrivate tenants – net lease

Landlord perception of leases  Preferred lease type – fully recoverable net leases  Greater security of the NOI and asset residual value, reduced investment risks  Strong objections to gross leases  NOI is prone to OPEX price inflations  Do not have freedom in raising gross rentals due to market competitiveness  Current leases in their portfolios  Auckland – net leases  Wellington – mainly gross leases due to the strong influence of public sector tenants  Despite the strong preference for fully recoverable net leases, their leasing strategies and behaviours significantly varied across submarkets in New Zealand with the sector and size of the tenant

Financial implication for investment returns  Gross leases are at high risk of receiving lower & more volatile net return  Unable to share or shift the risks associated with OPEX  Small landlords operating in isolation experience more negative impact  Low negotiation power, Ill-negotiated lease provisions  Poorly planned lease and OPEX management philosophies  The impact on NOI is minimal for large scale institutional landlords  Strong OPEX purchasing power  Long term fixed contracts with service providers  Carefully prepared OPEX budgets  Short rent review intervals “Large property funds operate both gross and net leases in a similar way, so that puts away a lot of arguments about pros and cons of net & gross. But for small, less sophisticated landlords with poor OPEX purchasing power, gross leased buildings will definitely be a poorer performer”

OPEX sharing process  Attempt to negotiate “gross plus increases” leases with public tenants  Recover almost all OPEX from net lease tenants  Pass-through some expenses which have been identified as non- passable in the literature  Sinking fund contributions, management fees, corporate fees  Reflect their strong negotiation power  Public sector tenants  Do not wish to pay any OPEX  Maintaining the property is landlords’ core business, not tenants’  Private sector tenants  Willing to share OPEX to have a well- maintained property  Unhappy that landlords retain the full control of OPEX management decisions  Want to have more control over the OPEX they are paying for Landlord’s perspectiveTenant’s perspective

Issues with OPEX sharing process under net lease  Perceive that there are no significant issues with the OPEX sharing process  Tenant queries mainly on:  Power expenses  Repair type work  Sinking fund contributions  Net tenants are more dissatisfied with their OPEX responsibilities than landlords perceive they are  Overcharging  Invoiced for items not legitimately considered as OPEX  Less transparency in OPEX calculations  Delays in OPEX reconciliations  Slow response to OPEX queries  Larger tenants have less issues  Receive all proposed OPEX and CAPEX budgets in advance  Opportunity to discuss and debate proposed budgets Landlord’s perspectiveTenant’s perspective “Every now and then we’ll have something someone wants to clarify. No, we don’t usually have problems, in OPEX wash-up time we might get 3 or 4 enquiries, but nothing of any real consequences”

Operation & maintenance process  Element of under-maintenance of gross leased properties  More evident in early stages of gross leases  More evident with short-term investors  Less evident in gross properties owned by institutional investors  Reporting requirements to their shareholders  Desire to maintain the reputation of their company and its buildings  Gross tenants are more satisfied with their buildings’ O&M process than net tenants  Net tenants have higher expectations as they are paying for O&M  Net international tenants compare O&M levels with their buildings overseas  Public tenants are more satisfied with their buildings’ O&M process than private tenants  Different expectations of public and private sector tenants  Strong influence enjoyed by public tenants  Private sector tenants may have more skills in early detection of O&M inefficiencies Landlord’s perspectiveTenant’s perspective

Landlord-tenant relationship  Adopt different relationship approaches with different tenants  Partial and biased towards more desirable tenants despite their lease type  Partnership-type relationships with major tenants  Adversarial-type relationship with small tenants  Gross tenants perceive stronger relationships with their landlords than net tenants  Simplicity in gross leases  More potential for conflicts under net leasing  Conflicts over the OPEX, more suspicious of landlord’s OPEX spending  Conflicting attitudes expressed by international tenants  Landlords’ aversion to gross lease has a negative impact on relationship levels Landlord’s perspectiveTenant’s perspective

Future lease preferences  Net leases with 100% recoverable OPEX  More flexible leasing approach in Wellington  Tougher lease provisions  More expenses items as OPEX passed through on to tenants  Annual rent reviews  Obligations on tenants in terms of environmental sustainability  Public sector tenants  Preference to maintain gross leases  Private sector tenants  Prefer net leases with measures to reduce uncertainty in OPEX  Capped OPEX  CPI adjusted OPEX increases  Recover only increases in OPEX Landlord’s perspectiveTenant’s perspective  Possible mismatches between tenant lease requirements and actual leases offered in the future

Flexibility in tenant future lease selections  Willing to consider net leases if:  the building is green or new, energy efficient  they are the sole tenant or have the naming right  the terms and conditions of the net lease are in favour of the tenant  they are satisfied that the landlord is competent, trustworthy, and substantial  International tenants  Strongly resistant to gross  Wouldn’t accept gross even offered  National tenants  More flexible  Willing to consider gross as an option, but would be cautious Public sector tenantsPrivate sector tenants

Discussion and implications  Different lease structures have significant implications for financial outcomes (net returns) as well as non-financial outcomes of leases  Distinctive perceptions, leasing behaviours and experiences of landlords and tenants under different lease environments  Despite landlords’ strong preference for fully recoverable net leases, they adopt more flexible leasing strategies with more desirable and more influential tenants in their portfolios  Power asymmetry could work in favour of either landlord or tenant depending on size and influence  Balance of power between landlord & tenant determines the nature of lease operation

Discussion and implications  Major differences between the perceptions, behaviours and experiences of private and public sector tenants, as well as international and national corporate tenants  Gaps between tenants’ lease requirements and those currently offered by landlords  Importance of understanding the dynamics of key market agents that create lease environments and how these agents interact and behave within these contexts