Incentives for Commercial Vacancies
Vacancies in commercial spaces harm local governments through lost sales tax revenue and neighborhoods by decreased amenities and liveliness. Despite these effects, landlords have a variety of incentives to keep their units empty:
The structure of commercial leases encourages the landlord to be conservative when committing to a tenant
Newer properties with debt prefer vacancies over reduced rent which devalues the building
Commercial spaces in mixed-use buildings built by developers can remain vacant due to inexperience and prioritization of residential units
Older low-debt properties can have vacancies due to low demand and low effort from landlords
Filling these spaces will require a mixture of solutions to account for these different incentives.
The cost of vacancies
A healthy vacancy rate is not zero. There is natural churn even in thriving business corridors and it takes time for a new business to renovate and open their doors. Long term vacancies, however, are troubling.
Local governments suffer from the lost sales tax revenue. The neighborhood suffers from losing a potential amenity or store. Foot traffic decreases, harming the nearby businesses. The area becomes less appealing and less watched, hurting security. A single vacancy does not imperil a neighborhood, but clusters of long term vacancies cast a long shadow.
But why do they happen?
General incentives commercial landlords have to keep a unit vacant
Signing a commercial lease is high friction. The landlord and tenant are making a long-term commitment to each other. Downstream of this are several reasons landlords are cautious filling a vacancy.
Tenant improvements
When a tenant rents a commercial space, they need to alter it to suit their business. From bookstores to restaurants, every business adapts the space through a process called tenant improvements.
To entice tenants, landlords will offer a tenant improvement allowance to partially fund this work1. Due to substantial investment from both parties, commercial leases are typically five to ten years. Landlords initially lose money bringing in a tenant, but make it back over the course of the lease. The amount of money needed to renovate a space varies, in part depending on how the developer chose to finish it. Not every landlord is willing or able to offer the money necessary for tenant improvements for a business to lease the space.
Option Value
Keeping a unit vacant preserves option value, the value of remaining flexible in what can be done with the space. Passing on $2000/month in rent today (for the next ten years) preserves the chance to get $2200/month tomorrow.
There are a few reasons a landlord would prioritize their option value:
Tenant match: Different tenants are willing to pay different amounts for the same unit. In commercial real estate, tenants are highly sensitive to the location & surrounding businesses.
For instance, a bar would not like to open up next to another bar, but for Taco Bell this location could be an asset.
Landlords can curate the businesses in their units to achieve a precise mixture with the aim of being able to charge higher rent. Signing a lease now with tenant A for $40/sq ft means they can’t sign with tenant B who was willing to pay $50/sq ft for the next 5-10 years.
Changing market conditions: If a landlord believes market rates will increase in the near term, it’s rational for them to wait to commit to a long-term lease.
Landlords who overestimated market rent can be slow to lower it due to the high cost and inflexibility of signing a lease.
Land speculation & redevelopment: The land underneath the building can be more valuable than the building itself. If the land owner speculates that the value of land will increase, they may choose to keep the unit empty because not having a tenant increases the buyer’s option value. Similarly, having a tenant can hinder their ability to redevelop the property.
Risk of tenant failure
Unless the lease includes “kick-out” rights, the landlord is committed to the tenant for the full five to ten year duration of the lease. On paper, the tenant is also committed. However, the business is not guaranteed to thrive. If it folds, the lease will necessarily end early. And if it happens early enough in the lease, the landlord will have not yet recouped their investment in tenant improvements and have lost money. This can discourage landlords from signing leases with local, unproven businesses. The unit remains vacant as they wait for a lower-risk tenant.
Newer developments
There are two major drivers of new unit vacancy: debt & specialization.
Debt
Buildings are expensive and developers typically finance them via loans. The bank lends them money based on the projected income, i.e. rent, of the building. These loans are often structured so the developer pays interest for five years, then owes the principal at the end.
For example, if the building was projected to be worth $10 million and the developer received a loan for $8 million, they would pay interest for five years and at the end owe as a lump sum $8 million. The expectation is that they would refinance this debt, not pay $8 million of their own cash.
Commercial buildings are valued based on their net operating income (NOI), that is the rent they charge minus their expenses. The loan the developer gets from the bank is based on the value of the building which in turn is based on the rents they expect to charge.
Extend & pretend
Overestimating the rent a space can command is a serious problem for the developer. Lowering rent lowers the building’s income & therefore its value.
Suppose the $10 million building’s valuation was based on rent being worth on average $48/sq ft/year. Once it’s built, there are many vacancies and the developer realizes the market rate is only $36/sq ft/year for this space. Because commercial buildings are valued based on their income, if they lower their rent to market rate(a 25% decrease), the building will now be worth only $7.5 million.
This is a disaster. It’s bad for the bank which lent $8 million for a $7.5 million building and it’s bad for the developer who borrowed $8 million to build it. In five years when the developer’s $8 million loan comes due, they would consider the $2 million already invested a sunk cost and walk away. The bank would take possession of the building and sell it, realizing a $500k loss on paper for themselves. Including the costs of foreclosing, the bank’s loss is even larger.
Instead, the bank and developer are incentivized to “extend & pretend”. The developer treats the vacancies due to above-market rents as an unforeseeable temporary aberration and does not adjust rents (& thus the value of the building). The bank goes along with it because they also do not want the developer to default on the loan. Both parties want to keep the value of the building high.
How long can extend & pretend last? As long as the building generates enough income to cover interest payments both the developer and bank are incentivized to continue to extend the loan, keeping the loss hypothetical, in the hopes that market rate rents will rise. The alternative is for both parties to realize a loss.
There are actions a developer can take to reduce vacancies, but critically they must avoid reducing the face-value of the rents on which the building’s valuation depends. For instance, they can offer a free month of rent, effectively lowering the price a tenant would pay, but keep the nominal rent high.
Credit tenants
A noteworthy case of extend & pretend is when the developer expects to have a “credit tenant”, typically national retailers, who are willing to pay higher rents due to their high profits. If the developer cannot sign a credit tenant, they will not be able to find a tenant willing to pay the rent that the developer told the bank the building would earn. The developer ends up incentivized to extend & pretend even without a market downturn.
Developer not specialized in commercial
In many cities, ground-floor commercial space is required for new, dense multifamily buildings. Some firms building these structures do not specialize in commercial spaces, leading to three problems:
Commercial rent was written off. The project was designed so that it made a profit even with the commercial units completely vacant. They were included because they were required, not as part of the core business model. Because the project is already profitable, the developer does not feel urgency in filling the units.
Poor design limited demand. Due to the lack of expertise in commercial spaces, the units were built in a way that limits the number of potential tenants, e.g. far too large for the market. They may have chosen to finish the space as a “cold dark shell”, i.e. a unit with no HVAC, lighting, or internal walls. This kept construction costs down, but increased the cost and effort for a tenant to use the space.
Outsourced finding a tenant. An outside, often large & non-local, firm was hired to find a tenant which focuses on credit tenants & other low-risk tenants, limiting the number of potential tenants and missing local businesses.
Lack of urgency, limited demand, or ineffective searches all increase the time a unit stays vacant.
Older developments with low debt
Older buildings require maintenance and are less desirable than newer ones. If it was built decades ago and now has little or no debt, new incentives emerge.
Minimizing costs
The landlord may choose to defer maintenance and improvements to avoid sinking more money into the older property2. Because the unit is less desirable, the market for it is smaller. The unit remains vacant until a prospective tenant believes they could run a profitable business in this location despite its deficiencies.
Note that this has the upside of commanding lower rents and having some of these units is valuable for a city.
Minimizing effort
As long as the property has some units paying rent, then vacancies may not put much pressure on the landlord to fill them. With little debt & a decent cash flow from the remaining businesses, they may be content to do nothing and continue collecting profits.
Conclusion
Commercial vacancies stem from many different incentives. Effective policy interventions must match the nuance of the problem. In the next piece, we will look at what policies local governments are exploring and how effective they are, including vacancy taxes.
Further reading
A deeper dive into extend & pretend:
Strong Towns piece on storefront vacancies
Harvard study on option value and storefront vacancy
NYC’s case studies focusing on individual blocks and neighborhoods
The size of the tenant improvement allowance varies widely depending on the market, the length of the lease, the state of the building, etc. It can range from tens of thousands to hundreds of thousands of dollars.
They may even be encouraged to not sink more money into the property by the tax code.
It is a difficult balance to strike between incentivizing vacancies and encouraging occupancy without overburdening landowners. As you noted, it is the neighborhood and its residents that suffer most from these empty storefronts. I assume that because of the desirable amount of foot traffic commercial areas such as the University District remain full, despite the churn and high rent. As we have talked about quite a bit at the neighborhood association, to incentivize building would serve to increase foot traffic, which would in turn incentivize commercial rentals. It will be interesting to see if the two large apartment projects currently under way in Roosevelt will be the catalyst that serves to start this virtuous cycle.