Is Fair Market Value Really Fair?

In most industries, when a manufacturer makes or sells consumer products there is a simple pricing formula. For example, in the clothing business a company would manufacture a garment for “X” dollars. It would be sold to the retailers at “2X.” The retailer would then double that price and sell it to the consumers. At the end of each season the retailer might have a 25% off sale but he still made 25% profit. Not bad.

With that said, it is unfortunate real estate isn’t structured this way. Or, for that matter, it would be wonderful if the industry had a magical formula that reflected cost to build plus expenses plus a fixed profit. Owners, rightfully so, look to maximize profits for their investors. Real estate investment is a gamble so maximizing profits is par for the course.

Rental rates or sales asking prices are simply based on what we all know as the “Market Rate.”

Market Rate is nothing more than what a willing and able tenant or buyer would agree to pay and what a landlord or seller would be willing to accept for a specific property. Therefore, in the case of rents, if a landlord is asking $2.50/SF/MO (often stated as $30/SF/YR in many markets) and a tenant is willing to pay that amount, that sets the market baseline for the next lease deal.

But is that fair to all? Think of it this way. A top high school football team wouldn’t take on the Super Bowl Champions. Both are great teams with great skills at their own level but it obviously would not be fair for them to compete against each other.

Real estate is a major item on a company’s bottom line and in most cases should not represent more the 5% -7% (max 10%) of the company’s yearly gross revenues. For example, an average sized-small law firm has two partners, three associates, a manager and 4 staff or paralegals. They likely occupy about 3,000 square feet. To hit that 5% of the gross revenue goal, even based on a $2,000,000 gross revenue, they would need to be spending a maximum of $2.75/SF in rent plus other charges such as parking and operating expenses. If all small companies competed on a level playing field, the rents would likely be between $2.50/SF and $2.85/SF in this sample.

But bring into play the large firms or even a Fortune 500 company who opens a regional office in your market. For them to pay upwards to $4.50/SF-$6.00/SF may be just a blimp on their balance sheet since the rents at their corporate headquarters may equal or exceed that amount not to mention the company’s balance sheet shows income in the billions.

Add to that fact many landlord’s, despite knowing the average tenant may only occupy 3,000 – 5,000/SF, tend to seek out major tenants who would take a full floor of space. They prefer to only break up floors for smaller users after efforts to land major tenants go unfulfilled.

This puts a lot of pressure on the small user.

Watching the bottom line is critical but we find many small tenants look only at the per square foot number and don’t equate it to the percentage of gross revenues. In reality, they can afford more than they think, or would like to spend. We had a client complain about a rent that was less than 1% of their revenues but the business owner was simply hung up on the per square foot rate. The alternative would be to look at a lesser quality property offered at a lower market rate.

While that rate may still be based on the last deal in the building or market area, at least a tenant might be competing against similar users. The playing field will never be equal but at least you can find a field with equal competition. You may need to either downsize

or look relocate to less than high end space.

This may not be the message one might want to hear but either find a way that your bottom line can compete with the larger firms or work with your tenant broker to find a property that has a level playing field. Landlords certainly won’t give you a break because you are a nice guy or your company is smaller and can afford less. They are in it to maximize profits as most businesses do so small tenants need the plan better and strategize more.