Negotiating Leverage is Dictated by Alternatives: Yours and Theirs

Nov 12, 2016

You are in the jungle and are suddenly bitten by a poisonous snake. You will not survive unless you receive an antidote within one hour. You panic until you are assured that a local businessman, Joe, has the antidote. When you ask Joe for help he asks you how much you are willing to pay for the remedy. You have $1,000 in your wallet and only 20 minutes left to act. How much will you pay Joe? My guess is you’ll fork over the $1,000 without much haggling especially if Joe knows what’s in your wallet. Joe has what you need, there are no other alternatives and, under the circumstances, the product is worth everything to you. In fact, you’d pay more if you had it.

Now let’s change the facts a bit and see what would happen. Assume you actually have 72 hours to get the antidote and it turns out there are four other people in the town who have the needed drug. Finally, let’s assume that Joe’s average annual income is $200. What do you think you’ll end up paying Joe now? Here, unlike in the first scenario, you have alternatives. Further, Joe knows you have alternatives so he will need to compete with others for your business. Finally, a lot less than $1,000 would be meaningful to Joe. Thus, Joe will likely be motivated to negotiate with you. While you would clearly pay all you have in your wallet to save your life, you may not have to because people will be competing for your business. By providing alternatives for the buyer, the dynamic of the negotiations changed.

Finally, let’s add three more important facts to the hypothetical. Let’s assume that (1) the antidote has a shelf life of only six months, (2) only about one person a year gets bit by this particular snake and (3) the antidote has no other use other than to counteract this type of snake bite. Given the rarity of your situation, if Joe doesn’t make the sale to you, there’s a very good chance his drug will become worthless by the time the next customer needs it. What do you think will happen to the price of the drug now? While your situation is still dire, Joe is now faced with a make or break economic decision that could materially change his life if he is successful. If he gets greedy and overplays his cards, he ends up with nothing. Each of you now has a compelling reason to reach agreement quickly and at a fair price. Under these facts you are likely to secure the best price for the drug because you not only have competition for your business, but you also now understand that Joe may not have any alternatives.

These examples all seem like common sense; however, they illustrate some very important principles in business negotiations. First, information is everything. The more informed you are about the other parties’ needs, alternatives and situation, the better you will be able to assess your leverage and, therefore, the more likely you will be to obtain favorable terms. Second, if you don’t have any real alternatives, you are ultimately at the mercy of the other party, especially if the decision is a necessary one as opposed to discretionary. Thus, if you are thirsty and want to buy a bottle of water, you may decide it’s not worth it to pay $5 to the street vendor even if no other vendors are around. However, if you are dying of thirst in the desert, you’ll pay the $5 because you absolutely need the water. Unless you come across an altruistic counterpart in a negotiation, once they know you have a need for what they have and that you don’t have any other options, you are going to pay a premium; the only question is how much of a premium? Finally, it’s important to understand what the other party’s alternatives are. Just as you are at their mercy if you have no viable alternatives, they may be at your mercy if their alternatives are very bad ones.

Now let’s apply these simple negotiating concepts to commercial leasing transactions, and lease renewals in particular. It’s important to understand that 65%-70% of tenants nationwide renew their existing leases with their current landlords. There are logical reasons for this given the business disruption and capital costs involved in moving, especially

if the tenant’s current space still works for them. The problem is that in many cases tenants fail to compete their requirements effectively or even at all. Despite the fact that landlords are in business to maximize their profits, tenants somehow think that landlords are altruistic by nature and will give them a good deal despite the facts that (1) the landlord often knows the tenant doesn’t want to leave and (2) the tenant isn’t really looking seriously anywhere else. Given the foregoing, it’s not surprising that landlords make almost all of their profits on lease renewals. In fact, if you look at the annual reports of any public REIT, you’ll see that a continuing goal for them is to increase retention rates for existing tenants in order to increase profitability. It is not uncommon for landlords to make two to three times more profit on a renewal than on a new lease. Loyalty by tenants isn’t necessarily rewarded by landlords with favorable economic terms; it is often exploited.

The problem with doing a “friendly” renewal that is not competed is that the tenant fails to take advantage of its leverage. You see, while a tenant may be willing to pay a premium for a renewal in order to avoid the alternative of a move, the tenant fails to appreciate that the landlord is equally afraid of his alternative (i.e., having to replace the tenant if they move) and would ultimately be willing to provide a meaningful discount to retain the tenant if he thought that alternative were likely. Luckily for the landlord, if the tenant is not aggressively competing its requirement, the landlord never has to worry about his downside alternative and, as a result, never has to provide aggressive pricing. Like the snakebite tourist in our first example, without a real alternative, the tenant is at the mercy of the landlord in a negotiation. However, if the landlord faces real competition and, therefore, has true downside should he lose, he has no choice but to be aggressive. Like Joe, once faced with the true possibility of his downside alternative, he will be motivated to sharpen his pencil.

Luckily for most of us, we’ll never be at the mercy of Joe to save our life in the jungle. However, a different Joe collects your rent checks every month and would love nothing more than to sit down with you and hash out a friendly renewal outside of a competitive process. When he does, think about our example. Unless your landlord likes you more than the return on his investment, you’re probably going to overpay.

This post courtesy of Exis Global