Shadow Space in Industrial Real Estate
There are several different reasons shadow space exists, and understanding this can be key to keep your industrial property's vacancy low.
Shadow Space in Industrial Real Estate
Shadow space is space that a company is leasing but not using. Shadow space is most commonly found in the industrial and office sectors, though it can be present in most kinds of commercial real estate. This leased space is not part of a market’s vacancy calculations, so it can be very difficult to track. Markets experiencing a surge in shadow space may be going through some challenges, however.
Shadow space is often looked at in a negative light by tenants. It is, after all, space a tenant must pay for, even though they aren't using it. For commercial property owners, too, the presence of shadow space late in a tenant's lease could lead to downsizing or even a non renewal. That said, a tenant underutilizing — but still paying for — its space is far preferable to having increased vacancy costs.
There are many reasons — either by circumstance or design — why a tenant may have shadow space.
Future Growth Plans
If a company plans to expand soon, it may be wise for the tenant to lease enough space to cover its future space needs. This is particularly true if the space is in a high-demand, low-vacancy market or in a modern industrial property. As industrial leases are long-term commitments, this decision should not be made lightly. If growth plans falter, the tenant will be left on the hook for the cost of something it doesn’t need.
Workforce Shifts
A company may have shadow space after reducing its workforce — or, in the case of office properties, shift to a remote-work model. This may result in a tenant downsizing its space requirements, though the now-unused space must still be paid for. Many tenants would look to potentially sublease any extra industrial space.
Consolidating Space
Often, shadow space can be created by a company consolidating two or more of its locations into one building. For example, if a beverage distributor with two 20,000-square-foot locations can meet all its needs with one location, the space “left behind” would be shadow space, as it would still be under lease.
Costs of Shadow Space
The main cost of having shadow space is, of course, the leasing rates a tenant must continue to pay. The costs generally go beyond this, however. This is particularly true in the case of triple net leases, where tenants must typically also pay building insurance, taxes, and common-area maintenance alongside utilities.
The costs of shadow space may be worth paying for some. If a tenant improves its distribution operations by occupying less square footage, the streamlined operations may provide a financial upside that exceeds the costs of leaving space underutilized. Plus, if your market has very tight vacancy rates, a sublease may cover these costs anyway.
Related Questions
What is shadow space in industrial real estate?
Shadow space in industrial real estate is any space that is being leased, but that a tenant is not currently utilizing. Generally, shadow space is most common in the office and industrial property market, but occurs for retail properties as well. In many cases, this is a result of company downsizing, but in other cases, a tenant may hold shadow space to prepare for future growth. Shadow space is not officially tracked, but a large amount of shadow space in a particular market is usually a sign that supply significantly exceeds demand.
In most cases, companies which have undergone a workforce reduction hold onto shadow space because they either believe that their company may expand again in the future, or they simply cannot get out the lease. In a lot of situations, companies may not be able to sublet parts of their office due to physical issues, such as the difficulty of segregating or walling off space, or, due to leasing contracts that prevent them from subleasing. Even if a tenant can physically and legally sublease part of their office or industrial space, if there is not much time left on their lease (i.e. 1-2 years), it may can be difficult to find a tenant willing to move into part of the premises for such a short time period, since they generally will have to move again after the lease period ends.
What are the benefits of investing in shadow space?
Investing in shadow space can be beneficial for investors in certain situations. For example, if the tenant is willing to offer a discounted rent, the investor can benefit from the lower rent payments. Additionally, if the tenant is willing to offer a longer lease term, the investor can benefit from the security of a longer-term lease. Finally, if the tenant is willing to offer a tenant improvement allowance, the investor can benefit from the tenant's willingness to pay for improvements to the space.
What are the risks associated with investing in shadow space?
The main risk associated with investing in shadow space is that the tenant may not be able to find a subtenant for the space, or may not be able to find a subtenant willing to pay the same rate as the original tenant. This can lead to a decrease in rental income for the investor. Additionally, if the tenant is unable to pay the rent, the investor may be left with a vacant space that is difficult to fill.
In some cases, the tenant may be able to sublet the space, but the subtenant may not be able to pay the same rate as the original tenant. This can also lead to a decrease in rental income for the investor.
Finally, if the tenant is unable to pay the rent, the investor may be left with a vacant space that is difficult to fill. This can lead to a decrease in rental income and a decrease in the value of the property.
What are the different types of shadow space in industrial real estate?
Shadow space in industrial real estate can be divided into two main categories: space that is leased but not currently being used, and space that is leased but cannot be sublet. In the first case, companies may hold onto shadow space because they believe their company may expand again in the future, or they simply cannot get out of the lease. In the second case, companies may not be able to sublet parts of their office due to physical issues, such as the difficulty of segregating or walling off space, or, due to leasing contracts that prevent them from subleasing. Even if a tenant can physically and legally sublease part of their office or industrial space, if there is not much time left on their lease (i.e. 1-2 years), it may can be difficult to find a tenant willing to move into part of the premises for such a short time period, since they generally will have to move again after the lease period ends.
How can investors identify potential shadow space opportunities?
Investors can identify potential shadow space opportunities by looking for signs of a market that has an oversupply of space. This could include a high vacancy rate, a large number of properties on the market, or a large number of properties that have been on the market for a long time. Additionally, investors can look for signs of a tenant downsizing, such as a tenant that has recently vacated a large portion of their space, or a tenant that has recently taken on a smaller space than they previously occupied.
For more information, please see this article.
What are the best strategies for investing in shadow space?
The best strategies for investing in shadow space depend on the current market conditions. If the market is in a downturn, it may be beneficial to invest in shadow space as it can be acquired at a lower cost. However, if the market is in an upturn, it may be more beneficial to invest in other types of commercial real estate.
When investing in shadow space, it is important to consider the length of the lease, the condition of the space, and the potential for subleasing. If the lease is short, it may be difficult to find a tenant willing to move in for such a short period of time. Additionally, if the space is in poor condition, it may require significant renovations before it can be leased. Lastly, if the tenant is unable to sublease the space, it may be difficult to generate income from the space.
Overall, investing in shadow space can be a risky endeavor, but if done correctly, it can be a great way to generate income.