Fear of Commitment

The fourth quarter of 2004 marked a significant turning point for the nation's beleaguered office market. Asking rents for Class-A office space ended the year at $28.60 per sq. ft., up 1.7% from the fourth quarter of 2003 and the first year-over-year increase since the recession. Class-A asking rent is expected to climb at the rate of inflation, or about 3% this year, while Class-B rent may rise 1%, according to Grubb & Ellis.

With office rents slowly rising, it's logical that large corporate space users would want to lock in long-term leases now at still attractive rental rates. “The most lucrative concessions have already disappeared in some metropolitan areas,” says Bob Bach, national director of market analysis with Grubb & Ellis. “If you're a large user, you should lock in your rate soon.”

So why are so many tenants ignoring that advice? For many corporate tenants, cost reduction is no longer the primary driver in real estate strategy, says David Kilborn, senior vice president at Atlanta-based Carter, a full-service real estate company. In an era of short production cycles and rapidly changing business models, the new mantra in corporate real estate is flexibility, which is often equal to, if not more important than, achieving the lowest occupancy cost.

“It varies from case to case, but if you're looking for a majority consensus, tenants prioritize flexibility over price,” Kilborn says. That reluctance of being tethered to a space beyond its usefulness makes some executives reluctant to sign a 7- or 10-year lease.

Experts say the right lease provisions can allay those fears, particularly for tenants that act before the market pendulum swings back in favor of landlords. Given the improving but still soft fundamentals in most office markets today, tenants are in a good position to demand low rent, long terms and the flexibility they crave.

Locking Low and Going Long

San Diego law firm Luce Forward Hamilton & Scripps LLP had plans to implement an electronic storage system to eliminate much of its extensive paper files and to convert former filing space for office use. The firm had almost three years remaining on its lease at One American Plaza when it proposed a lease restructuring in early 2004. The tenant offered to extend its lease commitment by several years, if the landlord would provide tenant improvement dollars to reconfigure the space for greater efficiency.

The landlord wasn't interested. After all, a 100,000 sq. ft. tenant doesn't have a lot of options right now in San Diego, which recorded one of the lowest vacancy rates in the nation at 9.8% in the fourth quarter of 2004, according to CB Richard Ellis. But when the law firm and its tenant representation brokers at Equis Corp. informed the landlord that developers of two planned office buildings were interested in leasing anchor space to the law firm once its lease expires in 2007, the landlord agreed to consider an early renewal.

“If the end result was to stay in the building, Luce Forward wanted concessions now rather than waiting until 2007,” says John Niemi, executive vice president and manager for the western region at Equis. In the end, Luce Forward renewed its lease for 10 years at One American Plaza at what Niemi describes as an aggressive, fixed rental rate.

In exchange for that long-term commitment from the tenant, the landlord provided funding to help the firm digitize its files, which will reduce its filing area by roughly 6,000 sq. ft. The landlord also paid to reconfigure the entire space to increase efficiency, reduce libraries and create additional offices for new hires.

This was Luce Forward's second renewal at One American Plaza. Previously, the firm exercised an extension option and accepted a rent increase set by the extension clause without attempting to renegotiate. David Hymer, a partner at Luce Forward, says the firm gained negotiating leverage in 2004 by identifying options at other properties before discussing a renewal. “Going into a negotiation with a landlord where you have no alternatives is not a good strategy,” he says. “We were fortunate to have several good options available to us.”

A growing number of tenants like Luce Forward are seizing the opportunity to lock in leases now while markets are soft and rents are low, rather than later when rent and occupancy will most likely favor landlords. That trend is reflected in the average term of U.S. office leases tracked by Grubb & Ellis.

The average office lease term fell with the onset of the recession, from a high of 63 months in the fourth quarter of 2000 to 57.3 months in the first quarter of 2001, according to Grubb & Ellis, which tracks office leasing in about 50 U.S. markets. At the end of 2004, the average office lease spanned 58.7 months (see graph).

Tips for tenants

Accounting consultant Robert Vallone advises tenants against “warehousing” space, or leasing room for future expansion as part of an initial move-in. Vallone, a partner in New York accounting firm Eisner & Lubin LLP, suggests tenants planning future growth secure an expansion option or first right of refusal on additional space, thereby avoiding extra rent until the space is needed.

He also suggests adding a termination clause that would enable the tenant to exit the space at a specified future date if, for example, its needs change five years into a 10-year lease. Should the tenant act on a termination clause, he warns, most landlords will expect the tenant to pay any remaining costs of tenant improvements.

In negotiating either a new lease or a restructuring or renewal, Vallone suggests tenants ask the landlord to pay for any tenant improvements, even if that requires the tenant to pay more in rent. That's because current tax laws spread the depreciation on those improvements over 15 years, even if the lease lasts only a fraction of that time.

For tenants that want to upgrade standard allowances of particular items such as carpeting or floor tiles, Vallone cautions against accepting a lump sum from the landlord for the construction allowance, which is immediately taxable. A tenant in that situation is better off paying for improvements in exchange for a rent credit from the landlord, he says.

Beyond rental rates and tenant improvements, now is a good time to revisit lease provisions relating to both maintenance and operations costs, which over time can escalate to equal base rent. Any expense for elevators, lobbies, common areas, extended operating hours and the like that the landlord agrees to pay for will reduce a tenant's overall occupancy cost. “When the markets are weak, it's a good time to reach in for not just rent, but many other aspects of a lease that are of interest to a tenant,” explains Rick Liebermann, executive vice president of Grubb & Ellis Corporate Services in Newport Beach, Calif.

Working flexibility into a lease can add to the rental rate, but most tenants welcome the tradeoff, says Paul Waters, senior vice president in the national sales group of tenant representation firm The Staubach Co. “Tenants will pay a premium for flexibility in a lease. It could be 50 cents or $1.50 per sq. ft. on top of the base rent, depending on the market.”

Unconventional Leasing Increasing

Lease provisions are just one component of flexibility. Barbara Hampton, vice president of knowledge management at CoreNet Global, a coalition of corporate real estate professionals and service providers, says that a range of flexibility options are coming into the marketplace.

Nokia, for example, signed a five-year agreement in 2002 to move 20% of its worldwide workforce — about 10,000 employees — into executive office suites provided by Regus Group. Those employees can work from any Regus office that suits their needs, shifting from New York one day to Singapore the next, without being tied to any particular office.

Hampton also cites an arrangement between Bank of America and American Financial Realty Trust (AFRT) as an example of how providers can offer flexibility. Bank of America sold 8.1 million sq. ft. to AFRT and leased back approximately 5.2 million sq. ft. with the ability to expand, contract or trade space in any of AFRT's properties under pre-arranged pricing. “Bank of America committed to millions of square feet, but there is flexibility at the individual site level for them,” Hampton says.

A Time to Reflect

Corporate real estate strategist Darcy Mackay, senior managing director of global corporate services at CB Richard Ellis in San Francisco, believes that it's an ideal time for corporations to assess how well their existing space matches business requirements. “We're coming off a three-year cost-cutting cycle, with corporations in either a cost containment or cost reduction mode,” Mackay says. “Now is the time to look forward instead of backward and make decisions about our future real estate commitments.”

The process of identifying and dispensing with unproductive space is known as “rationalizing” or “right-sizing” a portfolio. Once the portfolio is the right size and composition to serve a corporation's needs, executives can pursue opportunities to reduce costs in markets the corporation plans to occupy long term.

Boeing Realty Corp. is adopting a right-sizing strategy in its handling of aircraft manufacturer Boeing Co.'s roughly 100 million sq. ft. portfolio. “At Boeing, everything is based on long-term business unit requirements,” says Steve Barker, president of Boeing Realty. Rather than pursue low rental rates, Boeing focuses on getting the most from its existing real estate while pruning properties that no longer serve a need.

The company has sold about 1,000 acres of surplus land in recent years, and in some cases has razed aging buildings and rezoned its land to allow residential, retail or mixed-use development. “We want to capture the true market value of the surplus properties we have,” Barker says.

CBRE's Mackay advises corporations to assess local markets and their own portfolios before committing to a new lease term. In Phoenix, for example, rental rates for Class-A and B space are poised to accelerate for the next four years or so, then peak and decline, reports Torto Wheaton Research.

That means a five-year lease starting this year will roll over when rental rates are at or near their peak. “You'll be in an unfavorable negotiating position if your lease term expires when the market is projected to peak,” Mackay says. But an existing tenant that plans to remain in Phoenix may do well to negotiate a lease extension now, locking in current rates through the projected peak.

Will Window of Opportunity Close?

Limited development has kept supply closer in line with demand in many markets than in previous downturns, Mackay says. New construction accounted for an average of 7.9% of available office inventory in the five years leading up to and through the recession of 1990-91. That compares with an average of only 3.28% for the same period through the 2001 recession, according to Grubb & Ellis. With fewer surplus properties, rental rates and land prices will increase faster than in previous recoveries.

Still, Bach of Grubb & Ellis believes tenants will continue to find deals in most U.S. markets this year. “Essentially 2004 is the year that the market turned around, but it's going to be a slow recovery. It will be another two or possibly three years before we get back to an equilibrium of 10% to 12% vacancy, so concessions will disappear gradually.”

Matt Hudgins is based in Austin, Texas

‘Blend-and-extend’ deals can be a win-win

Tenants with several years remaining on a lease may still take advantage of low market rents through a lease restructure or “blend and extend,” which blends a favorable rental rate into an existing lease in exchange for an extension of the lease term. Restructuring can result in an immediate reduction in a tenant's rent, or yield tenant improvement dollars and other concessions from the landlord.

“A tenant with a lease expiring anytime from 2005 to 2008 should at least go through the process of understanding their ability to reduce their rent in exchange for a long-term commitment,” says John Niemi, executive vice president and manager for the western U.S. at tenant representation firm Equis Corp.

Typically, a tenant rep conducts a site search to identify options before approaching the tenant's landlord to inquire about restructuring the existing lease. Sometimes those other options are more appealing than what the landlord can offer, Niemi says. “A sizeable tenant who wants to look around early will be very surprised a lot of times to find landlords willing to offer tremendous deals, if the tenant is willing to make an early commitment.”

Restructuring an existing lease, however, provides cost savings to both the tenant and landlord. Tenants avoid moving costs while lowering their rent, and the landlord avoids a rent loss resulting from a tenant rollover.

Blend-and-extend deals work best under depressed real estate fundamentals and seldom occur where the landlord has good prospects for finding replacement tenants. That means a tenant's chances for negotiating a lower rental rate or space upgrade will dwindle as occupancy rises in the local market.

David Kilborn, senior vice president at Atlanta-based Carter, represents a tenant that passed on a lease restructuring deal in Houston because the landlord wouldn't agree to a new rental rate low enough to make an extension of the term worthwhile. “Now that we're getting into a recovery, blend-and-extend deals are going to be more challenging,” Kilborn says. “We're coming out of a trough and there are a lot of landlords looking to make up ground they've lost in the last four years.”
Matt Hudgins

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