Stephen A. James is a partner at NAI Hunneman Commercial and has focused on the leasing of industrial and office space in Greater Boston since 1985.
If your company needs space, how hard can it be to make a deal in a market where prices seem to be falling faster than Red Sox closer Derek Lowe’s sinker? Tenants can easily be distracted by the multiplicity of options and fluctuating pricing and become focused only on falling rent levels while overlooking other aspects of the transaction that will affect their bottom line in the years ahead. We see this as a golden opportunity for tenants with a well thought out plan to capitalize on these conditions and cost effectively obtain the real estate objectives they need to carry out their business strategy. How should a tenant proceed in the current market?
To answer that question, it is necessary for companies that are looking for space to understand the forces behind these pricing fluctuations as well as the motivations driving those owners and companies who have space to lease in the current market.
On average, office rents spiked in suburban Boston during the first three quarters of 2000, rising between 50 percent and 75 percent. Vacancy in the suburbs fell from 5 percent to 2.5 percent. Class A suburban rents peaked in the low $70.00 gross per square foot. With the rapid retrenchment of technology beginning in October of 2000, however, demand fell and sublease space grew dramatically during the first half of this year. What behavior did statistics like these cause?
Just Yesterday
The operative word in 2000 for tenants was “panic”. Everybody needed space quickly, and a delayed decision meant the risk of losing one of the few opportunities. Company presidents would look at space and make a decision virtually on the spot. Companies were also hoarding space and subleasing the excess to promising young technology companies. Geographic boundaries were being stretched farther and farther. Companies frantically tried to attract and retain skilled labor were forced to also focus on providing cool space with lots of amenities.
All this resulted in a landlord’s dream – potential tenants engaging in bidding wars at above-asking rents to win the space. Sealed bids and interviews were very common in the heady days of 2000. Many brokers who controlled property would be less than forthcoming with availabilities in their desire to fill the space themselves. Brokerage firms rushed to hire junior people with little or no real estate experience just so they could take orders for their exclusive properties.
In the first quarter of 2001, internal growth and low portfolio vacancy resulted in landlords not having to reach for tenants. What has softened the market in the second quarter from its all time highs in the summer of 2000 is the flood of sublease space. Many tenants prefer to avoid the costs of cabling, furniture and phones in a move. The “plug and play” market has emerged as the best pure value play in the suburban office market. Why not take advantage of a tenant that needs to “right size” quickly? Many tenants will now only consider sublease opportunities because of the tremendous infrastructure in place and cost differential. It is not unusual for the costs of furniture, cabling, phone and internet access to exceed $35 per square foot. Much of this cost “disappears” in many of the sublease scenarios on the market today.
In the current market, it is important for both owner and tenants to recognize that short-term sublease space is a highly perishable asset. If you’re trying to market sublease space, it needs to be offered aggressively at a very competitive rent. A sublessor cannot wait patiently for long. Every month that goes by translates into a greater proportional reduction in asset value than is the case for an owner. That’s because a sublessor merely has “X” number of months of potential income (e.g., 36 months on a lease with three years remaining) whereas the owner has an open-ended number of months of potential income remaining. In order to preserve property value in the long run, it may be much better for an owner to let space sit empty for a period of time rather than lease it at a temporarily low market rent. Given the compressed time frame until lease expiration, however, waiting for market rents to climb is a perilous strategy for a sublessor.
For owners and sublessors, setting the right asking rent is more of an art than a science. It depends on the supply of competing spaces that prospective tenants might find suitable as well as on the number of tenants actively seeking space in a particular submarket. Both of these variables are dynamic and can suddenly change directions. Owners and sublessors need to be flexible and quick in making decisions or fleeting opportunities will pass by. Companies looking for space in this kind of market need to understand how owners and sublessors are motivated into making their decisions.
Subleasing has its pitfalls. Some owners are unwilling to offer their approval of a proposed sublease in a timely fashion costing the potential subtenant time and opportunity. Tenants with specialized build out needs, like computer rooms, clean rooms or extensive conference and private office buildouts, may not get this financed by the lessor in a sublease deal.
What happens when the evaluation of all sublease options result in having to deal with a landlord directly? First and foremost, properly evaluate your needs over the proposed lease term. Now is the time to have the landlord build the space with “standard” finishes at landlord’s cost. Carefully evaluate the operating expense and tax escalations and other pass-through costs due to their massive uptick during the last year. Have clear options to expand and renew. Draft a sublease/ assignment clause that works for your company’s business plan and objective. Evaluate the efficiency factor i.e. how many people can comfortably fit in the space. Now is the time to satisfy space needs for the next 12 months and not inventory more space than is necessary. In other words it’s time to negotiate.
Regardless of whether negotiations are effected directly with the landlord or with a sublessor, the “make an offer” strategy – one that works for your company’s business objectives – is the recommended philosophy. What a business needs to achieve, in effect, establishes the market rent on a downswing as well as an upswing.
What should you do when faced with a lease expiring or a real estate need? First, call in a professional to help evaluate your needs and present the alternatives. Take the tour. Negotiate with three or more situations to help identify the hungriest landlord or sublease situation. Finally, “make an offer” that your team and advisors advocate and hold firm on the items you need to achieve.
