Today’s office leasing game has a lot of action but no real progress.
Offers of rent discounts, free rent, and other incentives ignited office leasing during the first half of 2010. While that may seem like great news for landlords and brokerage firms, the surge in activity is doing little to make a dent in the more than 732 million square feet of excess office space available across the U.S.
“We’re seeing activity, but we don’t see a lot of positive absorption. We’re just moving checkers around on the board,” says Ken Ashley CCIM, MCR, SIOR, a senior director in the Tenant Services Group at Cushman & Wakefield in Atlanta. Tenants that are taking on new space for expansion purposes remain in the minority. The majority of companies that are out shopping for space in the current market fall into one of two categories — those looking for bargains that will allow them to either cut costs or upgrade space, and those firms that want to reduce costs by downsizing or consolidating existing real estate.
“When we talk about activity, it’s great for landlords and brokerage firms, but we can’t confuse that with long-term absorption,” says Michael J. Flynn, CCIM, SIOR, executive vice president at NAI Hiffman in Oakbrook Terrace, Ill. Case in point is a 12-year lease recently signed by Career Education Corp. to occupy a 317,000-sf building in Schaumburg, Ill., that had been sitting vacant for more than four years. That is a sizable deal in any market, but factor in the 450,000 sf the company plans to vacate from its four other buildings, and it results in a big net loss.
Nationally, office space absorption has remained negative for the last eight quarters with absorption of -7.3 million sf in the first quarter, according to Grubb & Ellis. Although 1Q10 numbers show some improvement over the -55.8 million sf of absorption that occurred in 2009, it will be challenging for the office sector to climb out of negative territory anytime soon with office vacancies expected to slide further this year. Office vacancies rose 50 basis points in the first quarter to 17.9 percent, according to Grubb & Ellis. A number of industry experts are predicting that the office market will hit bottom late this year.
Landlords Get Aggressive
Given the bleak picture related to market fundamentals, landlords are under intense pressure to fill space and keep generating cash flow. The caveat is that landlords are still wary of risk and are focused on solid credit tenants. “If a tenant is doing well and has good financials, they’re like gold right now. The landlord will bend over backward for them,” says Craig Melby, CCIM, SIOR, president of The Melby Group, a tenant representation firm based in Brevard, N.C.
Building owners are offering a variety of perks including rent reductions, free rent, parking, and free furniture. “We were able to save one client significant dollars because the IT and telecom infrastructure was already in place and included in the lease,” says Ira Korn, CCIM, managing director at Coldwell Banker Commercial Meridian in Rochester, N.Y. Korn serves clients in Upstate New York and specializes in site selection and tenant representation.
The majority of the class A office market in Rochester is owned by real estate investment trusts. “Our part of the world always has been — and always will be — a very tenant-driven market,” Korn says. However, the pendulum has swung even further on the side of the tenants in the past two years. “We’re seeing flexibility, not only from local developers, but also on the part of REITs that we have never seen before,” he adds. One recent transaction involved a REIT owner who in the past had not done fixed rent payments. But, the REIT changed its policy to clinch a deal with a tenant it really wanted in the building.
Owners also are willing to accept tenants on a month-to-month basis, which is a novelty in markets such as Brevard. “Landlords aren’t putting a lot of tenant improvement dollars into that kind of deal, but they are seeing the wisdom of letting a tenant come in and start operating,” Melby says. If the tenant does well, then it is to its benefit to sign a longer term lease and stay in that location, and landlords are willing to take a chance that a tenant will extend.
Rollback on Rents
Tenants clearly are finding some attractive deals in today’s market where U.S. effective rental rates fell an average of 8.9 percent in 2009 and are expected to drop another 5.2 percent by year-end, according to Marcus & Milli-chap’s 2010 office market forecast. Yet the rents and concessions vary widely depending on the market, submarket, and individual owner.
“The profile of the landlord has a lot to do with the terms that you’re seeing,” says David H. Johnson, CCIM, a principal at Denver-based Radius Commercial Real Estate. Some of the private owners that are in a good financial position with good occupancies are being very selective on tenant credit and lease securitization, while some of the REITs that are scrambling to shore up occupancies are very aggressive on deals and less concerned with tenant credit. Landlords also are looking to manage their cash flow and thus are willing to do more as-is deals with free rent. “They will give concessions, but they are really trying to limit their out-of-pocket expenses,” Johnson says.
Free rent has become a standard part of class A office deals in markets such as Atlanta, where vacancies climbed to 22.6 percent in 1Q10, according to Grubb & Ellis. Atlanta had the added burden of five new buildings opening in Buckhead that delivered 2.1 million sf of new class A office space in the face of one of the worst economic downturns in history. That excess space continues to drag down the office market and is forcing landlords to offer big incentive packages as they vie for tenants.
In most cases, Atlanta landlords are offering free rent in increments of one month or more per year of the lease. “In some of the more aggressive submarkets, a tenant that leases space for 10 years might get a year or as much as two years free, which would mean locking into an 11- or 12-year lease term,” Ashley says. Other concessions that are common in the new Buckhead office buildings include substantial tenant improvement packages, more restrictions on rent escalations and operating expenses, and more-flexible terms in expansion and contraction rights.
Some landlords also are offering steep rent discounts to entice tenants. In Reno, Nev., for example, class A space that was renting at the height of the market for $25.80 per square foot on an annual basis is now going for $18 psf. “Every landlord’s position is to make this the bridge between where we’re at now and to get to the point where there is a light at the end of the tunnel,” says Melissa J. Molyneaux, CCIM, an associate with the Office Properties Group at Colliers International in Reno. “The landlord is at the mercy of the tenant when it comes to tenant improvements, free rent, and rental rates.”
Tenants Take Control
The uptick in leasing activity in recent months shows that tenants are taking advantage of the market conditions. “All of the deals that I have worked on are with existing tenants that are either moving to save costs or upgrade their space,” Molyneaux says. Tenants in Reno are able to move from existing class C buildings to class A buildings for about the same price.
The terms in the market are encouraging some tenants to come out of leases early or negotiate extensions for existing space. “We’re going back to the landlord 18 to 24 months before the lease expires to say we’re willing to extend our lease at today’s rents or negotiate a blended rate. Landlords are willing to do it because it’s good for their financing and it ensures they will have a tenant when things expire,” Melby says. Some landlords even are willing to pay a tenant’s penalties of exiting an existing lease and relocating to their building.
Despite the proliferation of bargain hunters, there also are pockets of activity that are being driven by legitimate expansion. Technology, medical and healthcare, government, and education are just a few of the sectors that are exhibiting bigger appetites for office space. “There were a lot of companies that tightened up out of sheer fear alone and hunkered down where they were, perhaps leasing temporary space to house people for the short term,” Korn says. Now those same businesses that delayed expansion are feeling more secure about their revenue streams for 2010 and believe it is a good time to be out in the market looking for real estate, he adds.
The Sublease Factor
An added challenge to the 732.4 million sf of vacant space on the market is an additional 113.1 million sf of sublease space, according to 1Q10 data from Grubb & Ellis. The hefty volume of sublease space is a big factor in many markets across the country. For example, Korn recently negotiated an extra 15 percent rate reduction on a lease simply because of the competing sublease space available in the market. The landlord met the tenant’s terms because it didn’t want to lose a prospective deal to a sublease space — even though the spaces were not comparable, Korn notes.
Yet the volume of sublease space on the market has not yet been a major influence on other markets simply because there is still so much direct lease space available. In Chicago, for example, the sublease market represents 2.3 percent of the overall 20.8 percent vacancy rate, according to NAI Hiffman. “When the market was tighter, sublease had a greater impact on rates because you weigh one against the other, but right now sometimes the direct space is less expensive than the sublease space,” Flynn says.
The biggest driver to wdeals right now is the cost of occupancy or cost of relocation. So to the extent a sublease space is furnished or perhaps has phones, that sublease space becomes very attractive for users in the marketplace. “That creates a great deal of leverage compared to a vacant landlord space,” Flynn says. “Those plug-and-play spaces have been moving very rapidly.”
Clearly, it will take time for the market to absorb the huge supply of both sublease and direct space on the market today. Yet there are signs that the economy is beginning to improve and job growth is returning. After flat job growth in January and February, employers added 162,000 jobs in March, according to the U.S. Bureau of Labor Statistics. “If that growth continues,” Flynn says, “then I think second half of this year and into 2011 you will start to see a more consistent application of absorption.”