A Tough Real Estate Market for Growth Companies

March 5, 2007 by jack petrie.

Tenant Sticker Shock 

As companies across Manhattan consider renewing their leases or expanding or relocating their businesses, many have been shocked by what landlords are now proposing for rental rates.  In many cases, lease proposals are coming in at 125% – 150% of what rates were a year ago, and in some cases, the proposed rent is more than double what the company is currently paying! 

Shift in Market Dynamics

Unfortunately, for companies looking to lease space today, the days of a favorable tenants’ market are long gone.  With vacancy rates at recent historical lows and tenant absorption substantially up, landlords are negotiating from a position of strength and confidence.  No longer are landlords hungry to find tenants for their properties and willing to do “whatever it takes” to persuade tenants to sign leases in their buildings.  The market has shifted, which for tenants translates into increased rental rates and a lowering of tenant improvement allowances, free rent, and other concessions, particularly lease flexibility options and clauses.
 

Market Evidence (2004-2006)

An example of these rate increases can be seen in some of the Midtown submarkets: Midtown Class A buildings which were averaging $53.91 per rentable square foot (rsf) in 2004, finished 2006 leasing for an average of $61.72/rsf, a 14.5% increase.  In the Plaza District, the increase from 2004 to 2006 in Class A rents was even more dramatic – from an average of $61.55/rsf in 2004 to $71.47/rsf at the close of 2006, a 16.1% increase.  In Downtown Manhattan, Class A space which leased for $34.40/rsf in 2004 was averaging for $43.05/rsf last year, a staggering 25.1% increase.  Even in Midtown South, a historical haven for cost conscious tenants, average leasing across all property classes rose by 18% from $31.38/rsf in 2004 to $37.02/rsf at the end of last year.  As the first quarter of 2007 nears closing, those rental rates seem almost nostalgic as a substantial portion of this year’s rent increases are already taking place.
 

Possible Solutions 

So….how do companies manage their costs in an environment like today where landlords are inflexible, rents are high and concessions are low?   
 

Most people do not realize that office space and facilities represent the 2^nd or 3^rd largest expense on a company’s balance sheet, next to payroll and inventory.  Effective management of these costs can be one of the major determining factors in the profitability and productivity of a company as a whole.  Overpaying for office space or facilities can often translate into the inability of a company to hire or retain quality employees, make a strategic acquisition, or create or expand a product line.  
 

Surf the Market Waves

Although intuitive, a good rule to remember in the current environment is: Sign long term leases when rental rates are low; sign short term leases when rental rates are high.  So, in a market like we have today, the key (if possible) is to renew in your existing space for short periods of time or find a short term sublease to get you through this segment of the real estate cycle.  Once the market shifts again and rates go back down, then sign longer term leases to lock in lower rental rates and enable your company to get through the next cycle of upward trending rents.  On a short term renewal, assuming you do not need to make significant modifications to your space, most landlords will be willing to give you a break on the rent in exchange for minimal retrofit costs. 
 

Salvage the Value of Existing Spaces  

If you cannot renew or expand short term in your existing building, or if you cannot postpone relocating your company, I would offer a few recommendations:  First, try to find a space that has been previously occupied by another tenant that is built out in similar condition to how you need your space to layout.  In a market where you are already looking at high rents and reduced concessions, the less a landlord has to spend to build out your space, the more money overall that you will be able to save on the transaction. 
 

Employ a Bidding Process to Keep Construction Vendors Honest 

If you have to retrofit, most landlords today are offering insufficient tenant improvement allowances to cover total costs.  Exacerbating this condition is the fact that there has been a nationwide increase in the cost of raw materials and labor.  As a result, many tenants are getting stuck with unexpected bills (of up to hundreds of thousands of dollars) because they did not realize that the cost to build out their office space was going to exceed their allowance.  Make sure that you have multiple contractors bid out your proposed tenant improvements to protect against unwelcome surprises.
 

Expand Your Boundaries 

Third, you may want to consider looking at less expensive buildings for the short term until the market turns around.  For example, if you are currently in a Class A building, you may want to consider leasing space in a Class B or a back-office building, assuming of course that it would not be detrimental to your business to do so.  Many companies are taking advantage of this strategy in today’s market to try to keep their office and facilities costs at a reasonable level.
 

Don’t Ignore Hidden Costs 

Lastly, it is important that you evaluate all of your relocation costs, as there are a number of other items outside of tenant improvements that will be important for you to account for.  A few of these items include cabling, telecommunications, furniture purchase and installation, the physical move, new stationery, updated marketing materials, announcements, the financial impact of downtime, and increased commute times (which could cause decreased productivity and turnover).  It is imperative to factor each of these costs into your analysis so that you can evaluate the total cost of your potential relocation.
 

Ultimately, one’s perspective on the marketplace boils down to which side of the fence you are on.  If you are a landlord or developer, times are good.  If you are a tenant however, this is not a market to be excited about, and careful planning and execution is critical.  Having a trusted advisor on your team will be a big advantage in helping you to navigate effectively through today’s marketplace.
 

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