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A Shorter Lease on CRE

Shorter Lease on CRE
By: John Salustri

SIOR Members Provide Guidance and Flexibility to Tenants in Need of Leasing Clarity

The gathering optimism over a robust return to the office hit a stumbling block in the closing days of 2021. But indicators so far point to a long-awaited relief from the grip of COVID-19 and a resurgence of the optimism that will ultimately fill our office buildings once more.

Of course, it’s hard to predict at this juncture exactly what lurks beyond the next corner in terms of new variant strains of the virus. But this we know: the previous threats—the delta and omicron variants—amounted to worrisome but ultimately small speed bumps, and occupancy numbers slowed, but did not stop.

We also know that SIOR members have been at their tenants’ side throughout the ups and downs of COVID-19 and its variants. All the way, they’ve been helping their clients craft a return to the office that will ensure both the safety of their employees and the benefits that office occupancy brings—the collaboration, the camaraderie, and the face-to-face strategizing.

Indeed, as we reported in the Winter 2021 edition of SIOR Report, while the industrial market remains blazing hot, the fortunes of the office market, the focus of this article, have been strapped to COVID-19-related issues. Could that finally be changing?

JLL, in its January 2022 Office Market Outlook, indicates that it might be: “The U.S. office market registered positive net absorption for the first time since the onset of COVID-19 during the fourth quarter. Despite the delta and omicron variants disrupting many elements of daily life and return-to-office policies still evolving, leasing velocity increased by 9.2 percent in Q4, lifting full-year leasing volume 14.6 percent above 2020 levels, while sublease space stabilized and vacancy plateaued.”


TAILORING SOLUTIONS TO THE NEED

It comes as no surprise that responses to COVID-19 to date have been varied, based on the specific needs of the tenant and individual states’ approaches to the latest virus iterations. (As just one example of the helter-skelter nature of the pandemic, in November, New York Governor Kathy Hochul called for a general return to work by the new year. Within weeks, in the face of rising omicron threats, the state mandated full masks in public places.)

The choices tenants are making include–obviously–holding pat with their current footprint or cutting back on their holdings until there’s more clarity on the pandemic. “Shorter lease terms allow corporate occupiers to buy some time until long-term decisions can be made,” says Michael Feuerman, SIOR, senior vice president with Berger Commercial Realty | CORFAC International.

Other tenants have opted for more outlier strategies, either shuttering their spaces completely or actually expanding for social distancing or planned growth. All the brokers we spoke with said these are the two least common options.

Whatever path they choose, growing trends such as hybrid work models are bound to play a role. “There’s a general consensus among my clients that they can maintain a workforce remotely, but they can’t grow and properly train remotely,” says the South Florida-based Feuerman. He points to the hit such important factors as mentorship and culture take when people are scattered to the winds. “Growth is inhibited.”

"There’s a general consensus among my clients that they can maintain a workforce remotely, but they can’t grow and properly train remotely."

But money speaks, and immediate necessity often trumps long-range strategy. Downsizing and shorter lease terms, while immediately beneficial to the tenant’s pocketbook, are also problematic long-term, for the landlord as much as for the tenant.

“When lease renewal time arrives, the landlord has the negotiation leverage, and the tenant is in a Catch-22,” says Dallas-based Nora Hogan, SIOR, the principal of Tenant Advisory and Workplace Solutions for Transwestern. “They either accept the economic terms and an amendment to the lease that will not have very favorable clauses, or they disrupt operations and start the costly and time-consuming process of relocation.”

Shorter term leases also threaten the landlord’s solvency. “We’re working with two sets of expectations,” she says. “The tenant believes the market is soft and rental rates should decrease. But then there’s the reality of the landlord’s lender requirements. Often landlords’ proforma models demonstrate that short-term decisions may adversely affect the valuation of the building.”

There is a premium tenants often have to pay to go short-term, “and we let them know that there’s a high likelihood of rent reduction if they commit longer-term,” says Feuerman. “But because these are short-term leases, the financial impact is minimal. In other words, for a year or two, or even three, tenants don’t seem to mind paying a rent premium to get the flexibility they’re seeking while they wait out the effects of the pandemic on the workforce dynamics.”

Shorter terms might be an expedient for the tenant, and at least the landlord keeps space occupied. But what of the above-mentioned outliers—those occupants that shed their spaces entirely in favor of a fully remote work strategy? Are office tenants in those cases being penny wise and pound foolish? They might be.

Jeffrey D’Amore, SIOR, offers a case in point. The executive director and real estate broker for Cushman & Wakefield | Pyramid Brokerage Company in Albany, N.Y., tells of a large insurance client that pulled the plug on both a new lease and a local 5,000-square-foot space they already occupied, all in favor of remote working.

While they may be saving serious capital in the short run, such decisions might be “rash,” he says. “So far, this tenant has no interest in re-engaging that landlord and taking back their old space. But I wouldn’t be surprised if they eventually try to take the space back or downsize into new offices.”

The problem is that, as the JLL numbers prove, there is a push to return to the office, and D’Amore reports a lot of eyes on that vacated space. “Tenants who’ve abandoned their spaces will be scrambling to find offices,” he says. “This client specifically spent a lot of money on their buildout and had beautiful offices. It won’t be available to them unless they act soon.”

THE TI ISSUE

Of course, on the other side of the spectrum, long-term deals come with benefits, such as richer tenant improvement (TI) allowances. But increasingly, tenants are fitting out those long-term leases with termination clauses, says D’Amore.

“Even on 10-year deals, landlords are protecting themselves with stepped up measures to lessen that impact, much more than was common prior to 2020,” he says. “These protections might include making the tenant responsible for unamortized improvements and brokerage commissions, and penalties in base-rent payments in excess of six months.”

But again, tenants trying to maximize flexibility in the face of ongoing unknowns may nevertheless eschew the benefits of the long term. “A long-term lease placed on the sublease market is never cost-effective,” says Hogan. “If a tenant can’t see the future clearly, they should pay the extra for a short-term lease and accept the limitations of a space that may not be perfect.”

It might be easier to live with spaces that are less than perfect, given the rising cost of construction materials, which puts the squeeze on landlords’ ability to deliver on TIs. Jay Cobble, SIOR, the Knoxville, Tenn.-based partner and principal broker for Providence Commercial Real Estate, reports that construction prices have jumped from $20 to $60 a foot in his local market.

“Landlords are stuck,” he says, “because while construction costs are high, lease rates haven’t gone up with them. It just doesn’t pencil out. Proposals I’m getting from landlords say they can make TIs work on a seven- or a 10-year lease. But tenants don’t even want to do a five-year.”

In what Cobble describes as a small market, leasing trends take two forms–either local decisions imposed by distant corporate decision makers or the more seat-of-their pants activity of small local tenants. “The mom-and-pops are moving forward, as much as possible, with construction costs being what they are. Meanwhile, the corporate groups are actively looking over their balance sheets and cutting expenses by reducing their footprint.”


SERVICE AT THE CENTER OF FLEXIBILITY

At the end of the day, the client’s preference rules. CRE experts we chatted with say that, as always, their responsibility is to help clients make those preferences as informed as possible. It’s called service, and, as Cobble explains, service is made up of “communication and relationships. I try to stay connected to national and local trends to help my clients make better decisions.” He includes in his sources SIOR Report (of course), market trend data, and even furniture and architectural vendors who “have enormous research departments and are always helping their clients figure out solutions for social distancing.”

“We can’t make these decisions for our clients,” says Feuerman. “What we can do is help guide them through the questions that have arisen during the pandemic, such as how many employees might be coming back and if they’ll be using a combination of office and remote work.”

"We can’t make these decisions for our clients. What we can do is help guide them through the questions that have arisen during the pandemic."

D’Amore agrees. “My job, the job of any SIOR, is to provide the guidance that will help our clients navigate their options,” he says. “We want them to see all of the possible opportunities that are available to them with the goal of both negotiating the most favorable terms and providing maximum flexibility when it comes to their space requirements and overall lease obligations.”

The office market is in a state of flux right now, and predictions of future occupancy remain somewhat cloudy, at least for the moment. If there is any clarity or consistency in the marketplace, it comes in the strong advisory relationships SIOR members have forged with their tenants.

Some things never change.




CONTRIBUTING MEMBERS

Jay Cobble, SIOR

Jeffrey D'Amore, SIOR

Michael Feuerman, SIOR

Nora Hogan, SIOR

 

Media Contact
Alexis Fermanis SIOR Director of Communications
John Salustri
John Salustri
Salustri Content Solutions
jsal.scs@gmail.com

John Salustri is a freelance writer and editor-in-chief of Salustri Content Solutions. Contact him at jsal.scs@gmail.com.