By Mark Heschmeyer
January 15, 2014
Even as net absorption and rents continue to rebound in most office markets, tenants with leases coming up for renewal still hold a lot of clout in negotiations with landlords in 2014.
A variety of economic, technological and workforce factors are acting as counter influences to improving property fundamentals, according to brokers and landlords involved in current lease renewals who were interviewed by CoStar News this week.
As a prime example of how many characterize the current lease renewal market, consider PRGX Global Inc., a recovery audit services provider based in Atlanta. PRGX renewed its lease this month on its 131,653-square-foot headquarters at 600 Galleria Parkway, extending for another seven years.
However, like many firms, PRGX downsized during the recession, and subleased a portion of their office space. Under its new lease PRGX will reduce the office space covered by the lease by 73,911 square feet and reset its starting base rent at $22 per square foot effective January 2015. PRGX was scheduled to pay more than $33 per square foot in the final year of its original lease signed in 2002.
Despite strong absorption and little new construction in most markets, real estate brokers say several factors continue to make this a tenant’s market.
"Landlords start off with high renewal rate expectations, but as the negotiations bear out, they have to reduce rates 10% to 15% to retain the tenant -- which is still better than re-leasing the space,” said Eric Leland, managing principal of Mohr Partners Inc., a tenant services firm based in Bellevue, WA.
In 2013, office landlord DynaCom Management Inc. in Naperville, IL, renewed 75% of its tenants.
“We are very optimistic about 2014 and hope to renew at least 75% or all, since tenants would still prefer not to spend money on a move if they don’t have to and just negotiate a better deal to renew,” said DynaCom senior leasing manager Mari Rodriguez. “Landlords such as ourselves have learned that it is less expensive to give great incentives to our tenants to renew than to market a vacant space and collect nothing at all.”
In many markets across the country - such as Houston, Denver and San Francisco -- job growth has been strong while others are still waiting for a strong job catalyst.
Rick Mineweaser, president of Diamond Pacific Investments in Scottsdale, AZ, said 90% of the tenants in the region are basically holding their own. The 10% that are expanding are somewhat offset by the 10% that are contracting, resulting in only a modest growth in absorbed square footage.
In Tucson, AZ, Thomas J. Nieman, principal, commercial properties at Cushman & Wakefield Picor, said, "In this market, landlords work very hard to renew any lease, large or small, as there’s just not enough new requirement activity to fill vacated spaces.”
Though the jobless rate recently fell to 6.7% from 7% for the month, the decline mostly represents job seekers giving up their search and leaving the workforce, according to Paul Giannopulos, principal of Cresa Chicago, a tenant services firm. He said the market still has not recovered all jobs lost during the Great Recession and therefore a lot of slack remains in the economy. Labor force participation has dropped to the lowest level since 1978.
Growing and Shrinking Firms Offset
Overall, Clarion Partners, an active New York-based U.S. real estate investment and management firm, said it is optimistic about office leasing in 2014 as the U.S. economic growth broadens. Nonetheless, it continues to see the pace of office absorption holding leasing activity back, due to shadow space and more efficient office space usage.
“While tech, energy and business services tenants are still the main drivers of office demand, large tenants such as financial services, legal, and government agencies are still shrinking their footprints upon renewals,” said Tim Wang, director and head of investment research for Clarion Partners.
The news this week that Wall Street titan Credit Suisse Group AG plans to sign a 20-year lease to keep its Americas headquarters at 11 Madison Ave. in Manhattan confirms Wang's assessment. The pending lease agreement is reported to be for about 1.2 million square feet. That means Credit Suisse would give back 600,000 square feet on renewal as it currently leases 1.8 million square feet.
New York’s banks and financial-services firms have laid off tens of thousands of workers in New York in the past few years, downsizing space to control costs amid tighter regulations.
Stephen Boyd, a director in the REITs group at Fitch Ratings in New York, tracks leasing trends as part of his coverage of office REITs and agrees with Wang.
“In finance the specter of increased regulatory burdens will keep the large institutions from expanding aggressively in places like NYC,” Boyd said. “Legal firms will likely continue to shrink their floor plates due to the technological developments (i.e. cloud computing which allows for more storage on-line for documents/legal journals, etc.). Government and government-related will likely still feel pressure from austerity measures at the federal, and to a lesser extent state levels.”
Technolgy and Workforce Trends Redefining Demand for Office Space
Cresa’s Giannopulos and others see a lot of technological and workforce trends also reshaping tenant office space demand.
“Demand for office space is being influenced by improved technologies (most importantly mobile) and younger workers are demanding new work/lifestyle expectations (further) reducing footprints,” Giannopulos said. “The average square foot per person continues to shrink. From 2010 - 2012, the average has dropped from 225 to 176 square feet. There are predictions that it will drop to 100 square feet per person by 2017.”
“Larger office users can often times significantly reduce costs through new work place designs planned around new space utilization metrics. The context is to enhance the work environment,” he added. “It is often easier and less capital-intensive to redesign vacant space, secure larger capital investments from new landlords and gain support through added building amenities.”
Howard L. Ecker, president and CEO of Howard Ecker + Co., a national tenant rep firm based in Chicago, sees the same trends at work in his firm’s markets.
“Tech companies will expand,” Ecker said. “If you look at the biggest users of office space recently, tech tenants are much more interested in cool rather than quality. Their idea of quality is high speed Internet and good air conditioning; not marble, glass, and steel.”
Efficiency Factor May Be Running Its Course
The ‘efficiency push’ companies are doing is a real trend that is here to stay and must be watched over the next several years, particularly for mature businesses, said Sean P. O'Reilly, senior manager of transaction advisory services for real estate at Ernst & Young in San Francisco. O'Reilly said the trend among businesses to use office space more efficiently is still in the middle innings, and there is more game yet to play, he said.
However, companies are still seeking the right mix.
“A lot of tenants are still experimenting with what is the right office density for their business and what is the right space layout for the various components of their business,” explained O’Reilly. “Several studies have already shown that the trend of established businesses adopting the high density collaborative environment seen in a tech company turns out to be penny wise and pound foolish as many jobs require more "focus" work than collaborative work. These studies have shown that putting employees who require a lot of focus work in a collaborative environment is causing a lot of employee dissatisfaction.”
“So I think some companies outside of the tech world are currently over shooting the efficiency goal likely at the expense of employee retention where the right space density and layout for different businesses is still being worked out,” he added.
Cycle Turning in Landlords' Favor
Jonathan Larsen, regional managing principal for Cassidy Turley in Los Angeles, said he expects a higher percentage of leases will be renewed in softer markets and a lower percentage renewed in tighter markets due to landlords trying to begin to raise rents and lower concessions.
“In 2014, more tenants will continue to look for the last opportunities to lock in lower rent and high quality,” Larsen said.
As the recovery progresses and moves into the secondary markets, tenants also may be beginning to realize that their timeframe of holding the power in negotiations may be narrowing, according to Tyler Boyd, an associate with Voit Real Estate Services in the Sacramento, CA market.
“We look for expiring tenants to spring to action, based on this assumption, and use their remaining negotiating power to their advantage,” said Boyd. “2014 should be the turning point for a lot of markets from early recovery into expansion, so we expect tenants to either lock in their rental rates for the next three to five years if they’re satisfied with their location, or make their final ‘flight to recovery’ move before it’s too late.”