 The commercial real estate market was flying until it suddenly wasn’t. After more than a decade of growth we knew the day would come when the office market would weaken. What none of us saw coming was a black swan event like the coronavirus pandemic where a market that once favored landlords shifted to favoring tenants in just days.
Every business in the world is developing plans for coping with the sudden economic uncertainty. With no lead time companies have been forced into experimenting with employees working from home. Unfortunately for some companies and their employees the coronavirus outbreak has already led to layoffs and furloughs. After staffing cost, real estate is the largest expense for most businesses. At some point soon every company is going to look at their office lease obligation and ways for reducing that cost. The first step is to do your homework. Study your lease to understand what rights you may have to make lease changes. Audit your lease and operating expense history to evaluate if you have been overpaying. Consider bringing in a planner to right-size your space if operationally it no longer fits. Then, together with your tenant representative, work with your landlord. Share with your landlord that you are seeking rent relief and are considering several options to mitigate your lease obligation. Sublease If you need to downsize your current space, and provided your lease allows for it, listing your space on the sublease market is one way to reduce your rent cost. Companies that have suddenly found themselves with excess space are already listing their space for sublease and dropping sublease rates 20% to 30% to get their space filled quickly. Landlords want to avoid competing with multiple below market sublease listings for empty space in their buildings because a sudden flood of sublease inventory deflates the building’s overall rental rate. The possibility of another sublease in the building could also make your landlord more willing to work with you on restructuring your lease. Restructuring One of the tightly kept secrets in commercial real estate is that your lease obligation is negotiable. There are two variables in your rent cost calculation. Rate and rentable square footage (RSF). Both are negotiable by either a rate reduction or contraction (giveback). Most dual agency brokers will deny it but brokers that only represent tenants know when negotiating leverage shifts from landlords to tenants, landlords suddenly become more willing to consider restructuring lease obligations. Why? Because in uncertain economic times landlords know that no one will be standing in line to pay your current rental rate for the entirety of your empty office space. Even before the coronavirus pandemic hit the Bay Area sublease availability was on the rise and rent growth was slipping. When the commercial real estate market was flying it would be rare to find a landlord willing to consider restructuring your lease. That’s no longer the case. Termination You may not have looked at your lease agreement since the day it was executed but now is the time to see if you negotiated a termination right. Depending on the termination right you may have the ability to terminate the lease contract before the expiration of the lease term. Be aware that the landlord may maintain the right to sue for damages for early termination or charge a fee for early termination. So, given the shift in leverage from landlords to tenants, why isn’t your broker enthusiastic about assisting you in seeking rent relief? More than 90% of the commercial real estate brokers are dual agents, representing both landlords and tenants. This creates a built-in conflict of interest that few tenants understand and even fewer brokers discuss. No one would hire a lawyer who works for the other side. Yet, the equivalent happens every day when tenants work with commercial real estate brokers and firms that also represent landlords. It is in the best interest of brokers that represent landlords to keep perceived asking rates as high as possible and vacancy rates as low as possible. But, large amounts of below market sublease space softens the market. Otherwise, landlords and listing brokers would openly publish asking and actual rents on every direct and sublease space they list. In order to gain leverage and rent relief you need to first eliminate conflict of interest by woking with a broker that only represents tenants. If your broker or anyone in their office has listings in the market, they have a conflict of interest. Then, work together with your landlord and tenant representative to explore all options for mitigating your lease obligation – sublease, restructuring, and termination.  Tenants are reading and hearing conflicting data on today’s San Francisco office market that makes it difficult to determine if the office market bubble is about to burst or if the market is strong and growing stronger.
The Bay Area economy remains strong, direct vacancy is tight, and tenants are paying record high rents:
On the other hand, there are indicators that an office market bubble could be on the horizon.
Reading the Tea Leaves From a tenant’s perspective it’s important to understand what is causing these conflicting market conditions in order to leverage your advantages as a tenant in the current office market. Nearly every rapidly scaling tech company has a business plan that relies on headcount growth, which is why tech tenants like Dropbox, Micron Technology and Splunk are “banking” space in advance of hiring and are offering to sublet portions that are going unused for now. These unicorns are wisely looking to monetize their leased but unused space until they grow and are therefore creating large amounts of sublease space on the market. This monetization of banked space is not likely a leading indicator of an office market bubble. In fact, it presents below market opportunities and leverage for tenants willing to move into a sublease. So, given the below market rents for sublease space, why isn’t your broker enthusiastic about sublease space options? More than 90% of the commercial real estate brokers in San Francisco represent both landlords and tenants. This creates a built-in conflict of interest that few tenants understand and even fewer brokers discuss. No one would hire a lawyer who works for the other side. Yet, the equivalent happens every day when tenants work with commercial real estate brokers and firms that also represent landlords. It is in the best interest of brokers that represent landlords to keep perceived asking rates as high as possible and vacancy rates as low as possible. But, large amounts of below market sublease space softens the market. Otherwise, landlords and listing brokers would openly publish asking and actual rents on every direct and sublease space they list. A bigger reason your broker isn’t enthusiastic about sublease space options is brokers are sometimes paid a lower fee on subleases. And, a sublease transaction is often more complicated and difficult to negotiate than a direct space lease. So, more work and less commission make sublease options a lower priority for most commercial real estate brokers. Leverage Your Advantages In order to gain leverage on your office transaction you need to first eliminate conflict of interest. If your broker or anyone in their office has listings in the market, they have a conflict of interest. Make sure you are working with a tenant representative firm and not listing brokers. Next, explore all your options with your tenant representative. There are very real differences and trade-offs associated with each of your options - shared, co-working, sublease, direct, etc… If you decide to explore subleases be certain they fit your timeline and flexibility. Companies that are uncertain about long-term growth plans may desire shorter lease terms. In this case, sublease may be an option that would otherwise not be available in the direct lease market. You’ll definitely be able to find sublease space at below market rates but your trade-offs will include limited flexibility on tenant improvements, renewal options and financial liability. |
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