 Office tenants always understand that you can’t determine rent without the asking rent and rentable square footage (RSF). What they often don't understand is that load factor is just as important to the calculation of their rent.
If you require a set certain amount of office square footage, understand that not all office spaces with the same advertised rentable square footage and the same asking rent are the same. Usable Square Feet (USF) One of the first steps in planning for office space is to determine how much usable space you need. These “rules of thumb” can help estimate the amount of usable square feet required for your business based upon uses. So far, the math is pretty simple. Determine the number and size of offices, conference rooms, etc... plus an estimate of space needed for circulation (hallways/corridors) and you can roughly estimate your usable space requirement. Simply put, usable square footage is the actual and exclusive space you occupy inside your suite where you conduct your business. Usable square footage does not include common areas of a building such as lobbies, shared restrooms, stairwells, storage rooms, and shared hallways. Now that you’ve developed an estimate of the amount of space you’ll need, it should be pretty straight forward to identify the space alternatives that meet your size and budget requirements. But it’s not. Because, while tenants understand and think in terms of their usable space needs and budget limitations, available office space is typically marketed as rentable square feet. Rentable Square Feet (RSF) Your rent will be based on rentable square feet so understanding the difference between usable square feet and rentable square feet is essential to evaluating alternatives. Rentable square footage is your usable (actual and exclusive) square footage PLUS a portion of the building’s shared or common space (lobbies, shared restrooms, stairwells, storage rooms, and shared hallways, etc..). Each tenant pays for these common areas in proportion to the amount of space they lease in the building. Since no two buildings have identical amounts of common area, you will rarely if ever find that two spaces listed with the exact same rentable square footage are equal in usable space. This is where the math stops being simple. Load Factor (LF) The variable in your rent equation that accounts for these common areas is called the load factor. Load factors are typically represented as a percentage and commonly range between 10% and 20%. The formula to calculate your rent looks like this:
While you’d think that such an essential variable in the rent equation would be included in marketing collateral and industry databases, load factor is often not. In fact, it’s not uncommon for listing brokers to be uncertain or unaware of the building LF when showing space. Two things listing brokers like to withhold in tight markets, the asking rent and load factor. (More on Asking Rent: WITHHELD). For example, two alternatives are marketed with the same size (10,000RSF) and asking rent ($60.00/RSF/YR) may appear equal but they aren’t. When you include the differences in load factor (20% vs 10%) you gain 757USF (9,090USF - 8,333USF) in option 2 for the same rent as option 1.
So, while the two alternatives are marketed as the same size (10,000RSF) and asking rent ($60/RSF/YR), alternative 2 is a better value at $66.01/USF/YR based on a lower load factor. That is why load factor matters.  As tenant representatives, we advise our clients that ownership matters. The differentiator between two similar buildings and spaces with like amenities and rent can often come down to the quality of ownership. Buildings that have been owned and managed by the same entities for a long period of time tend to be better managed.
 A What does the sale of the Transamerica Pyramid mean for Tenants? A New York investment firm and its partners closed a deal to buy San Francisco’s iconic Transamerica Pyramid for $650 million, marking the first time the building has changed hands since it was delivered in 1972. Most California office tenants know that commercial landlords typically pass on a pro rata share of real estate taxes, including property taxes, to their tenants. In the most common office lease, tenants are only responsible for property tax increases over the “base year” amount which is most often the year of the commencement date or the year following the commencement date. Proposition 13 was approved by 65% of California voters in 1978 and currently limits property tax reassessments (increases) to 2% annually but allows for full tax reassessments if the building is sold, more than 50% is transferred, or substantial new construction is completed. Property tax reassessments can have a devastating effect on California office tenants. Property Tax Liability As tenant representatives, we advise our clients that ownership matters. The differentiator between two similar buildings and spaces with like amenities and rent can often come down to the quality of ownership. In general, buildings like the Transamerica Pyramid that have been owned and managed by the same entities for a long period of time tend to be better managed. However, these same buildings may not have been reassessed under Proposition 13 for years and in the case of the Transamerica Pyramid, since it was built in 1972. As a result, tenants in buildings like the Transamerica Pyramid carry a potentially large tax liability when the property is sold or transferred during the term of their lease. What is the property tax liability for Tenants of a building like the Transamerica Pyramid? Let’s keep the math simple for this example with a 1.15% property tax rate and assume that you entered into a 5-year lease for 10,000 square feet in a building like the Transamerica Pyramid with ~500,000 square foot. You have a 2% pro rata share with a 2018 commencement date. The building hasn’t been sold since 1972 and had a Proposition 13 assessed value of $250,000,000 in 2018 (your lease “base year”) and property taxes for the building were $2,875,000. When the assessed value of the property was increased by the Proposition 13 maximum of 2.0% in 2019, the building’s subsequent year’s taxes were $2,932,500. You paid your 2% share of the $57,500 increase, or $1,150. However, in October 2020 the building sold for the first time since 1972 for $650,000,000. Under Proposition 13, the property will be reassessed and taxed on the new value, and the property taxes will be increased to $7,475,000. The increase in property taxes from your base year 2018 to 2020 will be $4,600,000 and since your firm occupies 2% of the building, you’ll get handed a bill for $92,000 ($9.20/SF). And, you’ll pay that bill and more every year until your term runs out. Why is Proposition 13 protection a third rail issue for brokers? How many CEOs would knowingly take on a contractual obligation without the ability to control, or plan for cost increases? This is why California office tenants should pursue Proposition 13 protection in their lease negotiations. Unfortunately, the example above is the rule rather than the exception for several reasons. The largest tenants in softer markets are more likely to gain Proposition 13 protection. In tighter markets and for smaller tenants where the landlord has the leverage, it is very difficult to negotiate for Proposition 13 protection. Not having Proposition 13 protection can be devastating for tenants but building owners are extremely resistant to agreeing to this protection. Simply put, commercial property is harder to sell if its tenants have Proposition 13 protection. So, it’s understandable that landlords are somewhat inflexible and seek to pass the tax reassessment burden onto tenants. Somewhat harder to explain and understand is why Proposition 13 protection is a third rail issue for brokers. The dirty little secret in office leasing is that more than 90% of the commercial real estate brokerages represent BOTH tenants and landlords. 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. So, if your broker or anyone else in their office represents landlords, you have a built-in conflict of interest. If your broker isn’t asking for Proposition 13 protection, it’s probably because like a third rail, touching it is extremely dangerous for their business. That is why many California brokers don’t pursue Proposition 13 protection for their clients. Seeking and obtaining Proposition 13 protection is easier said than done but it should always be subject of negotiation. If full Proposition 13 protection against reassessment is not possible, a more typical compromise is seeking some level of protection, for example a cap on Operating Expense (OPEX) increases throughout the term of the lease. At a minimum, it’s important to do the math on your potential Proposition 13 reassessment liability before entering a lease in any building in California. Tenants need to know when the property was last reassessed for Proposition 13 purposes, what its assessed value was and what its assessed value is today in order to forecast the potential liability due to a transfer of ownership . The longer it’s been since the last reassessment, the greater your exposure to property tax increases.  California is in the midst of an unprecedented economic crisis, and yet another threat is on the horizon. The 2020 California Proposition 15 would change the way commercial property is taxed and have a devastating effect on small- and medium-sized business that make up half of California office tenants.
Proposition 13 was approved by 65% of California voters in 1978 and currently limits property tax reassessments (increases) to 2% annually but allows for full tax reassessments if the building is sold, more than 50% is transferred, or substantial new construction is completed. Significantly, 2020 California Proposition 15 (aka “split roll”) would remove the 2% reassessment limit and require commercial and industrial properties to be taxed based on their market value beginning in fiscal year 2022-2023. In California, commercial landlords in multi-tenant buildings typically pass on a pro-rata share of building operating expense (OPEX) including property taxes, to their office tenants. In the most common office lease, tenants are only responsible for OPEX increases over the “base year” amount which is most often the year of the commencement date or the year following the commencement date. Property Tax Liability As tenant representatives, we advise our clients that ownership matters. The differentiator between two similar buildings and spaces with like amenities and rent can often come down to the quality of ownership. Buildings that have been owned and managed by the same entities for a long period of time tend to be better managed. Under Proposition 13, buildings like these may not have been reassessed at market value for years and in some cases decades. As a result, their tenants carry a large tax liability if the property is sold or transferred during the term of their lease. Or, if Proposition 15 passes. How much will tenants absorb when Proposition 15 tax increase is passed through to them? Let’s keep the math simple for this hypothetical example and use a 1.15% property tax rate and assume that you entered into a 7-year lease for 10,000 rentable square feet (RSF) in a San Francisco building with ~500,000 RSF. You would have a 2% pro-rata share with a 2019 commencement date and base year. In this example, the building hasn’t been sold since 1998 and has a Proposition 13 assessment value of $75,000,000 in your 2019 base year with property taxes of $862,500. When the assessment value of the property is increased by the Proposition 13 maximum of 2.0% in 2020, the subsequent year’s taxes will be $879,750. You will have to pay your 2% share of the $17,250 increase over base year, or $345. In 2021, taxes will be $897,345 and your 2% share of the $34,850 increase would be $697. All very manageable. However, in 2022 under Proposition 15 the 2% limit on property tax reassessments is removed and property will be reassessed and taxed on the market value of $400,000,000 (estimated $850/SF sale price) with property taxes increasing to $4,600,000. The increase in property taxes from your base year 2019 to 2022 would be $3,737,500 and since your company occupies 2% of the building, you’ll get handed a bill for $74,750. And, on top of your base rent you’ll pay that bill and more every year until your term runs out. How many CEOs would knowingly take on a contractual obligation without the ability to control, or plan for cost increases? Whether Proposition 15 passes or not, California office tenants still carry a large tax liability if the property is sold or transferred during the term of their lease. Just as we advise our clients that ownership matters, so too does a building’s property tax liability. In addition to ownership, the differentiator between two similar buildings and spaces with like amenities and rent may come down to size of a tenant’s property tax liability. For this reason, we pursue some level of protection for our office tenants by seeking a limit on Operating Expense increases throughout the term of the lease. For the last decade only the largest tenants in softer markets have been able to negotiate caps on OPEX increases. But a black swan event like the coronavirus pandemic shifted leverage in markets that once favored landlords to favoring tenants overnight. Seeking and obtaining OPEX protection is easier said than done but it should always be subject of negotiation. At a minimum, it’s important to do the math on your reassessment liability before entering a lease in any building in California. Tenants need to know when the property was last reassessed for Proposition 13 purposes, what its assessed value was, and what its assessed value is today in order to forecast the potential liability due to a transfer of ownership or passage of Proposition 15. The longer it’s been since the last reassessment, the greater your exposure to property tax increases. Every business in the world is developing plans for coping with the sudden economic uncertainty caused by the coronavirus pandemic. After staffing cost, real estate is the largest expense for most businesses. Today, every company is looking at ways for reducing that cost.
But people play a critical role in a company’s success and a black swan event like the coronavirus pandemic is a catalyst for employees to reconsider where they choose to live, work, and settle. Even before the coronavirus pandemic, for both employers and employees, the Bay Area's escalating housing costs, deteriorating quality of life, growing traffic congestion and higher taxes spurred many to move or relocate operations outside of California. Together with our alliance partners, CroninCRE serves the commercial real estate needs of clients from Northern California through Portland to the Puget Sound so we deal with this issue frequently. Driven by a need to both reduce costs as well as attract and retain a productive pool of talent, companies like Google, Apple, Square, New Relic and many smaller tech companies and startups are joining a growing number of businesses that are moving or expanding to the Pacific Northwest. Office Rent AND Cost of Living Matters Average office rents in San Francisco ($70.06/RSF/YR) are more than double rents in Portland ($27.62/RSF/YR) and almost twice Seattle rents ($47.48/RSF/YR). (Source: Costar) Reducing office rent impacts the length of a start-up company’s financial runway and is a major factor when new businesses consider where to start. For established companies looking to expand or contract, rent cost and/or rent reduction along with taxes and incentives are major factors for consideration. But apartment rent and cost of living matters too. Limited availability and increasing demand have driven up the average one- and two-bedroom apartment rents in San Francisco ($2,469/$3102) while significantly more affordable options are found in Portland ($1,124/$1,326) and Seattle ($1,357/$1,690). (Source: apartmentlist.com) Home prices offer even greater value in the Pacific Northwest than the Bay Area. The medium sale price of a single-family home in San Francisco is $1,370,900 compared to Seattle $716,900 and Portland $436,100 (Source: Zillow.com). If talent and money are your company’s fuel for growth, consider the impact of office rent, cost of living and quality of life on your ability to attract and retain talent before you select a location to start or expand your business.  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.  In full-service gross office leases, landlords typically pass on a pro-rata share of operating expenses (OPEX) related to the tenant's occupancy of the space. In the most common office lease, tenants are only responsible for common area maintenance, utilities, property insurance, and property tax increases over the “base year” amount which is most often the year of the commencement date or the year following the commencement date.
Each year during Q1 you and your accounting department receive estimates of current year operating expenses as well as reconciliation of previous year actual operating expenses. What to Expect Since landlord’s pass through operating expenses to tenants they have little incentive to control these costs. For this reason, operating expenses almost always increase from year to year. You can view any OPEX category that increases less than 3% or 4% over the previous year as reasonable while anything over that should be explained by the landlord. Check the Math If the Landlord doesn’t itemize your charges be sure to ask for an itemized break down by category. Whenever an annual reconciliation hits your inbox without sufficient back up to verify expenses and calculations, it’s time to check the landlord’s math and determine if a lease audit is called for. Your broker can help you check the math and assess if you are being overcharged by your landlord and assist in recovering any overpayments. If your broker doesn’t have the time or interest to assist you it may be that their brokerage doesn’t exclusively represent tenants. The dirty little secret in office leasing is that most commercial real estate brokers represent both landlords AND tenants. This creates a built-in conflict of interest that few tenants understand and even fewer brokers discuss. So, if your broker or anyone else in their office represents landlords, you have a built-in conflict of interest. If your broker isn’t offering to assist in your annual OPEX reconciliation, it’s probably because they or someone in their firm also represents the landlord that overcharged you for your operating expenses.  Finding the right office space can be an exciting challenge for a business. Once you've made the decision to seek your first or your next office, your instinct may be to ask Siri, Alexa, or Google search to "find office space".
Your results will be dominated by listings in free databases of office space (Loopnet, 42Floors, Officspace.com...), paid advertising listings from coworking firms and flexible office providers (WeWork, Regus, Knotel, Servcorp...), and likely some listings from commercial office brokers that represent landlords. One of the biggest mistakes to avoid when looking for office space is not finding multiple, competitive alternatives. On the surface it may seem like your search has produced plenty of potential alternatives but in fact, the free databases, coworking and brokerage listings are populated and paid for by landlords and brokers representing landlords. Therefore, you are presented with the listings and information that benefit landlords and their brokers, not you the tenant. Not every available office space is included in the free databases because of the cost to brokers and landlords. And, listings that are included often only quote a range of asking rents or in tighter markets, asking rents may even be WITHHELD. Paid advertising listings from coworking firms and flexible office providers direct you to their websites to begin your deep dive into their plans, pricing, locations and FAQs. There is nothing wrong with asking Siri, Alexa, or Google to find office space for an overview of the market through the eyes of a landlord and their brokers. But, the results are not comprehensive, lack key information and don't represent the true market condition for office space. Consider hiring a broker that works exclusively as your tenant representative who will save you time normally spent researching space and provide the peace of mind that every opportunity in the market will be presented to you. Firms that specialize in tenant representation are only focused on finding value and multiple alternatives, many of which aren't found by asking Siri, Alexa, or Google search. In commercial office lease transactions fees for the tenant representative are paid by landlords, not tenants. Even though tenant representatives are paid by the landlord, they work exclusively for you and unlike Siri, Alexa, or Google, have a fiduciary duty to represent your needs in everything they do.  Blockchain is best known as the technology powering cryptocurrencies like Bitcoin and Ethereum. The "block" is digital information stored in the "chain" which is a public database. The blocks on the blockchain are made up of digital pieces of information:
In contrast, the commercial real estate (CRE) industry has historically isolated information that is essential for searching, selecting and negotiating office leases behind private brokerage in-house databases and an imperfect subscription-based industry database. Much like the travel industry prior to the Internet, the commercial real estate industry is extremely inefficient and lacks transparency. Standard operating procedure for commercial real estate brokers is to keep transaction information secret and centrally controlled for the purpose of creating competitive advantage. There is an intentional lack of transparency on the part of brokers representing landlords that increases the potential for inaccurate market information. But what if the data related to every office lease transaction and every property was held in an open and shared public blockchain database for all involved parties in a transaction? Technology-driven information transparency is one of the major disruptive forces on the horizon for commercial real estate and office leasing. Globally, venture-backed real estate tech companies raised $14 billion USD in 2019 Q1-Q2, a 309% increase from 2018 Q1-Q2. (Source: CREtech, Mid-Year Report, 2019) It is not a matter of if, but when. And when that day comes, you can count on an erosion of the lucrative fee structure in office leasing. The market will eventually demand transparency and the removal of information silos built and maintained by commercial real estate brokers and real estate database companies. Today, the huge commissions that brokers earn are largely justified by the existence of these silos. Eventually, all markets demand transparency and so too will tenants of commercial real estate. As market information becomes more freely accessible the leverage in an office leasing transaction will shift from listing brokers and landlords to tenants and tenant representatives. This new market landscape will empower tenants to demand more value from their broker than just sharing proprietary market data. That said, an office leasing transaction is much more complex than booking travel online. No two deal terms are the same just as no two spaces with the same square footage are the same just as no two landlords or buildings are the same. So, there will be a role for a middleman in office leasing, but it won’t be about sharing lease comps or asking rents. It will be about adding quality, value and services to the transaction. Brokers clinging to legacy business models and fee structures are likely to feel like travel agents in the '90s standing on the wrong set of tracks when the Internet train passed by. |
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