Guess what? The sale in commercial real estate is coming to an end.
Commercial tenants have had the proverbial “life of Riley” for the past several years. Landlords would do almost anything to make the deal and tenants certainly took advantage. Now, I represent tenants for a living, so making the best real estate deal possible never hurt my feelings. In fact, we take great satisfaction in making CFO’s smile at huge cost reductions and big TI packages.
However, part of our job is to do a “sanity check” and deliver a sober analysis of our ability to make a deal and at what price. Eliot Brown wrote a good piece in the Feb 6th Wall Street Journal entitled Less Building Now, Higher Office Rents Later. The premise is that the real estate industry has suffered a shut down of virtually all new construction in the United States. New construction starts were just 56 million square feet last year, reports the Journal, the lowest level since 1960.
With skittish banks, high vacancy and Wall Street worry still circling, significant new construction may be delayed further. The Journal: “…while the economy added 243,000 jobs in January, given the overall sluggish pace of recovery, it could still take a few years to fill the empty office space.”
Harken back to macroeconomics and you will recall that limiting supply along with constant or increasing demand changes the price. Costs will almost certainly rise; it’s just a question of when.
Blue Light Special on Aisle 12
Commercial real estate is different than buying socks at Kmart. It’s not a commodity, and in fact, each transaction has tens of variables that can make true comparisons difficult to create. For example, location within one city or even one submarket can and does affect the net effective cost of real estate to tenants.
Another variable involves the ability to expand or contract. For several years now, we have been able to confidently advise our clients to go long and option up. In other words, lock in these great economics for years to come, but also plan for future changes in the business with options to grow or contract. When buildings fill up, this is a harder trick to pull off.
Mr. Nimble Must Be Quick
We certainly don’t think the party is over for tenants, and let’s face it: there is still lots of vacancy in office buildings around the United States. But they don’t pay you the big bucks to not be prepared and aware of the market. We simply have to plan for the worst and hope for the best. In certain gateway cities like San Francisco, LA and New York, the markets are already tightening up. Other cities will follow in 2012 if the current stream of heart warming economic news continues.
So what’s a poor CFO to do? May we suggest a few best practices that will help your transaction du jour succeed even in a recovering office market?
- Before you kick the tires in the market, have a clear understanding of your real budget and the timing of your lease commencement. The margin for error diminishes as the pendulum swings the other way.
- Speaking of timing, allow more, not less time to complete a transaction. In the next several years, as we get closer to “friction” between tenants, allowing time for a deal to die is important. Put another way, another tenant may have better credit and take “your” space and require you to move to another space or even another building. Frustrating, we know.
- Look deep in that crystal ball and require your business people to make (and then be accountable for) future growth plans. If you can see growth in the range of 1-3% a year, then build that into your initial take and perhaps a must-take expansion later in your term.
- Hyper growth has costs and landlords will bear only so much of keeping leasable space off the market. If the business is going to grow by leaps and bounds then you can lease ahead of the curve, or plan to enter into a new lease a few years into your term. As they say, this is the cost of doing business.
- Work to control and compress your internal decision-making time line. When the world collapsed in 2008, 2009 and 2010 we saw even simple decisions pushed to the highest levels of companies. Today, when the right deal presents itself, and it matches up to your clear understanding from the first bullet point above, strive to pull the trigger quickly.
Cycles keep things interesting don’t they? It began to be a little boring in the downturn to have landlords capitulate to your every demand. Now, as things pick up, this whole business of real estate will become a challenge. As the Boy Scouts say, Be Prepared. Keep focus, sprinkle in a little good fortune and together we’ll battle through the problem of optimistic landlords with great success.