With companies scrambling to determine Return to Office (RTO) strategies amid ongoing uncertainties, increased employee desire/demand for flexibility and even fully remote opportunities, management should no longer assume the next office lease will be anything like the last negotiation. Before thinking through typical considerations associated with office leasing strategy (e.g., location, lease term, layout and design, etc.), suitability of traditional leases should also be on the checklist.
After a substantial upturn in commercial office fundamentals, especially on the West Coast, the current economic and real estate environment has finally shifted leverage in the tenants’ favor. According to a recent CBRE research, most major office markets are still seeing demand meaningfully below 2018–2019 levels, and Marcus & Millichap is not expecting the office market returning to pre-pandemic levels until 2024. At the same time, the concurrent proliferation of flexible working space and abundance of sublease inventory have broadened tenant options, each with its own unique set of benefits and considerations.
#1 Direct Office Leasing
In a typical direct office lease, the length of the term can range between five to seven years—although some can run as short as three years and some longer than ten years. A traditional lease often also requires tenants to pay for common area maintenance (CAM) and other building expenses, on top of the agreed-upon rent and tenant improvement. (Tenant improvement, also known as TI – the upfront capital investment for space planning, furniture and other fixtures prior to moving in – and is partially subsidized by the landlord as an incentive.)
In the current tenant-friendly environment, tenants looking to enter into new leases or extend existing leases should feel confident in exercising their leverage. Per Cushman & Wakefield, effective office rents (which factors in free rent and TI subsidy) are down around 13% from the peak. While contractual rental rates are holding firm, concessions are rising sharply. Renting quality space in major markets can come with six to twelve months of free rent plus a TI subsidy of well over $100 per square foot. Bowing to tenant needs for flexibility, average terms have trended shorter, and some existing tenants have opted to renew on a month-to-month basis to carefully reassess their real estate needs before making a firm commitment going forward.
In short, the traditional lease structure offers a good balance between flexibility and stability. Depending on the particular RTO strategy, tenants have the luxury to:
- Negotiate more favorable terms,
- “Wait-and-see” with shorter leases, and/or
- Redesign space through large TI subsidies.
#2 Flexible / Coworking Office Leasing
Long considered a niche offering, flexible workspace has become a widely accepted product. JLL was already predicting 30% of all office space will be flexible by 2030 back in 2019. While specialists such as WeWork, Industrious and Regus/Spaces continue to dominate the market, traditional landlords (e.g., studio by Tishman Speyer) and real estate services firms (e.g., Hana by CBRE) have also invested heavily into the product.
Unlike traditional leases, coworking space can be leased monthly or even on-demand if necessary, and often comes with concierge services handling parcels, printing, audio/visual equipment and other needs (some do require additional costs). For companies that are growing rapidly or remote-centric, this type of arrangement offers immense flexibility in managing real estate footprint. The product can also serve as a temporary bridge or permanent solution in establishing regional hubs as management teams evaluate where to best source talent and address emerging employee preference toward lower-cost, suburban centers.
The main downside to utilizing coworking space is the relative financial costs and certain restrictions. Although no capital investment is required, expect to pay a meaningful markup in rent relative to traditional lease. In addition, tenants have limited influence in the design, layout and utilization of the space since flex spaces are designed with high reusability across various tenant types over a long horizon.
Companies looking for a cost-effective, short-term real estate solution should also consider entering into a sublease. In most instances, the existing tenant has already fully built out the interior but wishes to modify its footprint for a variety of reasons. As such, most of the time a meaningful discount can be had for space that is ready for move-in. According to Cushman & Wakefield, as of Q3 2021, there remains over 130M SF of sublease availability in the U.S., with asking rents representing 10% to 50% discount relative to a traditional direct lease. Moreover, most sublease tenants can successfully negotiate the rights to access amenities and onsite services provided by either the landlord or the tenant at reduced costs (or free), and they can avoid CAM and other unpredictable fees and charges. A sublease is also, for the most part, easier to qualify and execute. In the case of a fully vacant space available for sublease, the subtenant also has the flexibility to increase the footprint within the premise as needed, enjoying the flexibility without paying for it. Should the subtenant wish to take the entire space when the original lease expires, the party is also well-positioned to negotiate a direct lease with the landlord.
However, the financial savings do come with operational limitations. The in-place lease will dictate the terms and allowed uses, and in most cases, the subtenant must use the space as-is (for subtenants able to lease the entire space, occasionally unused TI allowance as agreed upon in the original lease may be available). In addition, any repair and maintenance (R&M) request may need to go through the actual tenant prior to landlord approval/action, causing unwanted delays. Moreover, a poorly negotiated sublease can leave the subtenant exposed to legal or financial consequences should problems arise between the landlord and the tenant. In a worst-case scenario, the tenant may default on the lease and/or declare bankruptcy, and the subtenant may be evicted with little recourse.
Office Leasing Strategy Summary
The “New Normal” should also require new thinking regarding office space needs. A traditional direct lease may no longer fit the organizational needs, be it operational flexibility or financial constraints. Each of the options outlined above has its own set of tradeoffs between benefits and risks, which needs to be carefully considered. Depending on organizational scale, needs and growth trajectory, all three options should be explored.
A quick sidenote for management teams that have the financial wherewithal to acquire an office building. Outright ownership offers additional benefit in full operational control, allowing management to better cultivate the culture and identity through highly curated design, planning and selection of onsite retail tenants, but it comes with asset management “tuition costs” that may present misalignment against a company’s core competency as well as potential distraction. Financially, the upfront costs can be significant along with the burden of ongoing maintenance, frequent renovation costs and annual property taxes. That said, institutional-quality buildings can be financed with 3% to 5% mortgage (usually up to 80% LTV), and depreciation, interest and applicable tax credits can help to shelter income. While not a commonly undertaken route, companies that strongly believe in their local presence and have ample excess liquidity can also examine such possibility.
If you’d like support in your return to office planning, we offer both business stabilization and contingency planning services and have a team of financial planning and analysis consultants who can help. To improve your planning, you might also consider downloading our 5-year strategic planning timeline template:
Categorized in: Financial Planning & Analysis, Business Stabilization