Corporate Real Estate Outlook: Opportunities and Risks in a Tenant's Market
28 Feb, 2010By: Michelle Cammarata
According to many economists, the recession is over, but the bottom is still a long way off in commercial real estate. Job losses have exceeded the increase in vacancy rates, meaning more vacancy is yet to come. (CoStar predicts national vacancy will go from 13 percent to 15 percent over the next 24 months.) Real estate is a lagging indicator, and it seems likely that true rent recovery will not occur before 2012. Full market recovery is not expected until employment reaches its pre-recession level, probably not before 2013. CresaPartners is counseling clients to develop proactive strategies to make the most of a tenant’s market while looking for ways to use space more efficiently.
Real Estate Recovery Still Years Away
Landlords are struggling on three fronts:
1. Vacancy continues to rise in virtually all markets, pushing rents lower.
2. Building valuations have decreased 30 percent to 50 percent as a result of the lower rent stream combined with higher cap rates. We are back to traditional cap rate levels of 8 percent to 10 percent.
3. Financing, once available with little equity, is difficult to find. When available, equity of 40 percent or more is required. This combination makes it difficult, if not impossible, to refinance buildings bought in the last five years. Some lenders have responded by simply renewing on a short-term basis rather than writing off the loans, but thousands of properties are at risk to default.
Importantly for our clients, the rental markets have softened significantly in the vast majority of our markets. Rents have dropped anywhere from 20 percent to 50 percent, and landlords are focused on retaining tenants at almost all costs. Virtually all markets have experienced increased vacancy rates of 5 percent to 10 percent, and rents will continue to correct through 2010. Many landlords are now willing to do one- or two-year extensions in anticipation of a better market in 2011 or 2012.
With many landlords stretched to the limit, we encourage tenants to be proactive in negotiations before leverage slips away. Credit-worthy tenants with flexibility to move will find abundant opportunities to reduce rents. Other essential lease negotiation points include non-disturbance agreements and securitization of improvement allowances. Short-term lease deals are available, but tenants need to carefully review flexibility versus likely rent hikes in two to four years. Opportunities increase when tenants are able to lock into long-term leases of eight years or more.
Less Space Means More Savings
While lower rents translate into significant savings for many tenants, real estate continues to be the number two corporate expense, following labor. Companies have never stopped looking for ways to plan more cost-effective, functional and creative uses of space. The average employee today accounts for 100 to 150 square feet, down from the previous standard of 225 to 250 square feet.
Ways to save include:
Think inside the box. The once maligned office cube hasn’t disappeared, but, as a result of economic necessity, technological advancements, and demographic changes, it is making a comeback. Today’s cubicles average 6 feet by 7 feet, compared to the previous guideline of 8 feet by 8 feet. New technology has enabled the design of workstations with less depth, featuring flat screen computer panels, more streamlined storage space, greater mobility for chairs, and better access to natural light.
Consolidate offices and staff in one area to improve communication and morale. Also, set aside comfortable common areas for collaboration. You may be able to sublet unused space or renegotiate terms with the landlord.
Promote hotelling. This space-sharing concept is becoming more popular, especially for employees who don’t need to be in the office every day. In some environments, as many as 10 employees share the same space, where they “touchdown” only as needed.
Go virtual. With advanced wireless technology such as laptops and smart phones, employees can be productive at home or on the road, keeping in touch through online meetings and video-conferencing while they save the expense of travelling and conserve energy.
Low-Cost Green Strategies
Cost-cutting is a trend with no end in sight. Green technology and sustainable building practices offer opportunities to improve both the work environment and the bottom line.
While companies are still leery about making major investments during a sluggish economy, certain easy and inexpensive improvements are within budget:
With costs decreasing for many green products such as carpets and cleaning agents, more companies are using recycled, VOC-free materials.
Companies are finding they can save 20 percent to 50 percent with energy-saving technology, natural daylight, and multi-function equipment, such as combination printer/scanner/fax machines.
Adding energy efficient light bulbs and turning off lights and computers when not in use reduces electrical costs.
A recycling program for paper, glass and plastic can be simple and inexpensive to implement.
If you’re not already going green, select an in-house champion and partner with a LEED-Accredited Professional.
Is it Time to Buy?
Creative space planning and energy efficiency can result in immediate, short-term savings. Looking at the wider picture, this may be an opportune time for certain tenants to adjust their real estate strategies and consider buying key real estate assets. In some markets, purchase prices have not been this low in many years. Also, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have proposed changes to lease accounting rules which will have potentially seismic affects on the balance sheets of public companies. Operating leases will likely be replaced by capital leases, resulting in the shift of trillions of dollars to balance sheets of companies worldwide. With all leases for commercial real estate being capitalized in this way, the debt of most companies will increase dramatically.
The proposed basic principles for lessee accounting are:
There will be no distinction between operating leases and capital leases.
Leases will be capitalized based on the present value of the lease obligation.
The capitalized lease value will include the base rent as well as residual payments, obligated renewals, and contingent rents.
Rent expenses will cease to exist; the lease will be recognized as an asset financed by debt.
Balance sheets will include a category for leased assets separate from other fixed assets, which include owned assets.
With so much at risk, tenants need to understand the proposed new accounting standards and begin to plan ahead now. In general, tenants should pursue a strategy that maximizes their asset value and liquidity, reduces occupancy costs and liability, and improves their bottom line.
Specific considerations include:
Look into buying vs. leasing. Since your asset will be on the balance sheet anyway, it may be more advantageous to purchase your property or equipment, as is now more customary in Europe.
Negotiate short-term or long-term vs. mid-term leases. Leases of fewer than 10 years will result in higher rental rates but will reflect less debt on the balance sheet.
Review alternatives for creative financing and lease structures. Many corporations have scrutinized how much of their cash is invested in real estate and have been considering options to free up this capital so it can be reinvested in other areas.
An exact date for adoption of the new standards has not been determined. The boards of FASB and IASB are planning subsequent papers on new proposed standards in 2010 and 2011, and there is speculation that these standards won’t go into effect for several years. While tenants can’t affect how quickly the wheels of public policy will turn, they can be proactive and put their own initiatives in motion.
Looking ahead, real estate will continue to present companies with significant risks and opportunities. Whether it’s a tenant’s market or a landlord’s market, you need to leverage every advantage. While real estate remains the number two operating expense, protecting your interests should always be the number one priority.