A stabilization trend is taking place in commercial real estate sectors, but in most markets rent will remain soft except for multifamily rentals, according to the National Association of Realtors®.
Lawrence Yun, NAR chief economist, said a pullback in construction is helping stabilize the market. “Very limited construction of new commercial real estate over the past few years has essentially fixed the supply of available space,” he said. “This means vacancy rates could fall quickly from any increase in demand for commercial space.”
From the first quarter of this year to the first quarter of 2012, NAR expects vacancy rates to decline 0.5 percentage point in the office sector, 1.3 points in industrial real estate, 0.1 point in the retail sector and 0.9 percentage point in the multifamily rental market.
“Even with declining vacancy rates, rents are not likely to turn positive in most markets until next year, outside of multifamily rental properties,” Yun said. For example, office rents are forecast to fall 1.8 percent this year before turning higher by 4.0 percent in 2012.
“Apartment rent increases are expected to accelerate from job creation leading to new household formation, particularly among the young adult population who will seek their own housing arrangements – many will be leaving their parents’ homes, or choose to live with fewer roommates,” Yun said.
Average apartment rent is projected to grow 3.4 percent this year and another 4.2 percent in 2012.
“Rising apartment rent in combination with rising oil prices could push the overall inflation rate beyond a comfort level, which could then force the Federal Reserve to raise interest rates later this year or early in 2012,” Yun added.
The Society of Industrial and Office Realtors®, in its SIOR Commercial Real Estate Index, an attitudinal survey of more than 360 local market experts1, shows a notable improvement in market fundamentals.
The SIOR index, measuring the impact of 10 variables, rose 8.1 percentage points to 50.7 in the fourth quarter, the largest quarterly gain in five years, and is at the highest level since the fall of 2008. However, the index is well below a level of 100 that represents a balanced marketplace. This is the fifth consecutive quarterly improvement following nearly three years of decline, but the last time the index was at the 100 level was in the third quarter of 2007.
Seventy-eight percent of SIOR participants expect improvements in the office and industrial sectors for the first quarter of this year.
There has been an increase of liquidity in Commercial Mortgage Backed Securities, which is helping to open the commercial market to more property transactions; commercial real estate sales had been stalled over the past few years with excessively tight credit conditions. In terms of development acquisitions, it remains a buyer’s market for those with cash or who can obtain credit financing.
Eager investors are pushing cap rates on well-leased, Class A properties in top-tier coastal cities to their lowest levels since 2007.
Does the drop signal a widespread commercial real estate recovery? Or is it the beginning of a mini bubble? Robert White, CRE, CEO of New York–based Real Capital Analytics, weighs in.
What factors are contributing to the rapid price increase and cap rate declines in core commercial properties?
Capital is looking for yields, and real estate is offering pretty attractive returns compared with money market funds or the stock market. Real estate also has a special attraction as a hard asset, which makes it valuable as a long-term hedge against inflation. So everyone is concluding: “If I can buy a well-located, stabilized office building in a large, high-barrier-to-entry market, my risk is low.” That’s pushing up prices.
So it’s a familiar story of a lot of capital chasing relatively few properties?
There’s definitely a concentration of capital looking for core office. In 2010, about 75 percent of the deals tracked by my company were core property purchases in markets like New York and San Francisco. The competition for product is producing cap rates in the mid-5 range. That’s a big spread when you consider that the average office cap rate nationwide is closer to 8.
Are these lower cap rates justified?
A lot of my clients ask me that. I don’t think most buyers will have to worry about overpaying. Even at a 5 1/2 cap, there’s a 250-basis-point cushion in the risk premium spread over 10-year Treasuries. In 2006, when we last saw cap rates this low, properties were trading at cap rates at or below Treasuries. Add to that the interest rates at near historic lows and an investor can still have positive leverage.
What about fundamentals? Do they justify the price increases?
Fundamentals are going to improve, and since most of today’s institutional and REIT buyers are looking at much longer time horizons than buyers were a few years ago, they have time to wait.
Do you expect current investors to keep bidding up core office prices in 2011?
No, the gap in the market in core pricing between first- and second-tier cities is already beginning to close. Investors—especially nontraded REITs, which have more geographic flexibility than some publicly traded REITs and institutional buyers—have already started to look for alternatives that provide higher yields. At the end of 2010, you were beginning to see more investment in core office properties in smaller cities like Minneapolis, Richmond, and Salt Lake City. The loosening of the credit crunch and the revival of the CMBS market should also support investment in smaller cities. The loosening of the credit crunch and the revival of the CMBS market should also support investment in smaller cities
We’ve focused on the price appreciation in office buildings. Are you seeing similar higher prices and lower cap rates in retail and industrial properties?
To a certain degree, yes, especially in larger retail centers with a grocery or big-box anchor. Over the last nine months, we’re beginning to see trades at cap rates in the mid-6s. Some of the same investors that have been bid out of a trophy office property have started to look at retail. Industrial has been more of a laggard.
The office market is making movement. If you have been sitting on the sidelines, now may be the time to get into that new space. Vacancy is down and rents are ticking up.
Recently, there were two high-profile industry conferences. The overarching theme for both was the same: The market is flush again with capital and capital providers looking to lend. Several insights emerged from these two conferences, including:
Money is available. Life insurance companies believe they will lend $32 billion to commercial real estate—double what they invested in 2009.
Additionally, six new commercial mortgage? backed securities (CMBS) conduit lenders are taking applications and actively making loan quotes.
The market is broken into three tiers. Tier 1 is life insurance companies, which are seeking the highest quality deals with the best borrowers, the best products and the best locations. They will price loans accordingly—as low as 5.75 percent. Tier 2 represents the banks. Bigger and/or healthier banks will “reach up’ to Tier 1 and compete with life insurance companies when they can. Smaller regional banks, on the other hand, will reach down to Tier 3 and, accordingly, they will price higher. Tier 3 is made up of finance companies and conduits who can’t compete with these lenders—or who choose not to compete because of yields. However, capital and capital providers are actively financing again with an interest rate range of 6 to 8 percent.
Loan-to-value is no longer a driving force in underwriting. Lenders are uncomfortable with market fundamentals and therefore the question of the true value of commercial real estate. Lenders are underwriting against debt service coverage ratio and debt yield. Debt yield is the ratio of verifiable net operating income divided by the principal balance. Lenders want a debt yield number between 10 and 12 percent, down from 12 to 17 percent.
Apartments, office, industrial and retail are the primary property types of interest to lenders. There is some appetite for hotels and medical offices. There is light appetite for vacancy—in-place income is key. There is also capital available for the borrower who needs to improve a property but doesn’t have the necessary Funds– but it will be expensive.
Interest rates will be flat to lower in 2010, and, as the year progresses. Over the next three years, interest rates will rise.
Proceeds seem to be in the 60 to 65 percent range but competitive pressure throughout the year should move life insurance companies to 70 percent and CMBS conduits to 75 percent. There is an outside chance that by year-end, a momentum play will create venues in the 80 percent range.
Lenders are motivated to make new loans because doing so helps to mitigate the risks in their existing portfolios.
There seems to be no way to differentiate one capital provider from another. They think alike and seek alike. Working with an experienced financial intermediary can help ensure that lenders select the right deals with the right structures for the right reasons. Relationships will be important.
The business decision to relocate or renew your office lease is a complex process and one that can significantly impact the performance of your company.
When considering your new office premises, it is critical to address the following questions:
What are my options?
Stay put: If your current space satisfies your business needs, but you are approaching the end of your lease, you may wish to consider renewing your lease. You will need to ensure the space is available, and then negotiate a new lease with the building owner through your tenant representative. However, no decision to renew your lease should be made without a thorough market evaluation and the introduction of competition for your tenancy into the dynamic of the renewal negotiation.
Relocate: The expiration of your lease could offer you an opportunity to transform your business and create new efficiencies by relocating.
Why should I relocate?
Business needs and Economic Benefit: If your current space is too small, too large, or inflexible relative to the way your organization works, a new office can energize your organization and act as a springboard for improved productivity and operational cost savings. Additionally, market conditions may create cost benefits supporting the business case for relocation.
Brand value enhancement: The quality of your building and the tenant improvements in your office space speak volumes about your organization. A renovated office space or new building can strengthen your employees’ perception of your core values and elevate your brand in the minds of customers and other stakeholders.
Employee satisfaction and retention: By repositioning your business and employees in an improved work space, you will realize increased staff morale and productivity. Our market research showed that even subtle changes in the work environment have created substantial gains in productivity, resulting in improved bottom-line financial performance.
How much will it cost?
Operational costs: The negotiation of rent and tenant incentives is dependent on the dynamics of the market. In certain areas, the development cycle has created higher vacancy, which favors tenants. In other markets, low vacancy gives landlords the upper hand in negotiations.
Tenant improvement costs: Your entry and exit strategy to a lease can greatly affect the real cost of your commitment. Workplace design and tenant improvement costs should be viewed as an organizational opportunity—a well-planned and executed tenant improvement will adapt to your organization’s growth and changing needs and minimize disruption costs. Balancing your tenant improvement costs and the benefit it yields to your organization is critical. In addition, “make good” commitments will affect your cash flow when exiting a lease.
When should I start?
Plan, plan, and plan: Whether you decide to stay or go, knowledge is key. Allow sufficient time to ascertain your current situation, review other options, assess the marketplace context and negotiate with your current landlord to ensure you optimize the end result.
Timing: The period required once decision is made just to conduct the lease negotiation and relocation process ranges from three to six months at a minimum. Depending on the size of your organization and the current market conditions, you should prepare to begin this process 12 to 18 months prior to your lease expiration. For larger companies it may take two years or more to complete the lease and relocation process.
Whom should I involve?
Your internal steering committee should be led by a senior employee, and supported by decision-makers and influencers including human resources, IT, divisional heads and staff. A single point of contact from your organization, matched with a single point of contact from your real estate advisor is an ideal match to make the process run smoothly.
You may wish to conduct a survey of your staff to determine their needs, preferred work style and location. Your tenant representative can conduct a needs analysis survey of your staff to determine the impact of relocation on commute times and employee retention.
Professional real estate advice is a critical part of the project team. This will arm you with insight into the marketplace, your alternative options and the financial implications of the stay or go scenarios. A skilled design professional and construction manager will complete the team by providing knowledge of productivity-enhancing tenant improvements.
When young soon-to-be professional people join the workforce, they are inundated with tips on what to wear to an interview to get an edge over other applicants. Advice such as “dress for success” and “you only have one chance to make a great first impression” might have been given freely by family and friends. Surprisingly, the advice is pretty much the same as it relates to how you outfit your company’s office space.
Good people are hard to find and money is one way to recruit and retain employees, but it’s not the only way. Environment is very important too, so you have to be mindful of that.
Although today’s job market favors employers, this market, like all markets—good and bad—will turn. And when it does, employers could find themselves scrambling to not only fill newly created jobs, but also to fill newly vacated ones.
According to a recent survey by The Conference Board, a nonprofit organization that conducts research and tracks trends for business executives, only 45 percent of employees surveyed say that they are satisfied with their jobs. Furthermore, according to the website CareerBuilder, one in five employee’s plan to leave his or her current job sometime in 2010. Should this “Great Employee Exodus” (as it’s been dubbed in the media) occur, it could affect a business’ bottom line. On average, it’s estimated that it costs a company one-third of a new hire’s annual salary to replace an existing employee. For a minimum-wage job, that cost is estimated to be approximately $5,026.
Today, employee retention is more of an issue than it has been for past generations. There is more mobility in terms of job changes for anyone in the workforce under the age of 40. Turnover means extra costs for a company. Companies are using their office space to recruit and retain top talent.
Shared Environment
To attract employees who share your company’s values, it’s important to create a work environment that rings true for your company’s culture. There always seem to be those companies out there who want to be the most posh. However, there are companies that have consciously gone the other way. They want their offices to be easy on the eyes, but not over-the-top opulent.
Many companies want to create an environment where, regardless of your position, you can feel comfortable talking with a partner at the firm. So anyone who walks into their offices should get the impression that they are practical and efficient. The space shouldn’t leave guests intimidated.
You can tell a lot about the spirit of a company by its office design. Most people don’t want to be in a closed-off organization; they want transparency. They want a friendly, efficient work environment. People work in places because they like the culture and the collegiality.
Some want the workspace environment to deliver a positive, uplifting response when their employees come to work. What matters most to them besides working for a great company is a good work?place environment.
When I am out with clients finding the new space, employee recruitment and retention is always at the top of the list.
The move is a part of many companies recruiting strategy, and the space they chose reflects their creative culture. Designing workspaces that foster a team-oriented culture and attract, motivate and retain top talent by providing a workplace equal to what they would find in New York or London.
Many college graduates entering the workforce today are placing more value on a company’s commitment to social responsibility. In a 2009 study by the Harvard Business Review, it was found that 75 percent of U.S. workforce entrants saw social responsibility and environmental commitment as important criteria in selecting employers. More and more companies are taking note of this trend when selecting new offices.
Many choose a building with a LEED (Leadership in Energy and Environmental Design) -certified shell and core. They are interested in sustainable design and want to see what could be more environmentally sensitive.
Location, Location, Location
An office’s address is another factor that potential employees take into account, considering transportation options and nearby amenities like shops, services and restaurants (more about the future tends with CRE is in my special report “Real Estate Outlook: 2010 and Beyond“). This will allow them to increase their overall connectivity to the city and recruit employees from the entire metropolitan area.
Some companies are choosing to relocate to areas that are untried, but promising. With their new offices in an emerging mixed-use neighborhood. In addition to office, there will be residential and entertainment components as well.
Non Traditional
When designing a new space or redesigning an old space, there are certain elements that employers should take into account that boost productivity and creativity—such as natural daylight and common areas for staff to relax or collaborate. For example, a “touch-down” area for employees dropping into the office and an oasis space that replaces the traditional coffee room, as well as an exclusive staff training rooms and an outdoor urban forest.
Many are going with a high ratio of conference and “huddle” rooms, as well as an expansive, 3,000-square foot decks—complete with glass canopy and fireplaces, again creating a comfortable work environment.
You listen to all of the HR studies and the differences between a [baby] boomer and someone just graduating from the university. New graduates want a professional environment, with the opportunity to grow. If they don’t have that opportunity they won’t stay. So you need to have a perceived order to your professional space. It’s a bit of a road map—how you lay out your space should indicate how things are done in your office, who employees can go to for assistance, and how employees can advance in their careers. And take into account the differences between generational work styles. Adding elements to the workspace that may seem insignificant can be very effective.
The average workforce today is about 35 to 40 years of age, and they are used to multitasking. That’s the environment they’re comfortable in, for instance, you might add a flat screen T.V. in view of your associates’ desks that continually displays stock pricing.
In the end, designing or choosing office space really comes down to creating an environment that attracts the type of employees you want to attract, and then keeps those employees happy and productive.
Employers need to establish a social fabric internally. It helps to connect people and makes a company more comfortable to stay with.
Knowledge of environmental issues facing commercial buildings is rapidly becoming a necessity. Demand for “green” space is on the upswing, with governmental agencies leading the charge for LEED and Energy Star certified buildings.
So how do you incorporate green principles into your office leases? Sure, you can take the easy way out and add a couple of plug-in green terms to your traditional office lease. Or you can think green every step of the way, by establishing sustainability goals, looking for a site within LEED/ Energy Star parameters, using an RFP with LEED/Energy Star related questions, preparing a letter of intent with core green business terms–and ultimately drafting a lease that incorporates green policies and tracks LEED/Energy Star guidelines.
Tips for greening your office lease:
Clearly define the roles of all parties to the lease, including which party is responsible for obtaining LEED/Energy Star certification and when.
Make sure you spell out which LEED/Energy Star rating system is applicable. There are many.
Be sure to allocate environmental incentives such as tax credits and rebates, between the parties.
Spell out the landlord’s obligation to stay green—to maintain the green building systems and certification.
Consider a long-term lease (i.e., 10 or more years).
Create a qualified team (attorney, engineer, and other consultants) who are experienced LEED/Energy Star professionals.
Building Rules and Regulations – The lease exhibit stipulates a building-wide recycling program.
Gross lease format with appropriate escalation clause and expense stop clause to reward landlord for operating a high-performance building.
Appropriate operational procedures and building control/management systems for charging tenants for after hours/excess energy usage, supported by appropriate lease language.
Right to Audit – This lease clause protects the tenant from overcharges and defines the audit process to protect the landlord from frivolous audits.
Hazardous Materials – A clause that defines what it is and that neither the landlord or any tenant violates laws or regulations regarding the hazardous materials.
Green Cleaning Specifications – This lease exhibit should define the materials, procedures and protocols for cleaning the building in a sustainable manner.
The lease renewal process can be a time consuming and repetitive task, often requiring a large percentage of corporate time. For companies with dozens or hundreds of employees, the challenges of managing the ongoing lease renewal processes can drain valuable resources that would be better directed elsewhere.
Following a traditional approach, large companies will manage the real estate lease renewals for each location in-house, based on the rationale that lease renewals are easy and inexpensive when managed internally, and that outside brokers will impede or cause problems with the process. But when you factor in the time for each negotiation, including internal staff discussions and meetings, research into current market values per location and the back-and-forth with the landlord’s agent, a corporation will quickly find itself extremely busy. And when nearly 100% of the corporate time and efforts are dedicated to lease renewals, the team is unable to focus on higher corporate priorities.
Companies often discover that time dedicated to lease renewals is better spent on strategy and that trusting the renewal process to a trusted advisor can free up scarce internal resources for maximum corporate benefit.
Selecting the Right Partner
Whether it is designing a new headquarters, IT, asset management, human resources or a new product line launch strategy, outsourcing discrete projects provides a neutral, outside perspective and allows companies to maintain focus on core business strategies while addressing internal needs.
Companies outsource every day – from accounting and administrative support staff to janitorial and food services to financial and marketing strategy – accomplishing the same goals without sacrificing internal staff on a time-consuming, sometimes repetitive or short-term, project.
Lease renewal is a time-intensive process that may also be managed by an expert to avoid incurring unnecessary costs at each renewal.
When renewing a lease for a specific location, the best outcome is a commercial agreement that utilizes the leverage of the firm, maintains a positive relationship with the landlord, provides flexibility for the future, and includes incentives or value-add for necessary or cosmetic upgrades, or reduced rent. Companies want each lease renewal handled with care to a favorable result, so finding the right trusted advisor is a critical success factor.
When managing real estate assets across multiple properties, regions or even countries, a company’s ideal partner is a preferred provider with multi-market experience. Although each lease renewal situation is unique, the right partner should meet specific criteria, including:
Commercial Skill – Partner (or expert team) should have experience in the commercial market, and possess good judgment and experience in contractual matters..
Communications and Diplomacy – Partner should communicate the needs of the client to the landlord and then communicate the position of the landlord in a respectful, courteous and business like manner, as if the partner was an employee of the company.
Results Oriented – Each renewal should be managed in an accurate and timely manner, letting the results-oriented partner successfully complete the assignment, minimize disruption of the operation and move on to the next task.
Analytical Ability – Every negotiation presents its own set of options and alternatives for the company. The partner should be able to present all reasonable options to the company, with a strategic recommendation for how best to move forward. Analytical skill for lease versus lease, lease versus buy, along with the many concessions (landlord and tenant) and incentives, is an important trait.
Hidden Costs
Putting too much faith in the relationship with the landlord (or management company) for cost savings is a mistake many companies make in the lease renewal process. Each landlord has a business to run, and has factored in a renewal commission and allowance for vacancy in their budgets. In a straight tenant-landlord negotiation, tenants believe they can negotiate this commission away, whereas landlords find ways to create sources of one-time profit within each renewal. Landlord budgets and rental rates reflect these renewal commissions simply because landlords would be naïve to assume that every tenant will renew in place and commission payments are not required.
Managing the Process
The true nightmare scenario is a lease renewal negotiation that goes badly, and ends up costing the tenant more money than expected or budgeted, or, worse, the loss of the space without a backup plan. So how do companies delegate the renewal process, yet maintain quality control? The key is delegation with control.
When outsourcing the renewal process, it is the preferred provider’s responsibility to work with the company to understand the business strategy, individual tenants’ needs today and tomorrow, and to create a plan to effectively communicate those needs with each landlord.
Lease renewals typically follow the same process:
Corporate sets strategy and engages a partner
Partner relies on local support to negotiate on behalf of corporate with the landlord
Partner communicates deal progress
Partner reports deal success and surveys for best/worst practices
Outsourcing the lease renewal process for all locations across the enterprise allows the corporate real estate team to reallocate internal resources to focus on business objectives, while a trusted partner with expertise in commercial real estate and a presence in the local market negotiates a new agreement.
By utilizing a trusted partner and a pre-determined strategy, including professional representation, optimum timing and extensive market research, tenants can successfully renew each location’s lease with a positive outcome. At the end of the renewal process, the client will have advanced their business objectives while negotiating multiple lease renewals that meet their needs today and tomorrow.
Deloitte has released their report titled “Perspectives on Real Estate: Uncovering Opportunity in a Distressed Market”. It is a good read. You will find that it pretty much tells you everything we already knew was broken, that we are facing problems with:
Declining Real Estate Values
Debt Maturity and Credit Access
Stalled Construction
Unfortunately, the rest of the report is filled with uncertainty; terms like “could be”, “may be”, and “are expected to”. Which leaves us in the same place we were in 2009, except it seems organizations have given up on trying to call a bottom. The concluding paragraph does a pretty good paragraph of summing things up:
“Will 2010 be a positive year for U.S. commercial real estate? The outlook is, at best, uncertain. The sector likely will see continuing pressure on operating results across every asset class. While the hospitality and residential markets may have bottomed out, neither will start improving significantly anytime soon. Many assets will continue to be challenged by declining occupancy rates and property values, debt maturity issues and credit restrictions. New construction projects are expected to be few and far between. As the economic recovery begins to gain hold, much of real estate’s revival will depend on the pace and strength of job growth. Some opportunistic buyers and realistic sellers will complete deals in 2010 that could prove to be very positive for investors. Realistically, however, it will be 2011 or 2012 before the United States sees significant increases in real estate value and a corresponding uptick in the industry as a whole.”
