When the topic turns to tenant improvements (TI), commercial real estate is a tale of two markets.
The office sector, still reeling from the one-two punch of COVID-19 quarantines and the explosion of work from home protocols, is a runaway tenant’s market. In the industrial sector, which since 2020 rose from a utilitarian investment play to an industry darling, landlords are clearly calling the shots.
But no matter who’s in the driver’s seat, both sectors are facing their challenges — even in office. “Tenants are getting more TIs from landlords, but labor and materials are impacting the cost of buildout,” reports Bo Hargrove, SIOR, a principal at Raleigh, N.C.-based Rich Commercial Real Estate. Despite the lengths landlords are taking to get tenants into spaces–retrofitting costs still too often exceed the TI allowances. This appears to be the result of both an inflationary market and the overhang of pandemic-era supply chain disruptions.
And the situation is worse on the industrial side, where in many cases, a “let-them-eat-cake” attitude prevails. Or at least it did up until Q4 of last year. “The attitude was one of, ‘if you don’t like our offer, there are other people behind you,’” says Phoenix-based CBRE executive vice president Pat Feeney, SIOR. If a tenant pushes for more than a typical $12-per-foot TI, it’s on them to pony it up. Happily, he adds, as the market normalizes, “landlords are backing off that severe attitude a little.”
The Challenges of a Tenant’s Market
Note, he said just a little. Supply chain stresses hit their high point in September of 2021, says Cushman & Wakefield in its “Americas’ Office Fit Out Cost Guide.” Those stress levels have “fallen 22% from their 2021 peak,” according to the report, “but remain 23% above the pre-pandemic levels of January 2020.” And that will have a telling effect on project execution, which will remain at current extended timeframes, “as opposed to worsening or improving.”
The same diminution of stress relates to the labor market, another cause of both delays and cost hikes. Some 47,000 nonresidential construction jobs were lost during the pandemic. Approximately 37,000 have come back, with another 2,000 anticipated for the year. But further job losses are expected as older construction workers reach retirement age. “In order to attract talent to these open positions, the sector has raised wages consistently and significantly over the past six quarters,” reports Cushman.
Indeed. A wage increase of 14% as of Q2 2023 nearly triples the construction employment growth rate of 5%, says the report.
The media says tenant decision makers need to entice people back to the office with beer and pizza and free gym membership. But people don’t choose to work in a location because of beer and pizza.
So intense is the labor shortage in certain areas that municipalities are taking action, although not action that can help office landlords or tenants. “Raleigh just announced they were temporarily pausing issuance of what they call express review permits,” says Hargrove. “So, it’ll be very difficult, at least for the near term, to get a permit for construction here. They just don’t have the staff or capacity to review the permits being submitted.”
What office requirements are the most expensive to spec? According to the Fit Out Guide, electrical is the dubious bellringer at 21% of the total fit out cost. Coming in at #2 are mechanical services. In terms of the commodities, steel prices have come down from their covid-19 highs, but only by about 1% and 4% quarter-over-quarter. However, they are expected to level off this year. Lumber has come down 12% year-over-year, and will remain flat through 2024.
But what exactly are tenants looking for? London-based iPWC director Mark Bradshaw wonders: As a workplace strategy consultancy, iPWC sees “two different types of tenant improvements. The media says tenant decision makers need to entice people back to the office with beer and pizza and free gym membership. But people don’t choose to work in a location because of beer and pizza.”
They’re looking instead for engagement and collaboration “in an environment that supports their safety and wellbeing,” he says. Corporate decision-makers “need to adjust their environments to support those needs.” Bradshaw’s clients are looking for–or are counseled to look for–amenities that support deeper and more meaningful relationships. In the office sector it means spaces for collaboration and chance meetings that can spur innovation.
Industrial’s TI Struggles
No matter the goal of an office renovation, it carries with it a built-in relief valve against the stresses of labor shortages and material delays. Assuming the bones are sound, a tenant can go with an off-the-shelf door or light fixture while they wait for the custom stuff to come in. Not so in industrial spaces.
“Cities won’t give you a certificate of occupancy until everything is installed,” says Feeney, and in industrial there’s no off-the shelf equivalent to a crash door, a dock leveler, or a 3,000-amp electrical service. “The lead time on 3,000-amp service is between 12 and 15 months. The tenant can be in the building, and he can assemble his material handling equipment, which will take four or five months, but he can’t turn anything on.”
For the record, industrial fit out costs were still elevated as of Q3 2022, at 11.4%, though happily down from the previous quarter’s 15.4%. In the industrial equivalent of the Cost Guide, Cushman reports that most surveyed general contractors expect their costs and supplier prices to increase.
Communication and Flexibility
As we wait for the supply chain disruptions to recede fully, we wait also for the current inflationary market — an obvious culprit in the overall price-hike scenario — to dissipate. The economy in general and the real estate market in particular caught a bit of relief when the Federal Reserve recently passed on yet another interest rate hike. What that means for prices for the remainder of the year — or if the Fed can avoid future increase — clearly remains to be seen.
But while we wait, deals still need to get done. Enter the broker.
That’s not to say their solutions are easy. “It’s a struggle every day and with every deal,” says Hargrove.
“There's not a whole lot you can do to mitigate timing and cost,” he says, pointing to a little wiggle room, at least in terms of the former, “if you start the project early enough.”
For that to happen, some flexibility on the part of the tenant might be called for. “They may have to make concessions they might not want to make in the negotiation of the letter of intent or lease document,” he says.
Feeney agrees, especially as it concerns flexibility in the face of specific schedule and cost hurdles. “Neither the tenant nor the landlord can control all these issues,” he says. It’s key to establish a team approach to overcome the hurdles that exist outside their mutual control.
And everybody wins.
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