“In 2024,” writes design firm Gensler, “organizations will continue to plan for in-person experiences in spaces that are agile and flexible enough to evolve with the changing demands of the workforce and useful enough to earn people’s commutes.”
But what exactly constitutes agility and flexibility? And are those goals as realistic for a small corporate tenant as they are for larger, presumably deeper-pocketed, occupiers?
Certainly, those two types of tenants share the same challenge. Given the widespread popularity of so-called hybrid work protocols, that challenge is to create an environment that actually draws employees away from their kitchen tables and into the office. Or, as CRESA senior vice president, Ralph Benzakein, SIOR, puts it, “a lot of tenants have realized it’s more beneficial to have people in the office. We work better as a company when there's synchronicity.”
But overcoming the allure of working from home (or the local coffee shop or anywhere else a worker might plug in) appears to be an uphill battle. Gallup late last year reported on the rise of hybrid working: “In 2019, 60% of remote-capable employees spent their week working fully on-site, whereas that figure has fallen to just 20% in 2023. In contrast, only 8% worked exclusively remotely in 2019, compared with the 29% of remote-capable employees who are fully remote today.”
Further, pulling out all the stops to make the office more appealing than the local Starbucks can be an intensive, expensive proposition. Especially if it includes such recommendations as Gensler’s environmentally conscious design and fostering the human connection, all in city centers built around a 24/7 lifestyle.
It could be argued that, given the current woes of the office market (In January, The Wall Street Journal put the national office vacancy rate at 19.6%—the highest since 1979), we are in a clear tenant’s market, and landlords across the country are rolling out the red carpet for whoever walks through the door. But, in reality, much of that leverage is being eroded by inflation.
“It is a tenant’s market in a lot of ways,” says Street Jones, SIOR, principal of Rich Commercial Realty in Raleigh, N.C., “and we’re getting more concessions than before the pandemic. But we’re seeing many of those concessions getting chewed up by construction and related costs.”
Benzakein, who is based in Melville, N.Y., agrees. Although he explains that suburban markets such as his have been slightly less impacted by current economic conditions than the major markets, tenants there are still feeling the pinch.
“In a typical supply/demand model, an abundance of supply would bring down prices,” he says. “You can’t use that model today, because owners’ costs haven’t gone down. They’ve done the exact opposite.”
As a result, tenants might squeeze an extra few bucks into owner-funded tenant improvements, say an additional $5 or $10 a foot, depending on how much term they are willing to commit to. “But it won’t buy them what it did four or five years ago,” says Benzakein.
It’s the smaller square-foot tenants that are the most active right now,” says Jones. “Could owners sit on the space and get a larger user down the road? Maybe.”
UNEQUAL EQUALS
In one sense, there is not too much of a difference between small and large occupiers. “All tenants, small and large, are asking for the same things,” says Benzakein. Clean, well-lighted places that combine health and safety with an appealing, functional design is the Holy Grail for all takers. How they go about getting that is where the delta comes in.
“Smaller tenants are more cash-conscious,” says Jones. “They’ll try to maximize TIs and push on free rent.” It has been his experience that larger tenants tend to focus more on the longer game and rate breaks. “They’re more inclined to self-fund improvements if necessary as they tend to have more access to capital, and often at a lower cost than if provided by the owner and amortized in the deal.”
Smaller tenants can also take advantage of second-generation spaces that might already have built in the amenities designated as necessary. “Smaller companies, since they don’t have the negotiation power, often look for buildings that already offer all of these extra amenities,” says Frankfurt, Germany-based Tobias Schultheiß, SIOR, managing partner of Blackbird Real Estate GmbH.
Those amenities can include meeting rooms, upscale grab-and-go eateries, or even game rooms and libraries, he says, all designed for the use of the entire tenant population. He tells of one investment colleague who refurbished his downtown Frankfurt building specifically to cater to tenants in such need. “It’s calculated in the office rents.”
“It’s very important for smaller users in a relocation to find second-generation offices that provide the amenities they can’t justify in their own spaces,” agrees Jones.
We should note here a significant difference between U.S. office design and that in Germany. While guidelines for sustainability are growing in the U.S. and becoming more of a mandate on the part of municipalities and stakeholders, office standards that support occupant health and safety are a matter of law in Germany. Loosely translated as “Workplace Guidelines,” the law dictates such musts as a minimum worker space standard of 10 square meters and energy efficient lighting. Unlike here, “It’s not allowed legally to offer space without windows,” says Schultheiß.
All of this serves smaller tenants and larger in equal measure, he says. Of course, interior design that does not affect health and safety, considerations such as the quality of carpet and paint or the choice of more or less wood paneling, are still subjects for the negotiation table.
Building owners, of course, have choices to make. SIORs indicated that now, more than ever, smart owners are recognizing the need to appeal to the smaller tenant now rather than hold out for the possibility that a larger taker might come down the pike in 12 or 18 months.
ROLL THE DICE?
“It’s the smaller square-foot tenants that are the most active right now,” says Jones. “Could owners sit on the space and get a larger user down the road? Maybe.”
And maybe not. It is a game of chance, or as Benzakein puts it, building owners “have to thread a needle” between filling a space and filling it profitably. “They’re not going to make a deal that will lose them money.” And even if they’re leaning toward a “yes,” their lending institution—especially if the building owner is flirting with a refi–might lean in the other direction. “Sometimes the go-or-no-go decision is out of the owner’s control.
“A tenant can come in thinking the landlord is dying to have them,” he continues, “and it’s true. But no landlord will enter into a transaction that’ll make his building cash-flow negative.”
LEASING PHILOSOPHY
Holding out for a larger occupant or dividing spaces to take advantage of a (smaller) bird in the hand is more than just an economic call. “It’s about philosophy and not about the individual tenant,” says Benzakein.
Well, maybe it is a little bit economic. “It all depends on how hard the last 18 months hit the owner,” says Schultheiß. One might stand pat and refuse all upgrades in confidence that, once in, they won’t leave. “But that’s rare. Most owners are very open to accepting a lot of tenant requirements,” especially if that tenant is already in the building. After all, there’s always the building across the street, managed by a company that might very well have a different leasing philosophy. “One thing I learned in my first year as a professional is that it’s always cheaper to keep than to find a new tenant.”
Smart owners seem to agree. They are not waiting for tenants to come to them. They’re bringing those features into the building with the recognition that many smaller tenants can’t have amenities within their space.
“Smart owners recognize that the market has changed,” Benzakein says. “They recognize that there’s a flight to quality, and they want to be included in the group of buildings that can be considered by smaller tenants.”
This article was sponsored by the SIOR Foundation - Promoting and sponsoring initiatives that educate, enhance, and expand the commercial real estate community. The SIOR Foundation is a 501(c)(3) not-forprofit organization. All contributions are tax deductible to the extent of the law.
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