Archives for August 2022

Owners are offering a variety of concessions and perks to maintain rents.

Interesting and unique factors and conditions have come into play in office rents as concessions, and other incentive packages – including furnished space and “free rent”– have firmly made it a tenants’ market right now, industry analysts said.

Colliers released key office rent data this month, including a positive turn for absorption from negative 0.5 million square feet in Q1 2022 to 3.1 million square feet in Q2 2022.

Meanwhile, asking rents showed little change, with average Class A full-service office asking rates falling by 0.4% to $41.05 per square foot in the second quarter.

The Common Remedy to Past Downturns

Cristina T. Sanchez, real estate attorney at Duane Morris tells GlobeSt.com, “While we have not seen asking rents diminish, we have seen landlords and tenants increasingly agree instead to various rent concessions.”

Examples of these rent concessions include “offering free rent periods at the beginning of the lease terms and tenant improvement allowances. These concessions provide the benefit to the tenant of reducing the ‘effective rent,’ while allowing the landlord to obtain its asking rent, and which may also be helpful with any potential financing.”

Petra Durnin, head of market analytics for Raise Commercial Real Estate, sees mostly the same, calling it a trend that has prevailed through the last two downturns.

“Asking rents are stabilizing because landlords are keeping asking rents higher but are offering increased concession packages for tenants,” she said. “Free rent and more tenant improvement dollars, that can also be converted to free rent, help offset a higher starting rent for the tenant.

“Also, the flight to quality is placing a higher demand on Class A space, which keeps asking rents at a premium. As companies implement hybrid workplace strategies, a highly amenitized, custom workplace is necessary to attract and retain quality talent and facilitate in-person collaboration.

“It’s also possible that in some submarkets, activity is concentrated in Class B product, leaving Class A space on the market and stagnating asking rent. Many companies are still seeking the blank canvas of low-rise, free-standing suburban office buildings to carve out their unique brand.”

Owners Must Keep Rents ‘Palatable’

David Oates, CRO at global commercial real estate data platform, Coyote Software, tells GlobeSt.com, that despite being some way off the record peak of 16.3% at the height of the global financial crisis, office vacancy rates have increased this past quarter to around 15%.

“That means it’s a tenants’ market right now, and so it’s hardly surprising that owners are having to keep rents palatable and offer concessions if they want to see their buildings full.

“If you look at cities like Austin – which has bounced back strongly from the pandemic – landlords there have continued to offer high incentive packages, largely in the suburbs, to ensure that tenants sign or renew leases. In that particular market, it has really paid off and other cities are no doubt sitting up and taking note.”

Jeff Shaw, CEO, Bridge Commercial Real Estate, the office operating platform for Bridge Investment Group, tells GlobeSt.com that in office assets across the country, he’s seeing rental rates either flat or increasing.

“Reasons for this are nuanced from market to market,” Shaw said. “In many cases companies are signing leases where markets have minimal supply, allowing landlords to hold or push rates.

“In other markets where there may be more office supply, the increasing construction costs and free rent concessions have bolstered rents with little push back.”

Some Concessions ‘Not Made Public’

Pierre Debbas, managing partner of NYC real estate law firm Romer Debbas, tells GlobeSt.com that landlords will try to maintain the rents that the public can see as high as possible, but the real change in the market is being reflected in the concessions that landlords are providing.

“Such concessions are tenant’s allowances for construction, free rent periods, or construction credits, which are all higher than pre-pandemic levels,” Debbas said. “Those concessions are not made public and thus are not reflected in the asking rents or rental figures that are public.”

Chicago Market Fairly Healthy

Jim Adler, executive vice president, Office Services Group, for NAI Hiffman, based in Chicago suburb Oakbrook Terrace, tells GlobeSt.com that landlords are answering inflationary pressures by increasing concessions 10% to 15% higher than a year ago, such as higher construction allowances and more rental abatement, to attract new tenants.

“In some cases, they are fully furnishing spaces to eliminate tenant concerns over rising costs and/or delayed deliveries,” Adler said. “These new enhanced incentives are supporting sustained rental rates.”

At the same time, the suburban Chicago office market recorded 2 million square feet of new leasing activity during the second quarter of 2022, up almost 19% over the first quarter, Adler said.

“So, while we’re not raising rents yet, the market is getting healthier and we think 2023-2024 will mark a return to normal yearly increases – the recovery is underway,” Adler said.

NYC, Atlanta, LA Top Absorption Markets

Colliers reported that the number of markets with positive absorption rose in the second quarter, with 53% of office markets seeing a gain in occupancy; up from 49% in Q1 2022.

New York City, Atlanta and Los Angeles were the top absorption markets, followed by Denver, San Diego and Phoenix.

It also reported that the gap between asking and effective rates remains significant. Tenant improvement allowances of $100 per square foot or more, accompanied by 12 to 15 months of rent abatement, on a new 10-year lease are increasingly common on Class A space in several leading metros.

CommercialEdge’s Doug Ressler, tells GlobeSt.com, “The average full-service equivalent listing rate was $37.75 per square foot in July, a decrease of 2.3% year-over-year but up 17 cents over June. The national vacancy rate was 15.1% for the month, up 10 basis points over the past year.”

Source: “Office Asking Rates Haven’t Changed But It’s Definitely Become a Tenants’ Market“

After a strong Q1 this year, firm forecasts continued growth across all asset classes.

With non-traded REIT sponsors continuing to deploy the significant capital raised and long-term investors recapitalizing existing funds through continuation vehicles in high-demand sectors experiencing favorable supply, PwC believes the strong performance thus far in 2022 should continue the rest of the year.

Furthermore, it said, continued consolidation in the listed REIT industry – given the growing importance of scale, growth and capital considerations – will further buoy key sectors.

More opportunities should emerge “given current levels of replacement cost, financing maturities and equity market valuations. These trends are contingent on the absence of any significant deterioration in financing markets.”

A flight to quality, focus on underwriting assumptions (given higher interest rates and inflation), enhanced attention to environmental, social and governance (ESG) considerations, and a focus on portfolio optimization will be the focus as investors deal with rising capital costs, macroeconomic uncertainty and inflationary pressures.

Industrial Sector Cools, Multifamily Thrives

PwC reported that asset-, portfolio- and entity-level transactions in the first quarter of 2022 exceeded the same period in 2021.

“While there has been some cooling in the red-hot industrial space, industrial and multifamily assets have continued to drive growth in transaction volumes,” the firm reported.

In multifamily, a lack of affordable housing continues to be a problem. That sector’s ability to reset rents to market on a monthly basis is an attractive quality.

Retail, Hospitality Volume More than Double

Meanwhile, cold storage, data centers, life sciences and content/media-related real estate “are emerging as cornerstones of real estate investment activity.”

The apparent shift from goods to services is driving more attention to experiential assets (e.g., marinas, ski resorts, golf courses, etc.).

Retail has emerged as powerful given its “proven resiliency” and consumers’ attraction to brick-and-mortar. Transaction volume for it rose 104% versus Q1 2021.

Hospitality transaction volume doubled as well, up 101%. Industrial sector transactions were up 76% and office increased by 62% in the same period.

Source: “Momentum Strong Enough to Overcome CRE Uncertainty, Says PwC“

And would “high” inflation really be all that high compared to the past?

If you think high inflation is a temporary thing and the world will be back to pre-pandemic normal, you’re at odds with some of the world biggest bond investors, according to a Bloomberg report. They figure the Fed’s goal of 2% inflation is largely a pipe dream, which is why they’ve loaded up on inflation-protected bonds, exposure to commodities, and keeping plenty of cash—yes, cash—on hand.

What sustained low inflation during a long stretch of expanding globalization were cheap energy and labor. (Long-term easy monetary supply that central banks kept hoping would juice growth would probably be a sober addition.)

But time for a deep breath. Look up the historical annual inflation rate in the U.S. Plenty of stretches had inflation rates of significantly above 2%, the Fed’s target. Commercial real estate didn’t fall apart.

What can throw people off is looking at the recent past. “To have a market, with low interest rates for more than 12 years, does not follow logic nor the cycle that existed for decades,” Kevin Swill, CEO at Thirty Capital Financial, tells GlobeSt.com.

However, moving back to normal doesn’t mean it will be painless, particularly given the investment strategies that followed those low rates. “Levered investors might struggle to cover debt service and secure loans if cap rates spreads to interest rates narrow,” said DWS Group’s U.S. Real Estate Strategic Outlook for July. “Real estate leasing could also retrench amid job losses and dwindling profits. Indeed, recessions have been the proximate cause of every broad-based decline in real estate prices since the early 1960s.”

Also, higher inflation will mean ongoing higher interest rates as the Fed tries to slow growth. That will affect the entire financing process and its cost.

“The real estate industry runs on credit and the fundamentals of real estate are out of balance,” says Peter Tuffo, president of the south region for Suffolk Construction. “Real estate investment is tied to confidence, and some projects are simply not penciling out. Real estate responds negatively to higher risk.”

“This situation has a significant effect on bridge and short-term loans that become more expensive for developers,” Rogelio Carrasquillo, managing shareholder and cofounder at Carrasquillo Law Group, tells GlobeSt.com. “As a result, programs such as EB-5 and other alternative sources of financing that would not be considered otherwise, become viable alternatives for the financing and development of commercial real estate projects.”

But even then, it’s not all bad news because “inflation could also mean higher rent growth and NOI that could offset some of the impact of higher interest rates,” says Zachary Streit, founder and managing partner at WAY Capital. Also, “We are seeing the trend of more deals getting done with fixed rate financings and some sort of partial recourse or creative financing structures like PACE to offset today’s higher rates offered by floating rate lenders.”

Source: “Should CRE Plan for Permanently High Inflation?“

While coworking provides similar solutions to flex space, there are some key differences. Flex space challenges the idea of traditional commercial offices, which typically require signing long-term leases.

The COVID-19 pandemic changed professional work environments for millions of businesses and redefined the traditional office for companies of every size. Prior to the pandemic, the majority of companies required in-office attendance. Now, an incredible 73 percent of companies plan to support a hybrid work model, with experts predicting that 30 percent of commercial real estate will be flexible office space by 2030. Startups were no exception to this shift. Accustomed to turbulence and adversity, they pivoted to survive just as so many other businesses but with less resources and time. In the ever-evolving business landscape, the strongest and most agile startups adapted to new economic conditions, and many did it by leveraging flex space.

What is flex space?

By definition, flex space is a short-term lease option in commercial real estate that commonly includes typical business needs such as warehouses, offices and retail space. Flex space challenges the idea of traditional commercial offices, which typically require signing long-term leases that lock in businesses physically and financially. Instead, flex space offers short-term options from one to three to six month-leases to provide a tailored approach to office space based on the company’s needs, resources and time frames.

Flex space vs. coworking

In the last decade, the workplace experienced the rise of coworking as an avenue for short-term office rentals and shared amenities between companies under one third-party provider. While coworking provides similar solutions to flex space, there are some key differences. Coworking locations are often branded and require customized build outs within the building location to match specific branding, security and amenity designs, which can be costly, particularly for building owners. Flex spaces, on the other hand, can be located within any building and do not have to be branded by a third-party provider, making it virtually unknown if a company is in a short or long-term lease. In addition, coworking locations require that all companies within the third-party’s office location share amenities such as tech equipment like printers and copiers, the kitchen, lounge areas and conference rooms. Flex space allows for companies to own and customize their amenities as needed. Finally, while coworking spaces may offer flexible lease terms, businesses are often required to pay additional fees to third-party managers, which can add up quickly and hurt companies, like startups, with limited resources.

Flex space for startups

In the last quarter of 2021, 376,000 new businesses were developed in the United States, which is the largest increase in this sector in the past 10 years. With the influx of startups entering the market, there are numerous factors that might cause them to consider flex space as their office solution.

1. Flexibility: It might seem obvious, but for companies in the Series A growth stage and on, long-term leases are restrictive, forcing them to plan and predict for growth as well as setbacks. If a startup faces a severe financial downturn, a traditional lease could drain thousands of dollars in precious resources per month. With flex space, shorter and more flexible time frames provide the ability to adjust as needed based on business performance and economic factors.
2. Reputation: While many may think of startups being built out of a garage, and some are, it can be challenging to secure the right clientele, funding and reputation without the first impression to match the quality of product or service. Through flex space, startups are able to work in the same buildings, floors and office spaces of global enterprise corporations in desirable locations, an opportunity that demonstrates company standards and was traditionally unavailable to businesses of this size.

3. Increased savings: It goes without saying that a short-term lease is a financially sound choice for any startup. In a location like New York City, a 3,000 sq. ft. commercial office space can lease upwards of $16,000 a month. For a startup in a sink or swim industry, a flexible lease can have great financial impact by significantly reducing a new company’s overhead costs. In addition, studies show that 83 percent of U.S. employees prefer a hybrid setup and 76 percent opt out of the traditional work setting, so there is no longer the need to have an assigned desk for every worker. Imagine the amount of underused office space that could be repurposed for technology or warehousing arrangements.

4. Employee satisfaction: Startups experience more employee turnover than any other type of business. Not only are employee departure rates higher, they rank twice the national average at 25 percent attrition. The added expenses involved in sourcing and training new talent makes it important for a startup to retain current employees for as long as possible. According to research from HSBC, nine out of 10 employees feel that the ability to work in a flexible situation, such as being remote or hybrid, has the greatest effect on their productivity. By incorporating flex space into a startup’s initial strategy it can be easier for a company to accommodate a hybrid working arrangement for employees to improve overall performance and productivity.

How to choose the right flex space option for your business

The options for commercial real estate are plentiful, but not all listings are created equal. If your startup is currently in the market for office space, beware of some websites that promote “flexible” commercial leasing options, as many, in fact, are not. Keep an eye on small business reviews that will paint a clearer picture.

In addition, it’s important to recognize that every startup is unique and comes with a different set of workspace requirements, so consider a few key questions prior to searching for your flex space.

• How many employees will be in the office location?
• Will you need space for visitors, guests or clients?
• Will you need retail space in addition to workspace?
• What type of amenities will the company require?
• Will there be any third-party fees?
• Will you have access to the landlord?

Startups are constantly evolving, making flex space the perfect match to accommodate fluctuating needs time frames. The benefits of flex space extend across companies of every size and industry, but for startups, flex space is a necessary solution to maximize flexibility across resources, employees and more to remain adaptable in turbulent conditions.

Source: “Flex Spaces for Startups: An Office Environment without the Commitment“