The TI Conundrum

The modern workplace is expensive to build. Technology alone can add millions of dollars in cost to an office buildout. Even though construction costs have pulled back since the pandemic began, costs to build the sticks and bricks in an office are near historic highs.   

  The Grand Bargain    

Landlords are willing to make a great tradeoff: if the landlord gets near his or her asking rental rate, then ownership is often willing to ladle in huge concessions in the form of free rent and something called a tenant improvement allowance (TI).   

TI allows end users to go a long way towards building handsome spaces with the latest technology with little to no “out of pocket” cost. Fold in the free rent and sometimes, in strong credit situations, the building owner will agree to “turnkey” that bougie office space at no out of pocket cost to the tenant.   

And so it went. The landlord gets higher face rates on the building with long term credit tenants. All this equals huge value for ownership and allows advantageous refinance or sale options.   

FOT  

Now that 2020 has happened and executives are wisely being very cautious with capital, there is a strong sense of a “Fear of Term.” FOT means many companies are trying to either (a) dump space in any way possible, or (b) commit to the shortest term possible.   

“Let’s see if we get a little paint for an 18-month term extension,” an executive told me recently. “Oh, and see if you can get the landlord to take back all the space on 22, while you are at it.”  

His Needs Her Needs  

In 2019 and for many years prior, the Grand Bargain between landlords and tenants worked. Now that corporate America is being understandably cautious stewards of company resources, something will have to change.   

I’ll not extensively debate here the need for office space in 2021 and beyond as we have seen ad nauseum, the argument about how much office space we will need going forward is raging now. I fully believe most companies will find the pendulum always swings in the office space demand game. It’s swung VERY hard one way now, but it will swing back once we settle down from our health crisis.   

But what are corporate executives to do once they have clarity on the other side Covid 19? If they are only willing to commit to extremely short terms, they will confront some pretty extensive tradeoffs and very high costs. I tell people that committing to very short terms is the real estate equivalent of eating out at every meal. It’s easy and delicious but pretty hard on the bank account.  

Approaches  

 Let’s assume we are post COVID-19 and also further assume you are in the majority of American companies that WILL come back to some level of office use. You have some options in your decision making for near term lease expiration dates.  

Of course, you can kick the can down the road and extend in place for 18 months. But that old space may not work (too dense) or it could now be in the wrong location to attract and retain the best talent. 

So what if you need to locate into a new space? 

First, the end user can write the check themselves for build-outs. However, it’s somewhat counter intuitive to commit to a 24-month lease and spend millions of corporate capital required to make the space look and feel right.   

Second, executives can work with their broker to negotiate termination options. Companies are much more likely to be successful in markets like San Francisco, Los Angeles and New York given the obvious shift in leverage to tenants. Be aware that a termination option kills value as investors will only recognize the lease term up until the termination date. Also, termination options can have nasty fees attached if they are deployed.   

Third, corporates could examine a serviced office approach. Flex work providers like WeWork would be happy to talk about “enterprise” solutions. Many landlords are developing their own “white label” flex work options as well. Translation? You can take occupancy of fully furnished office space with a very short term of say six, 12 or 18 months. These are great options with two drawbacks: you will have to take the space largely as is, and the monthly cost will be well above the traditional real estate market rates.   

Finally, in 2021, wily executives can stare deep into their crystal ball. They can evaluate business risk based on their years of experience. They can order their brokers to maximize leverage and know that for the vast majority of corporate America, the need for office space is not going away. Then they can take advantage of the office market equivalent of a Black Friday sale…and commit to medium term (five to seven year or even a 10-year look with flex options).   

Given the current sale on office space in many U.S. cities, the results of a reasonable forward commitment will likely be fantastic. Buy low, sell high.   

 And when and if you do, I bet even your CFO will smile at the results.