Go Long or Short? Market Changes Affect Office Leasing Decisions
Office tenants have to contend with a variety of changing market dynamics in determining whether to go long or short on a lease. Decisions can have a big impact on their bottom line.
Real estate experts say rising rents and construction costs, escalated by an extended economic recovery, are leading many businesses to enter into longer-term leases in order to lock in today's prices. But at the same time, new accounting standards and caution in the coworking sector are making shorter leases attractive.
The rising costs are splintering office tenants into two basic groups. Larger tenants that can stay in their current location often take shorter terms on their renewals. They tend to require fewer tenant improvements and feel less pressure to spread the costs over many years.
However, tenants needing or wanting to relocate often favor longer lease terms, because fit-out costs generally are higher, Jonathan J. Larsen, principal and managing director at Avison Young in Los Angeles, said in an interview.
Larsen highlighted the main reasons as landlords’ higher costs related to making tenant improvements, which have doubled over the past decade, as well as making energy efficiency upgrades that more local governments are mandating.
"The higher costs need a longer-term lease to amortize the costs over a longer period to keep the rent lower," Larsen said.
Andrew P. Lechter, vice chairman at Savills in Atlanta, sees much of the same.
"I think the length of lease term depends entirely on the needs of a particular business and their level of stability," Lechter told CoStar. "Of course, with a longer term comes the need for greater lease flexibility."
Tenants across the board are looking for landlords to give them more options and rights.
"If the landlord wants a 10-year, 12-year term instead of seven-year, they are going to have to give more expansion rights or more contraction rights," he said.
Many tenants want to avoid getting caught in an "above-market situation," Lechter added, where their rents are higher because market rents either fell or don't rise as fast as projected rent increases built into a lease.
The use of a wide range of options in lease terms is causing some headaches in the capital markets.
Lease Liabilities
New accounting standards for public companies require lease payment obligations to be reported on balance sheets. Longer leases amount to higher liabilities for all to see.
The rules allow for potential manipulation, Fitch Ratings noted in a report this month. Lease lengths can be changed, or a lease can see terms recast into what’s known as a service contract.
A lease transfers control of a space over to the tenant. In a service contract, the landlord or a third-party provider retains control. Service contracts come into play under some coworking agreements.
Companies may reduce reported liabilities by shortening the initial lease term with an option to extend. Because of the increasing variations, Fitch plans to stop treating lease payments as debt in its ratings, instead showing them as core operating expenses.
"This gets us back to a clean starting point," Fitch noted.
Coworking Retreats
When it comes to deciding between a long or short office lease, the rapid rise and recent slowdown among coworking space providers have added uncertainty on which option companies should go.
A few years ago, CoStar's national office data showed lease terms were lengthening, which contradicted what brokers were seeing from tenants demanding more flexibility.
More recently, in the past year and a half, average lease terms contracted, CoStar data shows, running counter to expectations. Market players attribute the out-of-sync results to the impact of coworking space options.
The rapid expansion of coworking inflated the average length of lease terms from 2016 to 2018, according to Bethany Schneider, director of research in Newmark Knight Frank's Washington, D.C., office.
While traditional office tenants typically sign five- and 10-year leases, coworking firms often sign agreements in excess of 15 and sometimes 20 years, essentially locking in elevated rental rates, according to commercial mortgage-backed security data analyzed by rating agency DBRS Morningstar.
Adding to that are the above-market rents that coworking operators tend to negotiate. In addition, the buildout cost for coworking spaces can often exceed $100 per square foot, according to DBRS Morningstar.
Last year saw the monumental failure of WeWork to launch an initial public offering, and the coworking sector has gone into retreat on new leases since then. In the fourth quarter, the average flexible space transaction size declined by 38%, according to JLL data.
"We predict most flexible space transactions will span a single floor or less in 2020," JLL forecasts.
The 2016-2018 lengthening of lease terms caught Schneider's attention when she was preparing a report on the decline of small office leases published at the end of last year. The longer terms seemed contrary to what Newmark was seeing in the market where tenants seemed to be demanding more flexibility and shorter terms, Schneider said. She attributed the increasing lease terms to the number of large blocks being taken by coworking space providers.
The segment also had a profound impact on the traditional direct office market for tenants needing less than 10,000 square feet, she said.
The average number of transactions smaller than 10,000 square feet in the 12 largest U.S. metro areas declined from 1,498 in 2016 to 908 in 2019, according to Newmark data.
In deciding lease terms in an era of options, there are a couple of implications for tenants going forward.
With slowing growth in the coworking sector overall, and an increase in property owners offering their own coworking-style programs, those owners may be ready to recapture a larger share of the smaller tenant volume in the coming years, Schneider said.
And with property fundamentals still strong and a consensus opinion that they will remain strong in the near future, Avison Young's Larsen said, "When it comes down to time to make a lease decision, it will be harder and harder for tenants to relocate and not sign long-term leases."
