The Questions
We’re having the same important conversation with nearly all our clients. It stems from 2 basic questions; 1) What if we don’t have an office, and 2) Can we structure the lease so that if the market declines over the coming years, the rent for our space will similarly decline?
We believe these are very important questions as they relate to broader issues about the value of an office lease to your specific organization. This is the most useful dynamic to evolve from the pandemic, a thoughtful analysis of how leasing office space supports, indeed promotes, employee engagement and productivity. And, it’s important to contemplate this value against the backdrop of the market in which occupiers and landlords alike must accept fixed cost/return outcomes despite ongoing fluidity that may result in a given space being worth more or less over time.
Starting at why. It’s a valid consideration. For many companies, the posture of the past couple of years has been de facto no office. Has it worked? Have the employees been more or less productive, happy, engaged? What contribution does the office make? How can it better serve the organization? What many are now realizing is the office is less essential as a place to do work. It’s more vital as a place to gather, to connect at the human to human level, without the interface of technology. If this is true, perhaps the office should be designed specifically to facilitate such connections. Or, maybe the conclusion is these connections can be achieved in other ways that don’t necessitate an office. While it’s tempting to make this assessment with a bias toward cost reduction, it’s important to avoid being swayed simply by how much can be saved without an office. Yes, office space is an expensive investment. But what is the return on the investment? It’s this ROI that gets to the heart of its value. Occupiers should be focused on increasing ROI by creating more targeted outcomes from the employee gathering spaces they provide.
Assuming an organization concludes it needs an office (by the way, the term “office”, itself, seems due for rebranding), it’s important to talk about the market, to understand how it functions and what’s likely to occur over the coming quarters. Of course, no one has a crystal ball, no one can predict the future. However, real estate firms that have a deep market presence and quality research can make reasonably good projections of market scenarios over a 12 – 36 month window. For example, the current market dynamic in San Francisco is interesting. Over the last 2 years, while occupiers effectively abandoned their office space and are now using it at a rate of about 35%, rents in San Francisco have fallen only 10%. This is because the true impact of the pandemic on landlords is only now beginning to play out. The market is 23% vacant and climbing. Landlords are in varying states of readiness to meet the demands of this market, based on the specific economics of their ownership. It’s undoubtedly an excellent time to negotiate, but occupiers who sign a lease now will not achieve bottom pricing. The bottom is likely ~3 years out. So, yes, while you may get a good deal now, you stand to get a better deal in 18 – 24 months. So what strategy should you employ? Your current space is likely too big. You have a lease expiring in less than a year. You could attempt a short term extension with the intent of negotiating a better outcome in 18 - 36 months. This is a common approach, yet it’s not without limitations. Firstly, the space may not be compelling in the sense that it serves the new purpose you’ve identified. In other words, the old space may be ill-suited to attracting your employees back to the office. Secondly, in many cases the existing space is too big and the cost, even at a steep discount, ends up being more expensive than a new solution. Another approach we’ve seen clients contemplate is to let the existing lease lapse and endeavor to reengage with the market at some point downstream, when conditions seem most optimal. This scenario may work if the organization is comfortable not having an office for a period of time. It should be noted, too, that the importance of having an office may translate in more ways than just its impact on employees. Consideration should also be given, for example, to branding and client engagement activities. One thing we have not seen in the markets, nor do we anticipate seeing it, is the ability to structure leases that provide downward rent adjustment mechanisms. If such a structure were to be accepted by a landlord, it would stand to reason that this landlord would also want an upside mechanism in case rents increase. For better or worse, domestic office leases in major metros are mostly fixed cost during the term based upon the rental economics negotiated at the time the lease is signed.
This is certainly a time to ask the right questions. While it may seem counterintuitive to engage your real estate advisor in conversations that include doing nothing, your advisor is a critical source of knowledge and input on this topic. The best of us are ready to help, to provide non-biased feedback, regardless of the near-term fee implications.