Why Flex is Hard (but Inevitable)
The “flex” in flexible office solutions is about the occupier’s ability to limit commitment. A one-year lease is more flexible than a two-year lease, so on and so forth. With occupier uncertainty about why, where and when they should provide office solutions for their employees at an all-time high, you’d think landlords would be eager to offer high flex options in order to meet demand where it’s at. However, it’s difficult for landlords to provide the flex product, despite its potential to command premium rents and increase demand. Why? Because it’s expensive to build office space, and it’s difficult to design space that has broad residual appeal to a large swath of occupiers.
Let's dig into this a little more by looking at the San Francisco office market as an example. Here the cost to build a new 10,000 sf space from shell condition ranges from $175/sf to $250/sf, with a typical cost of $225/sf, or $2,250,000. The investment required to build new space is underwritten (financed) over the term of the new lease, not the speculative useful life of the improvements (e.g., a guess as to residual value after the initial tenant vacates). Let’s say the market rent for this new space is $70/sf gross and the tenant is seeking a 3-year flex lease. When analyzed over a 3-year period, the net effect of this hypothetical transaction is the landlord loses a lot of money. This is true because even if you straight line the initial investment in the design and construction of the space over the 3-year term without interest, the spend is worth $75/sf per year. Of course, the gross rent also includes operating expenses and taxes (which are typically about $20/sf). Hence the net rent would be more like $50/sf. At this rate, the landlord is losing $25/sf, or $250,000 per year before accounting for other transaction costs (like commissions) or debt service. The only way this transaction makes economic sense is if on expiration of the initial 3-year lease, the landlord can quickly re-lease the space without having to spend additional capital on improvements, a risky bet as occupiers tend to value highly customized space solutions that are optimized to best meet their individual use case. In this way, a space that is designed for a law firm will have limited value to a technology company. Indeed it’s difficult to thread the needle by creating a space that has broad applicability.
Yet our view is flex space will inevitably become an increasingly common landlord product offering as occupier buying power and behavior leave many landlords with 2 choices; 1) offer flex or 2) endure long periods of vacancy. As landlords capitulate to occupier demands, look for the design of the flex space to become a central element of the negotiation. Landlords will need to believe they’ve created something that has residual value.
It’s also important to understand what’s driving the occupier's need for flex. It’s not just a preference for less commitment. There’s also the very real challenge of workplace planning for a distributed workforce. This phenomenon makes it much harder for companies to know where they’ll need office solutions because the location of employees becomes more distributed and fluid, as opposed to the highly concentrated approach prevalent before the pandemic, in which companies chose a geography for the office(s) and looked to hire from candidates already in that region or otherwise willing to relocate. It will make sense for occupiers to both pay more for flexibility and to accept that flex solutions may necessarily be somewhat less custom fitted to their specific use case. Yet in the end, the benefits of having truly flexible leases allowing occupiers to pivot in and out of markets and avoid being saddled with long-term, illiquid lease commitments, will far outweigh some degree of incremental cost increase and loss of customization.
When will the wave of flex leasing begin in earnest? When enterprising landlords make the first move. Their risk will be rewarded, clearing the way for others to follow suit. Offering more flexibility, more than adjusting rent or increasing concessions, is the single most important thing an office landlord can do in the new market reality to enhance its position.