Real Estate Now
Alba Aleman is moving on up. She recently signed a four-year sublease for 14,000 square feet of luxurious, Class A office space. Though the building in Chantilly, Va., is owned by a 24-hour shipping company, it feels more like a law office. The executive suites are furnished with cherry wood furniture, and the boardrooms are equipped with great new audio-visual equipment. There are even two kitchens with icemakers and dishwashers. The fancy digs are also in the perfect location for Cairo Corp., the fast-growing IT consultancy Aleman co-founded in 1998. It's a short drive to Dulles Airport, downtown Washington, D.C., and the suburban Virginia outposts of corporations like Oracle, Lockheed Martin, and AOL.
The best part about all of this is that Aleman is paying the same price per square foot as she was for her previous offices -- and they were in Class B space above a credit union in distant Manassas, Va., land of dreary industrial parks and strip malls. That old office smelled funny. It had mismatched carpet that was worn and stained and peeling wallpaper in the stairwell. But back in October 2000 when Aleman signed the lease, commercial real estate was high-priced and hard to come by, and it was all she could afford. This time, "I was floored at what we were able to get," says Aleman. "The impression this office gives is so starkly different."
How times have changed. All over the country, entrepreneurs who signed five-year leases in 1999 and 2000, when rents peaked, say they're amazed at the trade-ups they're able to make because of the soft commercial rental market. In fact, right now is the optimal time to sign a lease. Vacancy rates are higher than they've been in 10 years, according to the Real Estate Research Corp. (RERC). The national average is 17%, though some areas are in the twenties. The price per square foot has also valleyed around $26 across the country, and the median is $21.
"We're in a new era," says Roger Staubach. "Tenants have more choices and there's more competition..."
Historically low interest rates helped to drive the trend by luring more companies to snap up commercial property before the party was over. That surge in buying activity left fewer companies looking to lease space, creating a classic renter's market. Adding to the glut are subleasing opportunities created by many companies (both the downsized and the optimistic) that have unused space they'd like help paying for. As interest rates climb over the next two years, RERC projects that vacancies will decline and prices will increase slightly. In the meantime, landlords are eager to please. Offers of free rent, parking, and other amenities are now standard, says Roger Staubach, who runs one of the largest commercial brokerages in the country that represents only tenants. "We're in a new era," says the legendary Dallas Cowboys quarterback cum entrepreneur. "Tenants have more choices and there's more competition for the right tenant."
Interviews with business owners demonstrate that many are keenly interested in commercial real estate and looking for ways to maximize their investment. But interestingly, it's clear that many have had to figure out real estate through trial and error, often with scant advice. So we've come up with a series of questions about office space that any business owner should ask, and then answered them -- feeling that this once-in-a-decade market is an opportunity no entrepreneur can afford to miss.
I'm signing a lease. What's negotiable?
Landlords are fanatical about maintaining rent levels these days, but they're willing to dole out all other kinds of concessions, from reduced security deposits to snazzy Aeron chairs. In fact, a little cottage industry is springing up to provide party favors to tenants simply for signing a new lease. In Philadelphia, where the vacancy rate stands at 17.5%, a start-up called Turnkey Office Solution Systems contracts with landlords to put together a package of benefits to attract new tenants to their buildings. Services include budgeting, designing floor plans, installing IT networks, hooking up phones, buying new furniture and equipment (and selling the old stuff), and even moving itself. Tenant improvement allowances are also becoming more generous. They are paid either as a percentage of the total lease or a certain amount per square foot of space. In addition, entrepreneurs we talked to routinely asked for and received moving expenses, parking rights, and free signage.
Also, keep in mind that until you've literally signed the lease, you can keep negotiating. Edward Chaney of Sunchain, a tanning chain franchiser in Scottsdale, Ariz., has negotiated nine leases for his stores. He says the bulk of his negotiations happened after the terms had been set and he'd received a draft of the landlord's standard lease agreement, which always favors the landlord. (Some experts jokingly refer to this as the "landlord's wish list.") Chaney goes through all of the legal verbiage in the agreement, then counters the landlord's overreaching by trying to negotiate more generous financial concessions. For instance, if the contract basically says, "We can evict you at any time for any reason," he'd change the language to say, "No, you may not evict me at any time."
Landlords usually come back and say, "Can you ease off this a bit? How about six months' notice?" Chaney might reply by saying something like: "Gee, I'm putting so much money into renovating this space, and I don't want to be out all of that money if I'm evicted. But six months' notice would be okay if you give me more tenant improvement allowances." They almost always bite.
Do I have to guarantee the lease personally?
Not necessarily. Todd Palmer, founder of Diversified Staffing Services in Farmington, Mich., had no trouble getting his landlord to waive a personal guarantee when he recently moved (he also asked for, and received, four months of free rent). Landlords often ask for personal guarantees from start-ups, service businesses, and companies in volatile industries. However, if you are a credit-rated tenant with a history of growth and have three years of audited financials, liquid assets, strong cash flow, and little debt, you should be able to avoid them. Otherwise, a better option to a full personal guarantee is a so-called good guy guarantee, in which the guarantor is held personally responsible only until the tenant leaves the building -- even if that's before the lease is up.
I already bought commercial property for my business. What can I do?
Consider a sale-leaseback agreement, in which an entrepreneur sells commercial property only to lease it back from the new owner for an extended period of time. The arrangement allows real-estate-rich firms to free up assets and reduce debt while taking advantage of the soft rental market. "It's good for us because interest rates are still favorable," says Jeff Rosenblum, an acquisitions asset manager at Time Equities, a New York City real estate investment firm that buys space. One of Rosenblum's firm's recent transactions involved a manufacturer in Queens, N.Y. "We thought about moving at first," says the business owner, who spoke on condition of anonymity, "but we've put a lot of money into forming the space exactly how we wanted." Through the sale-leaseback agreement, the manufacturer says he got a great price on his building and was subsequently able to finance a growth spurt without piling on debt.
Should I take responsibility for the initial buildout of the space or leave that in the hands of my landlord?
Control freak that you are, you may be tempted to take charge of the buildout yourself. Don't.
Control freak that you are, you may be tempted to take charge of the buildout yourself. Don't. Most landlords have special deals with contractors. Plus, building materials like steel, cement, and lumber have gone up in price recently, owing in part to a building boom in China. Add to that the cost of demolition, rewiring, and installation fees for IT infrastructure and phone lines, and you can bust the budget quickly if you don't know what you're doing.
Pat Cooley of RelianceNet IT Experts, a tech firm in Annapolis, Md., learned that lesson the hard way. He was feeling pretty smug when he convinced his landlord to double his tenant improvement allowance to $30,000, with Cooley assuming responsibility for managing the buildout. It didn't seem like such a great deal when the final cost hit $60,000.
Assuming you leave your landlord in charge of completing the buildout, make sure he has every incentive to finish on time. "You can't leave the lease silent about the consequences," says attorney Chan Stroman, of Landlord Counsel LLC in Madison, Wis., which advises both tenants and landlords on commercial lease agreements. If construction needs to be finished by a certain date, insist that for every day the work runs over, you get two days' worth of rent credit. "The prospect of losing that rent money is usually a good incentive," she says. If you expect the project will take several months, set deadlines (and monetary penalties) for various milestones in the process to deter late starts. Also, if you and your landlord agree to a set price per square foot for the buildout, make sure that he's contractually obliged to cover any costs incurred above that amount.
What other hidden costs should I watch out for?
Ed Dintrone, president of NETexponent, a search optimization firm in New York City, says that in addition to the rent he pays for his 1,600 square feet in Manhattan, each month he also pays $80 for water, $80 for sprinklers, $100 for garbage collection, $150 for cleaning, and $50 for a doorman during regular business hours. Dintrone recommends that you have utility bills mailed directly to you, rather than letting a landlord pay them and invoice you. You should also ascertain whether you will be held responsible for HVAC repairs. When Dintrone was leasing space for another company in 1997, the building he chose had a very old central air conditioner. When it conked out in the middle of July, Dintrone was stunned to discover that, according to his lease agreement, he was the one responsible for fixing it. Not only did the repairs cost a few thousand dollars, but Dintrone had to rent several large fans in an attempt to cool himself and his suffering employees while the system was down. Now, before he signs a lease, he always asks how old the central air conditioner is and who is responsible for fixing it if it fails.
Cairo Corp.'s old lease specified that Alba Aleman pay a percentage of the building's total maintenance costs, which fluctuated along with building occupancy. "Several tenants left the building, so more of the operating costs were being shifted to us," says Aleman. "There was hurricane damage that caused flooding in the basement, and we were having to pay for that." The charges eventually added 8% to the rent bill.
Some landlords also try to slip a bogus escalation clause into a lease that allows them to increase rent gradually. It's often tied to an outside economic benchmark like the consumer-price index, which has little to do with actual real estate prices. Reject it.
My company is small. Should I consider subleasing office space from someone else?
Like factoring your receivables, subleasing space is a concept that exists to help small businesses, yet it paradoxically engenders great skepticism among them. Diana Pisciotta, managing director of communications consulting firm Denterlein Worldwide in Boston, says that when her firm's five-year lease recently ended (for a 2,500-square-foot space on the fifth floor of a six-story historical building), she wouldn't even consider subleasing, no matter how much cheaper the prices were. "I don't want to be the smallest tenant in the building, sharing a space with a big corporation," she says. "The landlord has no incentive to take good care of you." In June, she signed a new lease with the same landlord to take up an entire floor in the building she was already in.
Steve Marsh rejected subleasing for a different reason. The founder of Smarsh, a San Francisco firm that archives e-mails and instant messages for financial companies, pursued several sublease opportunities while hunting for space for a branch office in New York City this past June. But he was put off for security reasons. Because his computer systems house sensitive client information, it was unacceptable to him that sublessors couldn't tell him exactly who would have access to his space.
With these concerns duly noted, it's fair to say that subleasing has worked out great for some people. Two years ago, when there was less commercial space on the market, Justin Abernathy moved his direct marketing company, SureClick Promotions, to a brownstone on the outskirts of Washington, D.C. Having outgrown the space, he recently took over another company's lease for a 4,600-square-foot furnished office downtown. All it needed was a little repainting. Abernathy pays $8 less per square foot than what the tenant is charged. He's already hired five new employees who wouldn't have fit in the old space. And he only has an 18-month commitment, with an option to sign a longer lease later. "For me that was better than signing a five- or a 10-year lease because I don't know if we'll need this much space five years from now," he says.
I have empty space. Should I sublease it to someone?
Unless a lease specifies criteria for subletting, it is usually forbidden except at the landlord's whim. If you are in the process of moving and would like to sublease all or part of your new space, negotiate subleasing terms like any other. Most landlords will demand the right to review the credit and financial standing of the subtenant, as well as a final right of approval. In return for that, negotiate a short approval time and specify that failure to respond will be considered approval. You should also make sure there are no restrictions that hinder your ability to market the space or discount the rent if necessary.
In terms of contracts, you'll want to sign one with the sublessee, and it's also possible your landlord will require a sublease consent document signed by all three parties, defining rights and responsibilities. As far as finding the right subtenant, Abernathy, who has leased part of his office in the past, says, "It's like looking for a new roommate in college. You have to find one that you will get along with and will be a good fit with your company's culture."
How long a lease should I sign?
Ten years, if you can swing it. "We think that in five years, prices will be back up again, so it's best to lock in the low rates for as long as you can," says Bill Goade, chairman of Boston-based CRESA Partners, another national commercial real estate brokerage that represents tenants. Ironically, Goade, who leased new space in June, was himself unable to persuade his landlord to commit to more than a seven-year deal. Still, he went ahead with the lease because it meant moving into a Class A waterfront office overlooking the harbor for "basically the same price" as the Class B space CRESA had called home for 14 years.
How does this figure into my taxes?
The Internal Revenue Service requires that tenant improvements, broker's commissions, and legal fees be amortized over 39 years, even though most leases have a much shorter lifespan of 5, 7, or 10 years. "It's kind of a glitch in the tax law," says Arthur Koplowitz, partner at New York City accounting firm Weinick Sanders Leventhal & Co. After your lease is up -- or if you terminate it -- you have to write off the remaining expenses all at once. Suffice it to say, this is illogical and unfair, but sometimes you can use it to help balance out the upfront expenses that can't immediately be written off if you move to a new space. Some furniture, fixtures, machinery, and equipment (up to $100,000) can be written off right away with a Section 179 deduction. Otherwise, those expenses must be amortized over seven years.
Do I really need to consult a lawyer?
Yes. Even after you've reviewed the lease yourself, have a lawyer look it over because it's often the most glazed-eye-inducing portions that matter. The fine print usually includes tenant and landlord responsibilities in the event of fire, casualties, or other damage. Sometimes, important tenant protections are omitted. Consider Brett Hobson, CEO of Comfort Experts, a firm in Fort Worth, Texas, that installs and repairs air conditioners. His office is near train tracks. On January 30, at 7:20 a.m., a freight train derailed and slammed into the back of the 6,000-square-foot commercial space he leases. Hobson is thankful that none of his employees, some of whom normally work at that hour, was present when the train hit. But he cannot fathom that, because of ambiguity in his lease, he is still locked into the agreement, and he continues to pay rent on the unusable space. And that's on top of the $1.5 million to $2 million he lost in damage and missed sales.
More prosaic incidents can also result in steep losses. In recent years, for example, some unlucky California business owners discovered that, during repeated power outages, their landlords were under no contractual obligation to supply a generator or provide a rent abatement even if the building went dark for days on end.
What kind of insurance do I need?
After the wreck, Hobson discovered that he still had to pay rent on the unusable space.
Conscientious landlords ask tenants to buy their own general liability insurance because it ends up being cheaper than if they buy it and pass the cost along to you in the form of operating expenses. Attorney Stroman suggests you consider business interruption insurance to make certain that you will have your expenses covered if you have to move to a temporary location following a fire or a flood. Hobson of Comfort Experts concurs -- business interruption insurance helped him tremendously when he had to move to a temporary location after the train hit. He also advises that you update your content insurance annually. He'd originally taken out a $100,000 policy on his equipment but didn't bother to update the amount when he bought new direct-mail printing machines worth $200,000. The railroad will eventually have to pay up for the lost equipment, but Hobson could have collected that insurance money several months ago.
How much space do I really need?
On average, companies need about 250 square feet per employee, but that number fluctuates greatly depending on the type of business. A company such as a law firm with a lot of executive offices could need from 800 to 1,000 square feet per employee, while a call center could get away with only 180 to 200. Keep in mind that unlike residential space, specs for commercial space will typically include community space like hallways. Dintrone of NETexponent says he's found that a loss factor of 20% is typical. "If the landlord says there's 5,000 square feet, only about 4,000 is usable," he says. And bring a tape measure because stated dimensions can always be wrong.
How do I plan for future growth?
It's the classic dilemma: You don't want to pay for space you don't need just yet, but neither do you want to find yourself stuffing workstations into the supply closet. Roger Staubach recommends that you make flexibility one of the most important negotiating points. How do you do that? Ed Chaney always negotiates several options to renew the lease in five-year increments that cover an additional five to 15 years at a prenegotiated rate. Expansion options are also a good idea. Laura Roberts of Phoenix-based Pantheon Chemical moved her chemical company from a 2,500-square-foot office to a 6,000-square-foot office only nine months ago, but her company is growing so quickly that she may exercise her expansion option by the end of the year.
I'm in a bad lease. How can I get out of it?
If cost is the issue, you can try to extend your current lease in exchange for lower rent. Some landlords are eager to hold on to the tenants they already have and might be willing to make concessions.
If the building or the landlord is the issue, and you just want to get out of there, you can try to find another tenant to sublease the space or take over your lease (a so-called "lease assignment," in which the new tenant assumes all responsibility for the remainder of the lease). Another option is to shop around and see what prospective landlords have to offer. Some are so hungry for tenants that they might be willing to pay the difference on your old lease.
How important is it to use an agent?
The trick is knowing whom the agent is working for. Are you paying the broker or is the landlord? Often, even for some buy-side brokers, your best interests and the broker's are in conflict, since the broker gets paid a percentage of the lease. And as an entrepreneur, you may be more adept at negotiation than the broker. Chaney of Sunchain says that in each of his nine leases, the brokers were less willing than he was to press for a deal they said was below the industry standard. "They'd say, 'This is the best you can get. Don't bother asking for more than that," recalls Chaney. But when he prodded them to try harder, they came back with better offers. Pantheon Chemical's Laura Roberts had a better experience. Her broker orchestrated an auctionlike scenario in which several landlords were bidding against one another for her business. He also helped her locate buildings in designated zones that offered her tax advantages.
I need space now. How can I speed up the search?
Some property owners offer "plug and play" offices. Because approximately 75% of all new leases last year were for spaces of 5,000 square feet and smaller -- most of which went to smaller firms -- Chicago-based Equity Office Properties Trust, one of the nation's large commercial property owners, started a plug and play program called Fast Office. The company offers small companies prebuilt suites with private offices, a conference room, and space for cubicles. The space can come furnished and with telephone and Internet service already installed. The company also offers a shorter lease term of about a year and a shorter lease form (five pages compared with the standard 18-page lease).
These and other developments in the commercial real estate market underscore the fact that now is the time to make a deal. Alba Aleman, for one, is already thinking about expanding into another office in her swanky new building, though she's trying not to get too accustomed to luxurious environs. "We won't sacrifice our profits for a pretty space," she says. "But," she adds, perhaps recalling the musty odor in her first office, "it is a blessing."
Bobbie Gossage is a staff writer.