BY PHILLIP M. PERRY
Law firms are in the driver’s seat at lease renewal time.
For law firms looking to renew their office leases, the outlook has never been sunnier.
A pandemic-induced oversupply of commercial space has landed on the market at the same time professional organizations need less room to get their work done, thanks to the acceleration of hybrid work arrangements.
“This is a difficult time to be an office space landlord in any major central business district,” says Ruth Colp-Haber, President and Chief Executive Officer of Wharton Property Advisors, a real estate consultancy in New York City. “There are several reasons. First, the demand has shrunk. Second, any landlord losing a tenant is going to be looking at space that could sit empty for a long time.
Third, the landlord successful enough to find a new tenant will need to offer a better rate than the existing one and will also be hit with demands for a lot of construction to fill out the space.”
Colp-Haber, who has helped dozens of law firms find commercial space in her three-decade career, notes that the profession has been reporting only 40% office attendance rates in New York City. That’s actually a bit rosier (from the landlord’s perspective) than the same figure for other professions, thanks to a combination of inertia and conditions unique to the legal profession.
“Many older attorneys are requiring in-office activity,” she says. “Also, much legal work has to be done in-person, including meeting with clients and doing closings.”
It’s not just New York City. Other regions report similar gluts in working space. “The hybrid workspace is the biggest factor affecting the real estate market for law firms today,” says Allison Griffin Bittel, Senior Vice President and Principal in the Atlanta office of Colliers International. “People have figured out how to work from home and be productive. They are even looking at work flexibility and remote options when they consider whether to stay with their current firms or move to other employers.”
Ultimately, of course, the travails of landlords benefit tenants, who are in a better negotiating position than ever before. And real estate experts don’t expect the situation to turn around any time soon.
“The market right now for leasing is amazing if you are a tenant,” says Bill Himmelstein, Founder and Chief Executive Officer of Tenant Advisory Group, based out of Chicago. “It will stay that way for the foreseeable future, and I’m talking several years minimum. Today even firms looking for 200,000 square feet are going to have a significant amount of opportunity.”
Does the soft real estate market translate into better rental rates? Yes, although it might not seem so at first glance.
“The average quoted rents, the so-called ‘face rates,’ have actually increased slightly since the start of the pandemic,” says Himmelstein. “Landlords are maintaining higher face rates because that is how their buildings are valued, which is important in the event they want to refinance or sell their property. Potential buyers or lenders look at future cash flows, apply a multiple and end up with the value of an office building.” Not only must face rates remain elevated to support current valuations, but in some cases, rate reductions can result in violations of lending covenants.
In making their valuation calculations, banks ignore the amount of free rent or tenant improvement dollars landlords must give to attract desirable tenants. Those concessions, which are rising to impressive levels in the current soft market, essentially translate into lower rent.
“Very often tenants will get twice as much free rent and maybe 50% to 60% more tenant improvement dollars post-pandemic,” says Himmelstein. “As a result, the net effective rates (those paid after such concessions) are between 20% and 30% lower than before. Securitization requirements such as cash and personal guarantees are also lower.”
One reason banks ignore concessions is that they are considered one-offs that won’t be repeated come renewal time. Perhaps some willful blindness is a factor as well because lenders are reluctant to repossess properties.
“The last thing banks want to do is become owners of hard assets like real estate,” says Himmelstein. “Suppose they lend out on a valuation of $400 million for a building and the landlord can no longer service the debt. If the bank gets the keys to the property, they might end up selling it for $300 million, taking a 25% write off. Now the new buyer has a basis at $300 million and can charge lower rent and offer better deals.”
Despite the vested interest in high rental rates on the part of financial institutions, Himmelstein feels face rates will start to decline as costly concessions continue to threaten landlord profits and professional firms in all industries seek smaller spaces.
“As we get deeper into this pandemic, we’re going to see more keys getting handed back to the banks who turn around and sell the properties at a much lower valuation,” says Himmelstein. “That’s where rental rates will start to reset. And we will start seeing this soon, I think.”
Before that time arrives, law firms are looking to sublease to monetize their current larger-than-needed offices. “I’ve come up with an innovative sublease structure where I set up my own de facto coworking hubs, leasing sections of such large office spaces to smaller law firms,” says Colp-Haber. “Both sides appreciate the one-year lease terms. The smaller ones don’t have long-term liabilities, and the larger ones can get their space back if they need it.”
When the time comes to move to new quarters, high supply and low demand can only translate into a stronger negotiating position for law firms. Real estate experts point to several smart tactics to leverage a tenant’s advantages. The first is to start early.
“If you go to your landlord one month, three months or even six months prior to your lease expiration, you have lost a tremendous amount of leverage,” says Himmelstein. “Your landlord will figure you don’t have enough time to negotiate terms and get new space built out before your current lease expires.”
Delays, while regrettable, are understandable. “Real estate is not top of mind for law firms and often they wait too long to engage in the market,” says Bittel. She cautions that disruptions in the supply chain as well as in permitting and construction can lengthen the time required to get from signing a deal to actually moving in. A year before the end of a current lease is not too early to start the ball rolling.
As for what to do in that year’s time? The overriding concern is to plant the seed with your landlord that the firm might relocate.
“When negotiating a renewal, it’s important to build a sense of competition,” says Himmelstein. “What strikes fear into a landlord is the thought that you might move. Even in good times that is disastrous, but when vacancy rates are high, losing a tenant is even more costly. The best way to negotiate the most aggressive renewal terms is to talk to other landlords and get competing offers.”
Bittel agrees that convincing a landlord of a pending move is essential to success. A real estate adviser can be an invaluable partner, making the right moves when speaking with a law firm’s current and potential landlords.
“The first thing is to partner with an occupier expert who understands market trends and who can advise on strategy,” says Bittel. “There are a lot of complexities post-pandemic, and you have to be creative in redesigning your space.”
As mentioned earlier, concessions are a way of life in the current leasing market. Law firms would do well to get a handle on the local market’s current allocations of free rent and build-out expenses. Plus, every lease has some type of escalation clause determining the formula for future operating cost increases. Negotiating favorable terms for billing — things such as electricity — can pay off.
“In the past, I used to always suggest direct operating expense increases,” says Colp-Haber. “Today, though, we are faced with the possibility of large increases down the road in the price of oil, building maintenance and labor. Perhaps a fixed annual increase would be better.”
Prospective tenants should also determine the most favorable base year, designated in the lease as the rate floor from which future increases are calculated for property taxes, insurance and operating expenses. “You want to get the highest base rate you can so future increases are not as onerous,” says Colp-Haber.
Finally, the pandemic has brought home the benefits of preparing for disaster. “I always try to insert a clause that if the city goes into lockdown again, the firm will not have to pay for office space during that time,” adds Colp-Haber.
ENSURING A HEALTHY WORKPLACE
Speaking of the pandemic, the onslaught of COVID-19 (and the increased volatility of wildfires if you are out West) has ignited new concerns about air quality. At lease renewal time, law firms may want to assess the quality of their air cleaning systems in their current or prospective office quarters.
“The smart law firms are looking at ventilation systems and requesting upgrades,” says Himmelstein. “Larger firms of, say, at least 100,000 square feet can impact changes throughout their buildings. Smaller ones can take measures within their own space. A lot of attorneys are requesting that higher-grade filtration systems be part of a build out. And any new buildings are going to have much better ability to remove unwanted airborne diseases and germs.”
Leases may address the need for quality air and the steps that must be taken to provide and monitor a healthy operating environment. Real estate experts note that the expenses required to bring about a healthy workplace are more often borne by the landlord rather than the tenant.
LEASES FOR LONGER
Many law firms are pursuing shorter lease terms, given the uncertainty in the market. “Pre-pandemic we were commonly seeing 10- or 12-year lease terms for established law firms as they wanted to lay claim to the space they needed,” says Himmelstein. “Terms have come down to around seven or eight years. The decline is attributable to market uncertainty. We’re living in unprecedented times for this generation of managing partners. There is the continuing pandemic, supply chain issues, labor shortages, a war in Ukraine, historic inflation rates and rising interest rates. So law firms are erring on the side of caution by opting for shorter-term leases. No one wants to be trapped in a long-term lease when the next lockdown hits, ending up paying for space they can’t use.”
While there is a compelling case for shorter lease terms, longer contracts can work to the advantage of tenants, given the current soft market. “Established law firms with good handles on their growth trajectory will be better off signing longer-term leases,” says Himmelstein. “They will be able to get greater concessions, more aggressive face rates and better opportunities to reduce occupancy costs. The longer the lease, the better the terms. That’s what landlords want and that’s what often works better for tenants as well.”
Phillip M. Perry is an award-winning business journalist with over 20 years of experience under his belt. A three-time recipient of the American Bar Association’s Edge Award for editorial achievement, Perry freelances out of his New York City office. His byline has appeared over 3,000 times in the nation’s business press.
Copyright ©2022. Reprinted with permission from Association of Legal Administrators. All Rights Reserved. www.alanet.org.