The COVID crisis of 2020 has created the fasted change in history from a landlord’s market to a tenant’s market. I started in the commercial real estate business in February 1984, so this is the 4th major market cycle I have experienced. It won’t be the worst though. While the overall impact will extend throughout the entire economy, nothing is likely to ever match the devastation to the commercial real estate market of the late 1980s and early 1990s.
The real story of COVID is two-fold – layoffs and work-from-home. The stay-in-place orders throughout the US resulted in massive layoffs to certain industries and created an unexpected experiment in wide-spread working from home. This quickly proved that technology and, most importantly, broadband connectivity was up to the challenge.
It’s no surprise then that many companies are considering eliminating their offices in favor of a work-from-home strategy. The jury is out on whether they really want to, or whether they will be more efficient there.
Here is a snapshot of conditions in Dallas Fort Worth according to Costar.
Total Office Market Size – 398 million square feet (SF)
Direct Available Rate – 18.0%, 73 million SF
Sublease Available Rate – 2.3%, 9.3 million SF
Total Available Rate – 20.3%, 82.4 million SF
Under Construction – 1.8%, 7.4 million SF
Net Absorption – negative 1%, 3.5 million SF
Average Rental Rate - $27.64 DFW-wide (full service + electricity equivalent)
The sublease availability rate is the highest it’s been since the tech bust of the early 2000s. More than 3 million SF of additional sublease space has become available just since the beginning of the year. And 2.4 million SF of that was in the 2nd quarter. That’s the highest in one quarter in history.
What does all this mean? Plain and simple, falling rents. We’ve now had 4 consecutive quarters of negative absorption. That by itself would ensure falling rents. But when you add in new construction underway, companies trying to sublease as they experiment with work-from-home, and the uncertainty of how much longer COVID will continue, the likelihood of falling rents becomes a certainty of falling rents.
What’s amazing is that landlords have been slow to drop rents to any real degree. There have been a few cases of it, but it’s not market-wide. A new building in Plano delivered in late March and it dropped its asking rates from $30-$34 triple net (NNN) to $27 NNN fairly. That was the only landlord that did so for many months.
We are seeing more signs of falling rents, but it’s rarely in the face rate shown in the lease. Landlords want the face rate to stay as high as possible for two reasons. First, when they refinance or sell, they want the cash flow at that time to be as high as possible with no remaining concessions. Second, a higher face rate in the lease sets the tenant up for an easier lease extension negotiation in the future.
What does all this mean? Plain and simple, falling rents.
We received a proposal for one of our clients in Plano in which the landlord dropped their face rental rate by only 10%, but then offered 6 months free on a 4-year lease and gave $10.00/SF for improvements which can be converted to a rent credit if they don’t use the money for actual improvements. The net effective rent was, therefore, 30% lower than the quoted rental rate.
Another of my clients recently received an offer to extend its lease at a face rate 13.3% below the landlord’s quoted rate. After the 5 months of free rent they offered, the effective rate is actually 20% lower than their quoted rate. That rate directly competes with sublease options in the same project. That’s a smart landlord. They should grab every SF of occupancy they can now and lock it in for as long as possible even if they have to drop their rates. It will likely be worse in the future.
Sublease space will continue to be put on the market
Little of it will actually get subleased – negative absorption means no demand
Most activity will be existing tenants with leases expiring
Rental rates will fall as landlords compete with each other and subleases for the few tenants out there
Concessions (free rent & construction allowances) will increase as landlords feel the pain and desperately try to hang onto their face rates
My advice for office tenants:
Delay decisions on long-term leases, if possible.
Delay decisions on long-term leases, if possible.
Ask for a 12- to 18-month extension. Don’t lock in a high rate when landlords have yet to feel much pain.
Longer-term leases may still be required if significant money is required for build-out or infrastructure, or if landlords refuse short-term and the tenant won’t move.
If you must do a long-term lease, get a termination option in 2-3 years even if it requires a termination fee. That termination fee may be lower than the savings of a renegotiated lease at that time.
Consider subleasing someone else’s space at a discount. Subleases often come with furniture and shorter terms.
COVID will pass or at least a vaccine or effective treatment will be found. Lots of people will go back to the office and life will settle into a new normal. The new normal won’t look the same for every company. Keeping leases as flexible as possible will put tenants in a better position to react when they decide what their new normal will look like.
ABOUT THE AUTHOR
Bob Gibbons is a Real Estate Advisor & Tenant Advocate (REATA) exclusively representing companies and non-profits which lease or purchase office and warehouse properties. After working for landlords for 20 years, he felt so strongly about the value his experience would bring to users, he founded REATA Commercial Realty, Inc. to exclusively serve them. No landlord work…ever.