What is the current state of commercial real estate in the markets you serve? How has COVID-19 affected the market?
The watchword for the current market is uncertainty. What seemed to be a well-balanced supply and demand situation early in 2020 has shifted dramatically as leasing and development activity ground to a near halt. I can cite a score of examples of tenants who were on the verge of signing long-term leases for space who have (1) put the entire leasing process on hold, (2) signed much shorter-term leases while they assess how their own businesses are going to be affected long-term, or (3) decided to close their offices completely to focus on other markets or in some cases opting for a full work-from-home model.
Demand for space has fallen substantially, reflecting the rapid decline of the economy. After a decade or more of growth and the strengthening of a landlord-friendly market, most commercial real estate markets are on the cusp of a dramatic turn to a more tenant favorable environment. I say on the cusp because commercial real estate markets have historically been very slow to respond to economic downturns and, as of yet, have not seen the full impact in the form of lower rental rates and increased lease concessions.
What will be the pandemic’s long-term impact on commercial real estate?
There are a lot of conflicting opinions on this topic. The forced experiment with work-from-home models has opened a lot of eyes to something that was not really considered by most tenants. If work from home becomes a lasting concept on the scale we see now, the long-term effect on commercial real estate will be hugely negative for real estate owners and investors.
Countering that effect is the immediate need for larger office space to accommodate for social distancing. The trend over the past couple of decades has been toward denser occupancy with smaller and fewer private offices, bench seating configurations replacing larger workstations, and collaborative space for employees to meet and interact. With a growing perception that physical separation in the workspace is imperative, not just for dealing with COVID-19 but for unforeseen future health concerns, the space footprint for many tenants is likely to increase.
Our perspective is that the long-term impact is not going to be extreme. There will be a larger contingent of the workforce that works from home most of the time, but the social, collaborative, supervision and workplace efficiency needs of most tenants will drive a continued need for office space. No one has a crystal ball on this subject, but we believe a few years from now, the market will have adapted to changing needs and will be back to a somewhat “normal” status.
Are there any specific examples of industries that will experience long-term changes in how they use space?
Most industries will be impacted, and the legal profession is a good example. Over the years, law firms have pushed for more efficiency in how they use space. One of the metrics that is used to measure efficiency for law firms is the amount of space leased divided by the number of attorneys. Over the past two decades, this ratio has decreased from roughly 1,000 square feet per attorney to 600 square feet per attorney. This has been accomplished by a reduction in the size of attorney offices, implementation of a single size office policy for all attorney offices, and more efficient use of space by adding associate attorney offices to the interior of the space.
Historically, law firms have not embraced alternative officing concepts like hoteling and shared offices for attorneys. Without these office strategies, however, it is very difficult for a law firm to achieve the desired efficiencies below 600 square feet per attorney. That may be about to change.
As we move back toward “normal” after the pandemic is under control, we expect that most attorneys will return to the office full-time. However, due to the forced adaptation of work habits, some attorneys may choose to split their time between home and the office. This will prompt law firms to take a hard look at a shared office concept, whereby a certain number of attorney offices will be designated as “shared”. To use the office, an attorney will reserve the office for the day. This concept will reduce the number of private offices needed and allow law firms to achieve efficiencies below the 600 square feet per attorney threshold.
Tell us about Advocate’s services and the process of assisting office and industrial tenants with their leasing needs.
We provide a full scope of tenant representation services to our clients, from initial strategy development, site selection, lease restructures, lease negotiations, and construction project management.
One of the keys to a successful real estate leasing process is the upfront definition of the requirement. Before diving in and looking at various building and space options, we roll up our sleeves and work with our clients to develop a detailed real estate strategy. It is imperative that this real estate strategy is consistent with the overall business strategy. The business needs must drive the real estate solution, not the other way around. When this part of the process is complete, we have the full picture and a well-defined strategy that details the desired location, approximate space layout and need, technology requirements, economic considerations, as well as a host of other factors.
Next, we engage the market by creating a competitive marketplace for our clients’ occupancy. This is accomplished by seeking out all buildings that meet our clients’ requirements. Because Advocate does not represent any landlords, all potential buildings are put on an even playing field. We are never in a position where we have conflicting loyalties to both a tenant and a landlord. By leveraging all potential locations through our competitive negotiation process, we are able to achieve the best possible economics and deal structure for each of our clients.
Through our related company, ACRE Project Management, we assist our clients with the renovation, construction, and relocation processes. ACRE coordinates all construction-related activities and vendors, including architects, engineers, contractors, furniture vendors, IT specialists, movers, and so on. Additionally, ACRE manages the entire process to assure that the space is delivered on time and on budget.
Although Advocate’s and ACRE’s offices are in the Chicago and Detroit markets, we have worked with our clients on their leasing requirements from coast to coast in the United States. It is this familiar process, working side by side with our clients and fully understanding their requirements, that enables us to achieve the best results wherever that need may be.
What are the benefits of using a commercial real estate expert like Advocate?
Tenants go through the leasing process only once every several years, and even then, many try to avoid it due to the perceived hassle and potential disruption of relocating. We are in this business every day, and one of the biggest benefits is that we guide the process from start to finish and simplify it for our clients. There is no big learning curve on their part to overcome.
One of the other big benefits is market knowledge. When most people think about leasing office or industrial space, the focus is on the rental rate. While important, numerous other factors make up the total leasing package. A critical piece of what a good tenant representative brings to the table is an understanding of the market norms and what to ask for regarding construction allowances, free rent periods, rent increases, early termination rights, renewal rights and several other factors consistent with current market trends.
What is a lease restructure and when is an appropriate time to consider it?
A lease restructure is a renegotiation of an existing lease well in advance of its scheduled expiration. With a restructure, a tenant receives near-term economic benefits in the form of reduced rents, improvement allowances, free rent, and other concessions in exchange for a longer-term commitment to the landlord. From the landlord’s perspective, they are motivated to offer these renegotiated terms to avoid the high cost and risk associated with the tenant moving at the end of the lease term.
In our experience, the “sweet spot” for a lease restructure is two to three years prior to the lease expiration, although, in some instances, we have been able to achieve a restructure as many as four years in advance. The restructure opportunity is presented to a landlord as their chance to lock up a tenant for a longer-term before exploring the market is practical. When the remaining lease term gets down to a year or 18 months, it is no longer really a restructure because the option to relocate is more realistic.
There are other factors that could impact the timing of a lease restructure. For example, if a landlord wants to refinance debt that is coming due in the short term, it may be a good time to approach this specific landlord with a restructuring opportunity. Longer-term leases reduce rollover risk, which may lead to better refinancing terms for the landlord. Likewise, if the building owner wants to sell the property, longer-term leases may increase the valuation of the building, leading to a higher selling price.
Is now a good time to restructure your lease?
Given the level of uncertainty in the near term, now is a terrific time for lease restructures. From the landlord’s perspective, finding and keeping good credit tenants is critical. If a tenant vacates a space in today’s market, the amount of time required to find a replacement tenant is extremely long and uncertain. Additionally, the cost to rebuild the space for a new tenant is very high relative to the cost of refurbishing the space for an existing tenant. From a real estate lender’s perspective, longer-term leases with good credit tenants reduce risk and make lending against the property more attractive.
If work from home becomes a lasting concept on the scale we see now, the long-term effect on commercial real estate will be hugely negative for real estate owners and investors.
These issues, coupled with the weakening rental rate environment, present the opportunity for tenants to gain significant costs savings and concessions by restructuring their existing leases now. Landlords will benefit through a longer-term and secure cash flow as the tenant agrees to extend the lease term. Additionally, tenants will benefit from an immediate reduction in the rental rate, money to improve or modify their space, free rent periods or an immediate reduction in the size of their space. Securing an existing tenant for a longer term is something any landlord would desire in a normal market, but that is only enhanced in a softening market like we are seeing now. It is truly a win/win/win situation for the tenant, the landlord and the lender.
It is important to note that many of the restructures of leases we negotiate do not cover the same physical space footprint. In changing times, often tenants will need to reduce or expand their size. An early restructure of a lease can accomplish a downsizing, expansion, or significant reconfiguration of the space without the need to wait on a lease expiration.
In what ways has the pandemic affected your business? How have you overcome the challenges it has presented?
Our business has experienced a significant change in the past six months. On one hand, many leases that were on the verge of being signed were put on hold while our clients wait to see the longer-term impact of the pandemic on their operations. Fortunately, many of these transactions have only been delayed, not abandoned. We expect to see a substantial rebound for this portion of our business in 2021.
While the relocation/renewal portion of our business has slowed, the restructure portion of our business is very active. The transition to a tenant favorable market leads to enormous opportunities for our clients to save money on their existing leases. The past ten years have been very favorable to landlords, with rents increasing year after year and concessions packages declining. During this time, lease restructures made up 20% of our business in any given year. As the tenants’ market continues to evolve, we expect that lease restructures will make up 75% of our business activity.
At Advocate, we have adopted somewhat of a contrarian view as we work through the COVID-19 slowdown. We see great opportunity in the coming years and have been hiring in anticipation of a greater need to service both existing and new clients with their changing real estate objectives. Onboarding of new hires has been a challenge, especially during the early phases of the shutdown when there was no opportunity for in-person interaction. Like most companies, though, we made extensive use of technology in our work from home phase and barely missed a beat.
What do you think the rest of 2020 holds for commercial real estate?
The balance of 2020 is a pretty short time window, so I think we will continue to experience a pause in major activity. Many larger companies are just starting to move toward re-occupancy of their offices, and some have put off such a move until the first of the year or later. With the pandemic still not under control, there will still be a great deal of wait and see. We would expect to see the start of a rebound in activity in early 2021.
The rapid shift from a landlord favorable market to a tenant favorable market is beginning to manifest itself in the form of more aggressive concession packages. Landlords are now offering longer free rent periods and greater tenant improvement packages. Rental rates have remained steady for the short term, but we expect to see a weakening in rental rates, starting in the fourth quarter of 2020. I would not expect to see a steep decline in the near term, but landlords who try to firmly hold the line on rental rates are likely to miss out until the market makes a comeback.
What are your goals for the future of Advocate?
When we started Advocate 18 years ago, there were a significant number of competing tenant representation firms such as Staubach, Equis and many local and regional firms. Over the years, many of these tenant representation firms have been acquired by larger competitors. This consolidation has resulted in the emergence of several large firms with enormous overhead i.e. JLL, CBRE, Cushman & Wakefield, and Newmark, among others. As the demand for office space declines in the short term and the revenues of these large firms are negatively impacted, we expect to see significant cost-cutting. We see this as an opportunity for Advocate to add seasoned professionals to accommodate the growth in our business.
Our long-term plan is to continue to remain independent and to emphasize our personalized, professional, and most importantly, unbiased service. For now, we will continue to grow in both the Chicago and Detroit markets, but we will actively consider expanding our footprint into other Midwest markets under the right circumstances.