Cash Management

How to Save Money in the Real Estate Downturn

Some creative solutions for CFOs seeking to convert a depressed commercial real estate market into cash.
Ed ZwirnJuly 27, 2001

Click here for a breakdown of vacancy rates, rents and other data in 15 major metropolitan areas.

Richard I. Selig, CFO and principal of The Hunter Organization, recently found himself in a conundrum ironic for a real estate executive. He needed to find office space.

His midtown-Manhattan headquarters having changed hands last month, Selig, (whose firm is one of the major managers of real estate in the city,) found himself without a relationship with his landlord, who already had a management firm.

But, taking the lead of many of his clients, Selig has already secured new digs. His new office, just blocks away from the old one, is about 12,800 square feet, or some 28 percent larger.

And, he says, he has managed to save money in the process.

“We pulled it together by finding a space that required a minimum amount of work, just the usual paint, carpet cleaning and phone system stuff,” says Selig, who along with Peter Sabesan helped found Hunter in 1997.

In addition, the economic downturn has also helped.

Selig says he was able to negotiate for the space directly from the landlord, obtaining a new lease at slightly below market value, as opposed to paying about 10 percent below market to occupy the recently vacated premises via a sublease.

According to the CFO, while nominal rents have stayed relatively steady in New York–at least compared to other metropolitan areas– landlords are increasingly ready to offer either lower rent or other concessions, especially to attract tenants with higher credit ratings.

“Now is the time for triple-A firms,” Selig says.

“Prices stopped peaking here during the fourth quarter of 2000,” he adds. By the end of the first quarter of 2001, there was more new commercial space being made available on the market than getting filled up by businesses — a state of affairs the real estate pros call “negative absorption.”

Since much of the space being vacated during the current downturn is currently under long-term lease, a solid firm looking to secure office space can go either of two routes.

  • Enter into a sublease. This is usually the cheaper solution, but a less secure one: If the lessee goes under, the sub-lessee can find itself back to square one.
  • Work out a deal directly with the landlord. Selig says that with higher occupancy rates, owners are more willing than they’ve been in years to negotiate concessions into a lease. These usually come in the form of “work letters,” or provisions built into the lease itself which in effect loan money to tenants while technically keeping the rent at a higher level.

This is ultimately kicked back to the tenant in the form of amortized leasehold improvements.

“Let’s say the space [was] going for $50 per square foot [prior to the downturn],” he says. “That $50 may have stayed at $50, but the landlord may offer $20 a square foot to build a piece of space.”

Rents Dive With Economy

Office space is opening up in all the major metropolitan areas of the United States, particularly those most hurt by the past year’s dot- com implosion.

The effect on rents has been both predictable and pronounced.

Driven by an astonishing 182.8 percent increase so far this year in space available for sublease in 15 major downtown office markets, rents for top-tier commercial offices in these markets have dropped by an average 1.9 percent, according to figures compiled by Colliers International, a Boston- based real estate services firm.

This impact has been far from even.

So far this year, some markets, such as Chicago, have actually seen rents go up, according to the Colliers figures. New York has for the most part held steady since dot-coms constitute no more than 1.5 percent of office tenants, Selig says.

But most areas have seen rents decline. This drop is most pronounced in cities with high concentrations of tech firms.

San Francisco, for example, added more than two million square feet of office space during the first half of the year, as already-planned construction proceeded despite the downturn. As a result, rents there are down 17.2 percent.

Seattle, which has added more than one million square feet, has seen rents fall by 10 percent, while Boston has had a dropoff rate of 13 percent.

Let’s Get Creative

This trend leaves a great deal of room for deal-making.

“Until recently, an owner would typically say ‘this is the deal, take it, otherwise I’m going to the next customer,’” explains Joseph Genovesi, president of D.G. Hart, a New York commercial real estate brokerage.

“We started business in the early 90s, and really enjoyed that period, even though it was a downturn, because it was creative,” he reminisces. “These days, in order to address the needs of the market and do the more complicated deals, you need to be creative.”

And with the balance of power shifting at least partly away from landlords, many of the most complicated deals involve reassuring owners of continuous occupancy going forward while allowing tenants to take advantage of the weak market.

Stephen Dadourian, vice president at D.G. Hart, says the firm is currently helping a “major clothing retailer” obtain about 40,000 square feet of retail space at a prime Manhattan location.”The structure being proposed is not only a lease, but the lessee is also required to purchase a 49 percent stake” in the space, which will be organized as a condominium, he says.

The result will be a major “retail mall” in which the clothing firm will be the major tenant, he adds.

The remaining majority stake will be held by the current owner. Provisions allow either party to buy the other out over the 20-year lease period. “It’s a win-win situation,” Dadourian argues.

While the current owner gets to stay in control, he also gets a long- term commitment from the new owner-tenant.

And while the terms of the deal are structured so that “the rent basically incorporates both principal and interest,” the firm acquiring the space gets to reap the tax benefits, such as depreciation for all the work done on the office, that come along with real estate ownership.”

“On an after-tax basis, both the landlord and tenant will be better off,” he says, adding that this calculation assumes a “cost of money around prime.”

Click here for a breakdown of vacancy rates, rents and other data in 15 major metropolitan areas.

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