Ongoing softness in commercial real estate market

No one signs a 10-year lease anymore, but the costs to fit-up or refit space is near impossible to amortize over five years


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While the Northeast has hunkered down to get through this cold winter, one entertainment/distraction was the Sochi Olympics, which ironically struggled with warm temperatures. But just two weeks later, Russian troops are occupying the Crimean peninsula. As of this writing, there is serious saber-rattling going on. There is much talk about how the global capital markets will not allow Putin to take over the Ukraine (but maybe Crimea because that area is 70 percent Russian heritage). All very interesting.

These musings come to the surface when I start thinking about New York, Boston and other large cities that attract foreign investment and are home to so many foreign banks. It is a significant piece of globalization that seems to have faded into the background some, during the Great Recession.

But the bigger piece is the ongoing softness in the overall economy.

We see it in the commercial real estate sector, primarily with the term of leases. No one signs a 10-year lease anymore. Not IBM and not medical users (except for expensive clinical space). Yet the costs to fit-up or refit space are not cheap and it is near impossible to amortize the required improvements over five years.

We recently assisted a client in negotiating an office lease for seven years. They wanted to do 10, but a revision in the accounting rules makes them record the total obligation of the lease as a liability, so a 10-year lease (with escalating rents) is a 40 percent or 50 percent bigger liability than a seven-year lease. But they chose to amortize the retrofit of the space over 10 years, pledging to pay all unamortized costs if they do not renew after the initial seven-year term (which is big $$!).

Now, some tenants will sign a 10-year lease but insist on an early termination clause, perhaps after seven years, again paying the unamortized costs. It amounts to the same thing – seven years “in the bank” and a renewal more likely than not. But seven years from now, many things could have happened. More importantly, in seven years different people are likely to be making the leasing decisions.

Downsizing trend

Looking back over the last seven years, to 2007, things were really humming; real estate values were going up and up and up. Then, came 2008 and the bubbles started bursting left, right and center.

Unlike the previous four downturns, this one lingered and lingered. Some would say it is still lingering. As this downturn continued, people began to get serious about trimming occupancy costs.

Some of that was by investing in more efficient HVAC and lighting, but more significant was reducing the size of offices and workstations, including “hoteling,” where a workstation is unassigned and it is first-come, first-served.

Four years ago, a New York City client had three “hoteling” cubes; today they have eight. Many companies now say if you are not physically in the office at least three days each week, you do not get an office (or an assigned workstation).

A New York City client is moving from 96,000 square feet to 69,000 square feet (a 28 percent reduction). This is becoming the norm – get by with less space to better manage occupancy costs.

We do not see this trend changing, even when the economic rebound becomes more noticeable.

Bill Norton, president of Norton Asset Management, is a Counselor of Real Estate (CRE) and a Fellow of the Royal Institution of Chartered Surveyors (FRICS). He can be reached at wbn@nortonnewengland.com.

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