Can the cycle be exploited to save costs? A real estate broker offers advice about what companies could be doing now to position themselves to maximize the savings from the current real estate cycle--before it's too late.

One of the most overlooked areas for cost reduction is the status of companies' office leases within a real estate cycle. They work hard at negotiating the best possible economics when it comes time to negotiate a new lease--yet they don't have a firm grasp on whether their company is positioned to take advantage of a soft real estate cycle or fall prey to a firming market and rising rental rates. On the other hand, companies armed with a keen understanding of the current cycle, and its cause-and-effect relationship, have been quietly examining the feasibility of recasting their current leases.

In many office markets across the U.S., the pendulum has already begun to swing back to the landlord. Premium projects in several markets have now reached 95 percent occupancy. Rents in the more desirable submarkets within a given metropolitan area are beginning to firm. Selection of top alternatives has quietly thinned--perhaps much more than most people realize, given the typical lag in real estate reporting. These factors are often the precursor of a significant change in the market.

A closer look at the cyclical history provides an eye-opening illustration of what the next few years will look like. Reis Inc. (www.reis.com) a leading provider of real estate research and forecasting information, tracks rental rate changes and forecasts rental rate growth. Led by a team of Ph.D. economists, Reis developed an econometric model that analyzes job growth, employment patterns, office trends and the supply of new construction projects being planned and/or built. Reis then gauges the impact of these variables and the effect on market fundamentals to formulate its projections.

This provides an interesting trend line and insight as to the cyclical nature of the real estate cycle--and the upcoming surge in gross rental rates across the country. The study points out that nationwide, gross rental rates bottomed out in 2004, and will grow at over 17 percent over the next three years, with the trend most likely to continue past 2010. In some markets, it is projected that rates will increase by more than 35 percent in this same timeframe. In reviewing this, consider the following:

* The projected rates for 2008 are still well below 2001 levels.

* Operating expenses, often the largest component of a gross rental rate, have increased substantially in the last five years.

* Construction costs (labor and materials) have skyrocketed over the past two years, causing 1) rental rates to reflect the increase; or 2) the fact that more tenants are coming out of pocket to subsidize their own finish (effectively a "hidden" increase absorbed by the tenant that is not reflected statistically).

* Many landmark projects across the country have increased their rental rates in certain submarkets by 15 percent or more in the last nine months alone.

Typical Benefits to Leveraging The Current Cycle

There has been a recent surge of lease-recast activity in the last 18 months. Most of these companies will be successful in reducing their occupancy costs by as much as 20-30 percent, putting them at a distinct operating cost advantage over competitors. Catching the cycle properly will usually equate to a savings of $1.5 million over a 10-year term for every 25,000 square feet leased.

The typical renewal tenant had three or more years left on its lease, and was able to achieve all, or a combination, of the following:

* Lower the rent over the remaining term;

* Secure long-term rates that will never reach what they currently were to pay for the remaining portion of their lease;

* Obtain a new base-year expense stop;

* Obtain additional rights, such as signage, expansion, additional parking and free after-hours heating, ventilating and air conditioning (HVAC);

* Obtain refurbishment monies to modify their space to revised standards;

* And, perhaps the most pervasive benefit, avoiding being exposed to a dramatically firmer market and higher rental rates when its lease would normally have expired.

Below are actual case studies for clients that have already leveraged the market downturn to benefit their leasehold situation:

Case Study 1 -- 25,000-Square-Foot Financial Firm; Lease Renegotiation 3 Years Prior to Expiration

This client had three years left in a Class AA landmark project. The project was being marketed for sale, and several large tenants that had lease expirations prior to theirs. Other high-profile projects in the vicinity were approaching 90 percent occupancy. Seeing that there were several factors that could have a substantial effect on rates increasing within the project (potential new ownership, lack of quality space at neighboring projects, larger tenants about to renew), the client was advised to consider an early renewal to leverage the current situation before it changed to the client's detriment.

The firm was able to lower its current remaining rental obligation substantially and obtain a new base-year expense stop. More importantly, two months after the lease was executed, a larger tenant recast its lease, the building took on a new direction and pulled all its previously tendered proposals off the table. In this extreme example, the landlord literally raised its quoted rate $4.00 per foot overnight.

Just by positioning itself properly before the cycle changed, this tenant calculated that it saved $2.3 million than had it waited until its lease would normally have expired.

Case Study 2 -- 50,000-Square-Foot Engineering Firm Renegotiates Last Five Years of Existing Lease

This suburban tenant was five years into a 10-year lease. What makes this case interesting is that the tenant had a cancellation option effective at the end of the fifth year, with a sizable penalty. After some analysis, it was determined that the market had deteriorated from when the lease was signed in 1999. Furthermore, the initial lease was aggressively stair-stepped, with the remaining portion of the lease at a much higher rental rate that the initial five years the tenant had enjoyed.

Even though it had five years remaining on the lease, in exchange for not exercising the cancellation option, the tenant was able to negotiate a savings of $974,000 over the remaining term. It also benefitted from a new base-year operating expense stop, and was able to obtain additional expansion rights that were desperately needed after it had exhausted all its rights from the original lease.

Why would a landlord want to do this? There currently is a feeding frenzy of building sales. Fueled by relatively low capitalization rates, owners are positioning their projects to maximize long-term value by securing long-term leases with their larger, credit tenants. Landlords are thus willing to provide benefits in the short term for extending lease terms.

Even though the landlord may lose some short-term revenue, he avoids the risk of the tenant relocating when the normal lease term would expire. Although rental rates may be on the rise, the landlord would avoid having the space go dark for several months to re-lease it, and the likelihood of having to fund a larger required allowance to retrofit the space to fit the needs of a future tenant.

While the landlord community has had a robust appetite for early lease renewals, there is an indication that this current window of opportunity will be closing--perhaps completely within the next 18 months. Not every landlord's crystal ball is the same, and there are several factors why a particular landlord may not be as aggressive in renewing tenants.

The landlord's motivation may be tied to how long it plans to continue occupying the project, how filled up the project is and what they project rates may escalate to. There may be other factors as well, such as the creditworthiness of the tenant or that the landlord is quietly trying to accommodate another tenant interested in the same space.

If you are contemplating an early lease renewal, make sure you revisit all the points in the lease, including establishment of a new base-year expense stop, landlord's responsibilities for adherence to The Americans with Disabilities Act (ADA) and other regulations. Then there are items such as whether a lobby refurbishment program is planned and other areas that may not have been properly addressed in the lease, such as building hours, extra-hours heating, ventilating and air-conditioning (HVAC) costs, parking charges and what obligations exist if you were to surrender of the premises.

Are You Candidate for an Early Renewal?

A simple checklist (see box on this page) can be used to determine if your company is a good candidate for an early lease renegotiation. If you occupy a full floor or more in an office building, you are a great candidate: Landlords will stretch for these users, since it means that they often do not have to pay for the cost to multi-tenant the space and rework the corridors. Also, they have to compete harder with other projects to keep these tenants.

If you can answer yes to two or more items on the checklist, you most likely can take advantage of the current window of opportunity.

In summary, we are in the midst of an extremely soft real estate market, and it would be remiss not take advantage of it before it turns. There are signs in several markets that rates have stabilized and the selection of larger blocks of space is beginning to diminish--often a precursor to much higher rents.

Much like the game of musical chairs, once a number of tenants are already in place, the remaining tenants may miss the market; lose necessary expansion options; be forced to move in a period of higher rental rates, higher tenant construction and moving costs; and find shrinking concessions and a smaller selection of desirable alternatives.

National Office Rental Rate Trends

$ per square foot

2000  $25.83
2001  $23.73
2002  $21.85
2003  $20.65
2004  $20.40
2005  $20.63
2006  $21.18
2007  $22.01
2008  $22.94

Data Source: REIS

Note: Table made from bar graph.

RELATED ARTICLE: Checklist for Lease Renewals

(2 or more put you in a good bargaining position)

__ Less than four or five years remain on your lease.

__ Current occupancy of your building is less than 80 percent.

__ Many neighboring building alternatives have available space.

__ Several leases in the building are due to expire in the next two to five years.

__ You occupy 20,000 square feet or more.

__ Your landlord has an interest in selling the project.

__ Your remaining rental obligation is higher than what your landlord is currently quoting.

Source: The Staubach Co.

RELATED ARTICLE: take aways

* The commercial real estate market is currently quite soft.

* However, there are signs that it is stabilizing in some areas, and rents in certain cities and regions are starting to rise.

* Smart companies could do well to take advantage of this part of the cycle to re-lease or take another lease elsewhere at attractive rates.

Frank Ricca, CPA, is a Senior Vice President at The Staubach Co. and has over 19 years of experience in real estate brokerage, focusing primarily on negotiating leases and build-to-suit projects on behalf of tenant users. He can be reached at [e-mail].