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The opportunities and challenges of today's office leasing market.

The opportunities and challenges of today's office leasing market

Never before has more new office space been available or under construction in major markets across the nation. In these circumstances, "dealmaking" office tenants, such as corporations, banks, and professional firms, face considerable opportunities-as well as challenges-if they are looking for large amounts of space in proposed buildings. Potential tenants become dealmakers if their leases are such a significant percentage of the entire building that their participation will put the developer over the top.

The dealmaking tenant can be motivated by the prospect of an equity interest in the form (more often than not) of a limited partnership with the attendant benefits of cash flow participation, a tax shelter, and future appreciation.

Consider what has happened in the Los Angeles market, which offers valuable lessons for developers and tenants everywhere. When seeking office space in the past, Los Angeles' major firms were usually content with very competitive rents, above-average tenant improvement packages, and possibly signage rights to put their name on the building. Not any longer.

New concessions

Within the past few years, Los Angeles' tenants have begun asking for - and often receiving - equity positions in buildings.

O'Melveny & Myers was one of the first big Los Angeles tenants to succeed at this strategy. This law firm secured control of a major parcel on downtown's redeveloped Bunker Hill, and then proceeded to select Olympia & York as developer.

As part of this transaction, O'Melveny & Myers signed a lease for approximately 200,000 square feet of office space at the proposed 400 South Hope Street building, and it received a 50 percent equity interest as a general partner in the 689,000 square-foot building. The combination of O'Melveny & Myers' land and lease aided Olympia & York with the arrangement of the financing package for the building.

No sooner was this partnership deal finalized when the accounting firm of Price Waterhouse started to negotiate for 106,000 square feet of space in the same building. As the lease negotiations developed, it became clear that Price Waterhouse was going to insist on a rent cap. Not wanting to open the door for everyone by agreeing to a rent cap, the partnership instead sold a 10 percent equity interest in the building to Price Waterhouse.

The 400 South Hope Street transactions were relatively simple compared to the deal put together by Maguire Thomas Partners with Pacific Enterprises for downtown Los Angeles' Library Square project. By mid-1986, this proposed 73-story tower was 35 preleased, but it needed one more large tenant to obtain a go-ahead.

Enter Pacific Enterprises, a $5.3-billion firm which owns the Southern California Gas Company, Thrifty Drug Stores, and Big 5 Sporting Goods, among other. In a complex deal, Pacific Enterprises signed a 180,000-square-foot lease at Library Tower and made a significant equity contribution to the project. In return, Maguire Thomas Partners gave Pacific Enterprises a 50 percent share in the building and a limited partnership position, and entered into a lease takeover agreement for Pacific Enterprises' current 125,000 square feet of office space in downtown Los Angeles's Chase Plaza.

In an equally complex transaction, Southern California Gas Company signed a lease with Maguire Thomas Partners for 500,000 square feet at 52-story Grand Place with favorable rents and terms, and it obtained a 15 percent equity share in the building. Then, Southern California Gas Company sold its existing square-block downtown property to Shuwa Investment Corporation with a leaseback, which enabled it to continue to occupy the building until moving to its new headquarters in 1991.

The tenant's responsibility

When dealmaking tenants take equity shares in buildings, they also have to make the choice of whether or not to become general or limited partners. Either role involves issues of control as well as financial responsibility, and requires very careful consideration by both the tenant and developer.

Tenants will generally prefer to limit their ultimate responsibility unless they feel that they have adequate expertise in the development arena. The developer, in turn, will prefer to remain the general partner in order to retain control over the project.

Before entering into such an agreement for a general or limited partnership and signing a letter of intent for its proposed lease space, a tenant must evaluate the challenges of the new role. With the advice of a broker and attorney, the tenant will protect interests by structuring a deal which meets its corporate planning and financial objectives. Most tenants become limited partners in the building, thereby taking no risk other than monetary outlay.

As limited partners in the building, tenants often assume a different perspective from the developer. Because of their dual role, limited partner/tenants want a good quality building as well as a competitive rent. On the other hand, developers will tend to maximize the project's profit potential by controlling costs.

If tenants become limited partners in a new building, they must gain a say in its design, planning, and construction if they want to get full value for their equity share. By taking this step, the developer will satisfy its cost concerns and will complete a building which suits the tenant's long-term goals as limited partner in addition to its everyday requirements as tenant.

Both parties' interests require that their agreements address not only all promises with great specificity, but also the methods of implementation. The agreement will include the description of performance criteria for the building and its systems - such as elevators or air conditioning - and will detail implementation procedures which should be clarified between the parties from the very start. Tenants run the risk of not gaining full advantage from their negotiations because they will be involved with a very professional and experienced developer, but will have little technical expertise of their own.

The project consultant's role

A project management consultant can advise tenants, attorneys, and brokers about the establishment of technical criteria for the building as well as the implementation procedures as they relate to planning and construction issues.

Tenants require expert advice for the review of the project's schematic building plans as they relate to parking layout, site planning, architectural design, material selection, core configuration, the spacing of structural supports, the building grid, and bay depth - plus the testing of these layouts to demonstrate that they will meet the tenants' proposed requirements.

Equally important, tenants and their advisers must determine the building's performance criteria for elevator systems; heating, ventilation, and air conditioning systems; and electrical systems, as well as any of their special requirements. Likewise, tenants must scrutinize the project budget and schedule to confirm that they meet the tenants' financial and timing requirements. And the overall building design must be compatible with the image of the tenants as well as fit the character and scale of its environment.

Dealmaking transactions between the developers and potential tenant/partners come in all ranges of difficulty. Witness the relatively straightforward Price Waterhouse deal at 400 South Hope Street, the complex O'Melveny & Myers transaction at the same property, or the even more complex Pacific Enterprises and Southern California Gas negotiations with Maguire Thomas Partners.

But the rewards of diligent negotiations are obvious. They can represent the classic win-win situation: the tenant gains a valuable equity share and a say in building plan, design, and image. Plus, the developer achieves the all-important go-ahead for the project.

Fritz Kastner is chairman of Stegeman and Kastner, Inc., a Santa Monica, Calif.-based project management consulting firm.
COPYRIGHT 1989 National Association of Realtors
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Author:Kastner, Fritz
Publication:Journal of Property Management
Date:Sep 1, 1989
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