These are trying times for office landlords. While several economic indicators suggest that a recovery is taking shape — Gross Domestic Product growth is expected to exceed 4% in the fourth quarter, corporate earnings are on the rise and consumer spending is healthy — the employment market remains painfully sluggish. The U.S. Labor Department reports that the economy lost 93,000 jobs in August, raising total job losses since the start of the year to 431,000.

Clearly, the weak jobs data continues to delay recovery of the office sector, but it has also given corporate tenants tremendous leverage in lease negotiations. That's particularly true in the weakest markets where vacancy and rental rates have conspired against owners.

For example, in San Francisco and Dallas, where CoStar Group Inc. reports vacancy rates to be among the highest in the nation at 20%, tenants are aggressively locking in 10- to 15-year terms at discounted rates, despite resistance from some landlords holding out hope for a rebound in rental rates.

Landlords' resolve is being tested, however. The average national asking rent has fallen from the peak of $28.71 in early 2001 to $25 at the close of this year's second quarter, according to real estate research firm Reis Inc.

Given the clout they now wield, some tenants with no intention of uprooting themselves are using the steep national vacancy rate of 17.6% to strong-arm landlords into sweeter renewal deals, say brokers. Not all tenants are bluffing, however, as one huge San Francisco office lease shows.

Mega-Deal in the City by the Bay

When San Francisco law firm Orrick, Herrington & Sutcliffe took stock of the office leasing market last year, it found plenty of landlords anxious to court its business. The venerable law firm ultimately settled on a brand new office building located south of Market Street in downtown San Francisco.

In fact, the Orrick deal was San Francisco's largest office lease of the year and the negotiation process played out in dramatic fashion. The deal pitted two office REITs against one another in hot pursuit of Orrick. Equity Office Properties Trust ultimately prevailed, leaving rival Boston Properties with an empty office building.

Orrick signed a 157,000 sq. ft. lease at Equity Office's Foundry Square II building in March. The firm paid $28 per sq. ft. for 10 years with an option to extend for five years, according to a brokerage source. To put those lease terms into perspective, consider that just over three years ago top-tier, Class-A space in San Francisco fetched $80 per sq. ft.

The 10-story, Class-A tower with 482,900 sq. ft. of office space has since been renamed the Orrick building. As of mid-September, the property was 57% occupied following the Orrick deal.

“We received proposals from about eight or nine different buildings. From our perspective, it became apparent about midway through that Boston Properties wasn't going to be as aggressive as several of the other building owners,” says William Murray, a real estate partner at Orrick who helped spearhead the lease negotiations.

It's easy to see why Equity Office went to such great lengths to bag a tenant. Equity Office's San Francisco portfolio was 22.4% vacant as of mid-June, and that figure doesn't include sublease space. The giant REIT reports that lease expirations between now and the end of the year will total 466,432 sq. ft. at its San Francisco properties, representing $16.6 million in annual rent.

How Bad Are Fundamentals?

CB Richard Ellis lists the mid-year office vacancy rate in San Francisco at 19.3%, nearly 2% above the national average. Needless to say, job losses in the technology sector have crippled this market — and sources believe that more layoffs are forthcoming. More than 750,000 sq. ft. of office space was returned to the market during the second quarter, according to Boston-based tenant rep firm CRESA Partners.

The counties of Marin, San Francisco and San Mateo lost nearly 30,000 jobs between May 2002 and 2003, a 2.7% decline. Meanwhile, asking rents in San Francisco's CBD have declined 18% since the beginning of 2003. Adding to San Francisco's misery is 11 million sq. ft. of new office space that has come on line since the end of 2000, according to CoStar.

“Landlords are less in denial than they were one year ago, but they still don't want to limit their upside by signing incredibly long leases,” says Daniel Cressman, managing director at Grubb & Ellis' San Francisco office.

Orrick's 15-year term at Foundry Square II officially begins next July, when all 375 of its employees will move into the space. Boston Properties' 400 Sansome Street will see its occupancy decimated — Orrick is the building's sole tenant.

“Equity Office bent over backwards to accommodate us here, and we looked at over half-a-dozen buildings,” says Murray. San Francisco-based CAC Group represented Orrick in the deal. Murray says that the new building's location — which he calls “edgy” — was less of a draw than its high-tech, brand new status.

The property boasts 60,000 sq. ft. floor plates — large by San Francisco standards — as well as 12-foot ceiling heights. The large floor plates will give Orrick flexibility to change its office configuration as the firm expands, says Murray.

“We were very aggressive with Orrick since we have some shelf space in this building,” says Rob Paratte, a partner at Wilson Meany Sullivan LLC. Paratte's firm developed Foundry Square and now handles all leasing assignments at the complex.

Paratte believes that the building's unconventional location south of Market Street, plus the flexibility to expand as needed, were key factors in Orrick's decision to ultimately sign the lease. “Also, on the side of the building they will get a sign with their name on it.”

Indeed, the building has already been renamed after the firm, and additional signage rights come with the lease. Cressman says that signage rights are fairly unusual in the San Francisco market, especially south of Market Street.

For its part, Boston Properties declined to comment on Orrick's lease at 400 Sansome Street, which expires in August 2004. But one San Francisco real estate source says that Boston Properties' “smug” approach to the possibility of Orrick leaving 400 Sansome Street didn't help matters. “I don't think that Boston Properties was that aggressive, either, and there aren't tenants knocking on the door to replace Orrick there,” says the source, who asked not to be named.

While most San Francisco landlords can't ignore tenant demands for longer lease terms, Cressman believes that long-term deals represent a Pyrrhic victory. “No landlord wants to cut a 10-year deal on these rates, but there are some buildings where they just have to do it.”

Timing Is Everything

Law firms aren't the only ones leveraging the gloom to cement good deals. In April, the California Academy of Science leased 200,000 sq. ft. for only $15 per sq. ft. at downtown San Francisco's 875 Howard Street. The initial four-year term comes with extension rights of five more years, making it effectively a 10-year deal.

Only three years ago, tech firm March First signed a 175,000 sq. ft. lease at the same building. The now defunct dot-com spent $49 per sq. ft., or more than three times what the Academy of Science spent on the same space this year.

Meanwhile, Wells Fargo Bank, which leases 1.6 million sq. ft. of San Francisco office space, has renewed nearly 800,000 sq. ft. within the past seven months. “We've been pushing for, and getting, 15-year leases in the low $20s with plenty of TI's [tenant improvements], and these leases have a lot of flexibility,” says David Nelson, senior vice president of corporate properties at Wells Fargo. The financial services giant has saved more than $80 million on lease renewals based on the attractive rates it is locking in, according to Nelson.

Some landlords that Nelson encountered resisted his overtures to go long. In most cases, however, resistance proved to be futile. “It's a strategic move to take advantage of market conditions. We now have long-term leases, plus exit strategies.”

In Dallas, Renewals Are The Rage

Taking charge doesn't necessarily mean relocating. Despite the many options open to tenants, plenty are staying put. In many cases, these tenants are merely bluffing. One Dallas leasing broker has seen plenty of “well-orchestrated searches,” but few actual moves into new space.

“The business here in Dallas is all about renegotiating on renewals. Landlords here are resisting longer-term leases, but many of them have to give in,” says Randy Cooper, senior vice president at CB Richard Ellis' Dallas office.

Dallas/Fort Worth was the nation's weakest office market at mid-year, with 20.7% vacancy (among all classes of property), according to CoStar.

Nearly one-third of all CBD office space in Dallas was vacant at the end of the second quarter, while asking rents have fallen for seven straight quarters. Dallas landlords are allowing tenants to renew leases as early as 24 to 36 months ahead of expiration, and 6 to 18 months of free rent are common concessions.

Case in point: Dallas law firm Baker Botts locked in more than two years ahead of its lease expiration. The firm recently signed a 170,000 sq. ft. renewal at 2001 Ross Avenue, a Class-A office building in downtown Dallas. The new 15-year deal doesn't kick in until Jan. 1, 2006, a full 27 months from now.

When Baker Botts explored the office market last spring, the firm's attorneys were thinking about a 10-year renewal, tops. “A lot of our real estate lawyers said ‘don't sign a 15-year deal!’ but it was just too hard to resist. When we saw the numbers, we knew we could go longer,” says Jonathan Dunlay, a partner at Baker Botts.

While Dunlay refused to disclose the economics of the lease, he did say most landlords in Dallas weren't anxious to sign Baker Botts beyond 10 years. “We looked at moving to other places. It's unusual to see so many 15-year terms out there.”

Resisting Tenant Demands

Not all Dallas landlords are caving in to tenants' long-term demands. When Schlesinger Associates, a marketing research company, visited Lincoln Property's One Lincoln Park office building in north Dallas, Schlesinger liked what it saw at the 262,000 sq. ft. building. But Lincoln Properties balked when Schlesinger demanded a 10-year lease with a built-in termination clause.

Since One Lincoln Park is 91% occupied, the landlord didn't have to sign Schlesinger. “We're not against the concept of a 10-year deal,” says David Quizenberry, senior vice president of marketing at Lincoln Property Co. “Some tenants think the market will get worse before it gets better, and are renewing for short terms.”

According to Quizenberry, rental rates peaked at One Lincoln Park in late 2000 at roughly $29 per sq. ft. Now, however, space is being leased at One Lincoln Park for around $22 per sq. ft.

“Less than 10% of Dallas landlords can consider turning a tenant away in this market,” says CBRE's Cooper. “These guys are the exception.”

Recovery Timetable In Question

So how soon until the pendulum swings back in favor of landlords? It all hinges on job growth. Even if job growth picks up this quarter as economists predict, it will take time to burn off the empty space. The national vacancy rate at mid-year was 17.6%, which amounts to a half a billion sq. ft. of empty office space. That's the highest national vacancy since the early 1990s. Just three years ago, vacancy was 8.5% with 230.8 million sq. ft. of vacant office space, reports Grubb & Ellis.

When the national office market is in equilibrium, say industry experts, the vacancy rate ranges between 10% and 13%. Anything below that 10% threshold is considered a landlord's market.

So for the market to drop to 13% vacancy — or the top end of a balanced market — from where it stands now, a staggering 154 million sq. ft. must be absorbed. Despite this glut, some believe the market is in the early stages of a leasing recovery now: a full 529,000 sq. ft. of Class-A space was absorbed during the second quarter alone, which is the first quarter of positive net absorption in three years.

The best scenario possible for the office market is for GDP to keep rising, which will spur new hiring in Corporate America. Doug Duncan, chief economist for the Mortgage Bankers Association, projects GDP growth of 4.5% in the second half of 2003.

“I'm a bull for the next six months,” Duncan says, pointing out that employment growth generally lags significant economic expansion by one quarter. “If the third quarter registers economic growth of 5.5%, then you will start to see employment pick up in the fourth quarter.”

But it's unclear how soon thereafter demand for space will pick up by corporate users. Many landlords banking on a 2004 or 2005 recovery are pushing for shorter-term leases while some credit tenants like Orrick are vying for longer terms that will carry them through the next tight market. Tenants are also building termination clauses into their leases, which gives them the best of both worlds.

“This is the perfect time to do long-term planning,” says Marcus Rayner, managing director of CRESA Partners. “Tenants can take advantage of the market instead of having it take advantage of them.”

Going Long Isn't for Everyone

Uncertain about the future, many tenants shy away from 10-year leases.

For every law firm eyeing a 15-year renewal, 10 other office tenants are shying away from long-term deals. Why? Many tenants prefer two- to three-year terms today simply because they are uncertain about the future of their businesses.

While it's true that by taking that route they run the risk of having to renew their lease in a much healthier market for landlords, the alternative of being trapped in a 10-year lease makes them tremble. The middle ground is a longer lease with a built-in termination clause, but landlords are only granting that option to credit tenants.

“Most tenants are still uncertain about their long-term business plans. Some sectors like health care and law firms are more confident, and they are the only ones looking for long-term deals,” says Bob Bach, national director of research for Grubb & Ellis.

In fact, Grubb & Ellis data shows that the average length of an office lease has shortened since the end of 2000 [see chart]. Back then, the average lease spanned 62.9 months, or slightly more than five years. By the beginning of 2003, the average was down to 54.4 months, or four and a half years.

As the chart shows, the average length has risen by 1.4 months since the beginning of 2003, which could be an indication that tenants, in particular law firms, realize the market is at the bottom and now is the ideal time to go long. Law firms accounted for 20% of all lease transactions in San Francisco last year, encompassing some 1.1 million sq. ft.. Other major markets experienced active leasing on behalf of law firms, too.

“Tenants want flexibility today. I'm hearing from brokers here in Chicago that people are concerned about losing their jobs,” says Tom D'Arcy, vice president of leasing at Hines' Chicago office. “That makes it hard to sign a long-term lease, both for tenants and landlords.”
Parke Chapman