The State Of The Market
by Robert K. Spicker
What do landlord’s see? Vacancy rates vary from 5% to 8% depending on whose reports you read. Rents rose about 20% in 1996 and there are some who believe that we will see a repeat in 1997. We are projecting a more conservative estimate of 6% to 10%. Most importantly rents are not at a level to justify new construction. So if vacancies are declining and there is no new building on the horizon, why aren’t rents going to continue a double digit rise in 1997? Demand is not as strong as in the past few years.
While job growth in the greater Bay Area will be strong we don’t see that same strength in downtown San Francisco. As a matter of fact, some of the leasing activity in 1996 was the result of strong growth outside San Francisco, particularly, Silicon Valley that forced some large space users to look to less expensive space alternatives in San Francisco. We see this as a false job growth that is not a portent of the future. In addition there are significant blocks of space coming available in 1997 as a result of the 1996 leasing activity. Among the leaders will be 345 California (280,000sf), 211 Main (360,000sf), 1 Beach and 2 North Point(200,000sf), and 215 Fremont Street (260,000sf). With the exception of 345 California these are not premier spaces, but they are alternatives for big users that will keep a lid on South of Market beauty contest sites. Only the Gap project with Montgomery Securities as the anchor tenant is likely to get off the ground before 2000 and this will in turn create a big vacancy in the Pyramid which some people would consider a class A building site.
In summary, we see vacancies remaining fairly constant in 1997 and rents going up by less than 10% in 1997. Still it will be a landlords market and improvement allowances will be lower and lease language discussions will get shorter.
Negotiating Leases & Partner Liability
As I just mentioned discussions relative to the lease language will get shorter in the months ahead. This doesn’t mean that important issues won’t have an audience, but it does mean that 50 comments on a lease for 5,000sf where there may be back up offers could cost your firm or your client to lose the space. Don’t be surprised on a small deal if a landlord says take your best shot at 3 comments. We find that this turn in the market is most disconcerting to tenants represented by non Bay Area counsel or, in particular, in house counsel where all leases regardless of size are expected to conform to a standard.
Loyalty to a firm seems to be a thing of the past in the legal profession and a landlord doing a 10 year lease with a law firm may likely not recognize anyone at the end of the term and the change in the firm can be significant enough that the lease may not run the term without renegotiation or default. As a result, landlords are demanding and getting partner liability either in the form of a guarantee or letter of credit or a combination thereof. Frankly, I think firms don’t mind partner liability because it works to get a commitment out of their partners. The discussion today is not about whether there will be any form of liability, but how much. A formula that seems to be generally used is that the initial amount is the landlord transaction cost plus some component of the rent. The landlord cost part will typically be amortized over the term of the lease and the rent component will remain to the end of the term. How fast the landlord cost will be amortized is based on the financial strength of the firm. A very strong firm that has been a long-standing tenant may expect the cost part to amortize over the first 5 years of a 10 year lease term. A renewal by a small firm with no landlord cost may be the only exception to the rule, but this will again be based on the nature of the history between the tenant and the landlord. If you are relocating to a new building and there is no history you may only have one option of a letter of credit for the entire amount of the landlord cost. Here again it is typical for the amount of the letter of credit to decline on an annual basis subject to a lack of default. In some instances the decline can be quite rapid since it is only the lack of a history that is missing from the landlords equation.
Office Sharing And Subleasing
An office sharing situation where the tenant takes more space initially than they need can be an easier process than subleasing. In an office sharing arrangement the landlord's consent is not necessary, but giving the landlord a copy of the shared agreement is the process. Office sharing is restricted to situations were the non tenant is using common facilities such as the phone system, conference room kitchens, receptionist etc. From a landlord position the important thing is to designate where the office sharing can occur physically in the premises and a precise number of offices. The number of offices is going to be small if a landlord is going to agree.
Subleasing usually involves some amount of construction to separate the tenant from the subtenant since they can often be a non law firm. In subleasing, consent is a requirement and the tenant will be expected to pay for the landlords legal fees to review a sublease. The landlord issues surrounding subleasing are the rights to extend and expand. Options are for the tenant and are not viewed by landlords as benefiting them. Expansion and extension options are viewed by landlords to be personal to the tenant and not to be passed on to a subtenant. Settling on some percentage of the premises that can be subleased without losing the rights to extend and expand is usually an acceptable compromise. Obviously the landlord is going to want a low percentage, particularly, below 50%. With rents rising we will be entering an era when the landlord is going to be calculating the possible profits for a 50/50 split. I would not be surprised to see landlords going for an increase in their split in the current market.
