Part 3 of 4

[IMGCAP(1)]

SAN FRANCISCO—Many markets on the West Coast—including the San Francisco Bay Area, Silicon Valley, Portland, and Seattle—are home to a unique breed of start-up companies. These companies have strong venture funding, potential for high growth, and exciting exit strategies. That is according to Eric Turner, principal at Cresa Portland. We recently spoke with Turner about the specifics of start-up requirements, along with Joe Brady and Peter Hamann, SVPs at Cresa San Jose in part three of our four-part tenant Q&A series. “While the future often looks bright for these companies, they may experience turbulence when they need more office space to accommodate their growth,” Turner says.

This is especially true since these companies and their landlords can have conflicting interests and trouble meeting each other's demands, he adds. “Fortunately, forward-thinking companies and landlords can overcome these challenges.”

GlobeSt.com: What do these start-ups all have in common?

Eric Turner: They are typically less than three years old; desire “creative space” to support their company's culture; strive to find ways to attract and retain employees and achieve high growth; and are targeting an exit strategy within one to 10 years.

GlobeSt.com: What are some of the goals for early stage companies?

Joe Brady: Goals for early-stage companies are to limit upfront financial exposure, limit lease length, secure attractive space to recruit and retain top talent, and negotiate lease terms that align with business objectives. Aligning with a real estate advocate who understands these needs creates leverage in negotiating with prospective landlords. 

[IMGCAP(2)]

GlobeSt.com: Can their creative space requirements be easily met? What about in markets where demand is high and inventory is limited?

Peter Hamann: Creative space requirements can be difficult to meet, especially in those cases where demand is high and inventory is limited. Converting traditional office space into creative space is also expensive. For example, to convert a traditional office space with dropped ceilings and high walls into an open, collaborative environment with no dropped ceilings, exposed HVAC ducting, exposed brick & beam, and other high-end features can cost upwards of $70 per square foot to $90 per square foot. Landlords asked to pay for this work typically require longer-term leases (five to 10 years) to pay back their investment.  In addition, landlords will look for strong financial credit from the tenant, similar to a lending institution, and will require cash, letters of credit, personal or corporate guarantees, etc. to help mitigate their risk.

GlobeSt.com: What should a landlord keep in mind when evaluating these start-up tenants?

Turner: When evaluating a prospective tenant and proposed lease, the credit and financial stability of the tenant is a major factor. Landlords will want to review the historical and future funding or revenues of the company, its financial statements, and executive leadership. When evaluating a company's ability to fulfill its lease obligations, not all tenants are created equal. 

GlobeSt.com: As a follow up, what should happen in the early negotiations?

Turner: Early in negotiations for a property, start-up tenants should “frame” the context of their future goals to best position the company in lease negotiations.  Since there is no standard way of securitizing a lease, partnering with a real estate advocate who can speak to the company's leadership, culture, growth plans, and financial wherewithal, etc., allows start-up tenants to align their plans with a potential landlord to minimize upfront capital obligations and lease length. 

In this context, questions arise:

• How can start-ups balance the necessity of creating attractive space that reflects their brand against committing to a 5-10 year lease or spending significant upfront capital? 
• What components drive the landlord's requirement for long-term leases? 
• What can be done to secure the right space yet remain flexible? 

[IMGCAP(3)]

GlobeSt.com: What are some of the creative solutions you have found or seen lately?

Brady: Even in tight markets, companies can find creative space and short-term leases, especially if they are flexible. The best way to secure a short-term lease and favorable economic terms is to minimize the landlord's capital contributions and/or provide landlords with long-term, marketable improvements for their building.  Accepting a space in “as is” condition and finding solutions to minimize tenant improvements through furniture systems can reduce the landlord's capital exposure. In the event that tenant improvements are needed, try to create a work environment that meets the needs of the company as well as improves the long-term marketability of the space for the landlord. 

Another approach is to identify the sublease options within the market.  Often, a sublease can represent a discount in market rent, shorter lease term, and built-in infrastructure that often includes workstations, data cabling, and furniture. Tenants should ask their advisor to identify all “on the market” and “off the market” sublease opportunities.  Larger corporations may not want to actively market a sublease for internal reasons, and an experienced advisor who tracks and speaks with tenants should be able to locate these options. 

GlobeSt.com: What about the negotiations? What should start-up tenants consider in terms of protecting their interests?

Hamann: All lease terms, including tenant improvements, are negotiable.And if start-ups find a suitable space that doesn't require significant capital contributions, they're in a better position to negotiate other terms like length of lease, rental rates, rent abatement, termination options, etc. It is especially important for early-stage companies to protect their interests.  They should consider aligning with a non-biased real estate advocate who will not be compromised in landlord negotiations.  Also, partnering with a firm that incorporates project managers to assist with space programming, test fits, and building due diligence will protect against unforeseen issues.

GlobeSt.com: What if Short-term Leasing Isn't an Option? 

Hamann: Fortunately, other creative options can be negotiated into a lease: Subleasing, for example is the process of disposing all or a portion of a leased space to another company while remaining primarily obligated to the lease. This can be an attractive option, particularly if the space was creatively designed and highly marketable. Also, do your homework on

landlords. Do they own properties that could accommodate you? Some landlords are willing to enter into a new lease mid-term to accommodate a growing company in a different space they control. 

GlobeSt.com: What are the types of lease options these tenants should investigate?

Turner: As part of negotiations, tenants should weigh lease options to help mitigate future risk, including: 

• Option to Terminate.  For a negotiated penalty, tenants can terminate their lease obligations.  This is valuable in the reduction and absorption of space and can be important in the valuation of a company through mergers & acquisitions.
• Expansion Rights.  Tenants have pre-defined size rights to grow somewhere in the building or buildings controlled by the landlord. 
• First Right of Refusals and First Right of Offers need to be properly evaluated.
• Option to Renew.  Tenants have the right to stay in the building. During a renewal period, the landlord typically has limited down time, limited capital expenditures, and diverts risk. Therefore, tenants should receive below Fair Market Value rates.
• Option to Contract.  For a penalty, tenants can give back a predefined amount of space. 

Key to the overall process is the strategic planning that should precede the search for space.  It's important to think through potential impacts to the company's headcount and be realistic about growth. 

GlobeSt.com: Are there any other upfront considerations we haven't already covered?

Brady: Other upfront considerations include:

• Headcount: What does potential growth look like in one, three, five years?
• Timing:  Typical commercial real estate transactions can take 6-12 months (or more) to execute.  In tight markets, the sooner you start the process, the sooner you can be opportunistic in the market.
• Defined space requirements: For example, open and collaborative work environment vs. traditional private offices.
• Costs of relocation, including moving or purchasing new furniture, installation of data cabling and network equipment, costs of the physical move, etc.

GlobeSt.com: Any last minute advice on how  start-ups can mitigate risks?

Hamann: Start-up companies can mitigate risks and maximize returns if they start planning upfront.  If they conduct due diligence on the front end, they will invariably save considerable time and money. Whatever the market conditions, try to exercise your leverage, and make sure you are aligned with experienced and objective real estate advisors. 

Check back in the next day or so for part four of this exclusive tenant Q&A series, where we talk about conflicting business models and conflicts of interests in CRE.