The Corporate Tenant Gamble

Becky Bergman is a contributor to Real Estate Southern California, from which this article was excerpted.

When it came time to renew its lease or move to a new location, Transamerica Occidental Life Insurance Co. opted to remain at the AT&T Center in Downtown Los Angeles for another 10 years. After scouting potential sites in Burbank, Glendale, Long Beach and Woodside Hills, Transamerica executives figured it would be cheaper and more convenient to re-ink a deal for 260,000 sf.

Hinted to be worth an estimated $75 million, one of the largest leases signed in the region during 2006 turned out to be a coup for the landlord, who didn’t need to go on a costly hunt for a replacement tenant. Transamerica, which didn’t have to change its letterhead, also scored big in the win-win deal by inheriting a plethora of new amenities when the 32-story tower underwent a major rehab.

While the insurance firm certainly didn’t mention upscale renovations and trendy architectural elements during its leasing negotiations–that would be taking tenant improvements to a whole new level–industry leaders say building owners know may proceed with the improvements anyway, knowing that it’s better than risking a major renter’s business.

Whether the market favors tenants or landlords, property owners are privy to when corporate tenants need to be wooed to stick around and when it’s simply okay for them to say “no deal” to their current leaser.

For Transamerica, the deal was critical because the renewal meant it wouldn’t have to shell out hefty relocation costs. The company could maintain a close proximity to its worker pool and, most importantly, the guaranteed the space it needed.

Although it occupies considerably less space, the Ratkovich Co. faced the same issues when its 20,000-sf lease came up for renewal last fall.

The law firm, which signed a 12-year deal worth $6.8 million, wanted to stay at 800 Wilshire, a 16-story office tower in Downtown’s financial district that is close to several freeways and metro lines.

Both the Transamerica and Ratkovich deals are significant because, while the vacancy rate inched above 14% at the end of 2006, several national corporate giants have already started gobbling up available class A office space in the Downtown region and CBD, although move-in could be another two years out.

Analysts anticipate the CBD could turn into an appealing alternative for cash-strapped, budget-conscious corporate tenants because current rental rates average $2.86 per sf per month for class A space and roughly $2.12 per sf per month for class B.

Driven by a strong regional economy, robust housing trends and a healthy job market, Southern California is poised for a bullish comeback of sorts, although it’s anyone’s guess who, tenants or landlords, it will favor in the coming year.

As rents shoot through the roof and vacancies dip to single-digit lows, the demand for class A office space continues to outpace new spec construction. Local real estate leaders say it may be only a matter of time before escalating rents begin to dive and the landlord’s market softens–or maybe not. The pendulum could shift in about 24 months, according to local experts. Landlords with projects in the pipeline now are eyeing tenants that will be ready to move in two or three years, when new projects are completed and current leases have expired.

“By the end of 2007 and throughout 2008, some of our most popular submarkets will see some significant new vacancy due to the availability of some new inventory and the relocation of some major tenants,” says Gerald Porter, chairman and founding partner of Cresa Partners in Los Angeles.

“By 2009, several new projects should be delivered to the market, which should relieve some of the pressure on tenants,” adds Porter, whose clients include DreamWorks SKG, Amgen Inc. and BAE Systems.

No one will deny that property owners are faced with daunting expenses, such as land, building and construction fees, which leave little wiggle room for financial surprises. On the other hand, large corporations say real estate fees typically eat up one-half to one-third of their income, playing a fundamental role in where many of these companies call home.

You don’t need to be a real estate exec to appreciate the “location, location, location” mantra. For several tenants in San Gabriel Valley, where vacancy rates dipped 2% last year, to 7.4%, community ties go hand-in-hand with corporate strategies. By inking deals to occupy space in the Majestic Realty Co.’s Crossroads Business Park, a one-million-sf office complex that sits on 110 acres, its three tenants, Comerica Bank, Kaiser Foundation Hospitals and law firm Alvarez-Glasman & Colvin, will have the advantage of being close to their customers, allowing them to conduct business directly within their community.

As annual vacancy rates hovered around 9.4% throughout the entire Los Angeles region in December, overall asking rates shot up for the 12th time, according to Grubb & Ellis. Class A office space runs about $2.86 per sf per month in Los Angeles while class B office space fetches roughly $2.24 per sf per month. That’s about a 12.6% and a 9.3% jump, respectively, over the previous year, according to Grubb & Ellis’ Office Market Trends published in December.

Chris Houge, a principal at Madison Partners, expects fewer corporate moves this year as higher construction prices and increased tenant improvement costs drive up rental rates. Tenant improvements can be a sticking point between renters and landlords, says Houge, who adds he’s seen $20 to $25 per sf allowances for everything ranging from conference room walls to exterior signage approved without a hitch.

Tenant improvement construction can run up as high as $75 or $80 per sf for complete build-outs, while allowances will only cover about a fraction of that, says Houge. Typically, the tenant is responsible for the balance or the landlord may simply add the cost onto the rental fees.

Houge recently renewed a deal with Lions Gate Entertainment to lease 85,000 sf in Santa Monica, where rents don’t come cheap: Houge says he’s seen some deals go for as much as $6 per sf per month. Lions Gate execs didn’t want to shell out moving fees and other high costs associated with relocation, says Houge, but the entertainment company did need additional space. It found what it was looking for when it snagged an adjacent building with an extra 31,500 sf.

Not every deal turns out to be a winner, however. While cheaper digs, more amenities such as parking, larger units, on-site security, proximity to transportation and corporate identity can and do motivate renters to uproot, not all corporate tenants are on the hunt for something new or better.

Some, such as a client Houge worked with last month, are looking to unload a problem and will do almost anything to find relief.

Houge says one client–whose name was not disclosed–was recently blindsided and forced to move when its operating expenses shot up a whopping 450% without warning, from $800 to $4,800 per month. This was due to Proposition 13, a statewide measure that freezes the value of property taxes levied on the building owners based on the time of purchase but didn’t afford the same benefits when a new landlord acquired the site.

Robert Lester, a real estate exec with Coldwell Banker Commercial’s Almar Group in San Diego, has had his share of dealbreakers in recent months as well. He recalls a group of attorneys who tried to gain the upper hand during negotiations with his landlord client, who wooed the team with a good rental rate, a few concessions and a favorable early termination clause. But the attorneys kept pushing, finally going too far when they requested that Lester’s client shoulder the firm’s liability insurance, which would have included mold, fire, theft, burglary and accidents coverage. Instead of closing the transaction, the landlord balked. The deal flopped and both the attorneys and property owner were back on the hunt for space and tenants.

A landlord would have to grow desperate to assume such a request, Lester explains; and, while changes are on the horizon, there is no indication yet that tenants will be calling the shots to that degree anytime soon. “You’re not going to see a landlord agree to that kind of deal anywhere,” Lester says. “It doesn’t matter what the market conditions are.”