Why All the Sublets and What Does It Mean for the Future of Commercial Real Estate?

In the past 12 months there has been a significant uptick in the number of sublets hitting the market.  And these sublets are very different from the sublets we have seen in the past.  In many instances, companies are not merely looking to shed a fraction of their space, they want to exit their premises completely.  In addition, they are not looking to get out of their space in the last year or two of their leases, they are looking to shake things up much earlier in their lease terms.  What’s going on?

What’s Happening and Why?

As we have discussed in previous articles, businesses today are changing at a pace never before seen due to technology, consolidation and shifting preferences.  That makes predicting the future very tricky for corporate executives.  Unfortunately for businesses, real estate tends to be a long-term commitment.  The bigger the space and greater the capital outlay, the longer the required lease term needed to justify the disruption and amortize the cost.  For very large clients, 10 to 15-year leases are not uncommon.  In today’s world, however, a lot can happen within that time frame that was never anticipated when the lease was first signed.

When a business has a reduction in headcount, they typically pull out their lease to see if they have any contraction or early termination rights.  If they do not have these contractual rights, subletting becomes the next best option unless a consensual deal can be worked out with the landlord.

That’s what we’re seeing today.  The recent proliferation of sublets is the result of major changes in businesses that were never anticipated when the leases were first executed.  And the frequency with which companies will encounter unexpected changes in their business will increase leading to a paradigm shift in the way they consume real estate.  Interestingly, the increase in sublet space only reflects a fraction of the underlying efficiency problems faced by businesses. Sublets are only viable if the tenant can break off and market a discrete piece of their premises (or the entire thing).  However, there are many companies who cannot realize potential space efficiencies or shed excess space without significantly renovating their entire premises.

Law firms represent one of the best examples of this phenomenon.  Almost every major law firm in the country whose lease has expired in the past five years has shed a material amount of space in its next lease.   In Center City, most Am Law 100 and 200 firms who have signed leases or renewals in the past five years have shed one or two floors.  Smaller firms (unless they are growing headcount) have shed proportionate amounts of space.

Fifteen years ago, large law firms were generally consuming between 750rsf and 850rsf/attorney depending on the type of practice and use of paralegals.  Today, these same firms are achieving ratios of between 550rsf and 650rsf/attorney.  What’s driving the efficiency is the reduction in administrative support (secretarial/attorney ratios have grown from 1.5-2/1 to 2.5-4/1), smaller office sizes and less space devoted to large conferencing, libraries and filing.

However, to capitalize on the foregoing efficiencies, law firms cannot merely move everyone off of a floor, backfill them into other floors and then jettison the vacated floor. It requires a major renovation and reconfiguration of the existing space. That means law firms need to wait until they have leverage with the landlord to negotiate a new deal with major tenant improvement dollars before they can reduce their footprint and realize efficiencies.  And, while many law firms have now gone through this transformation in the past five years, the evolution of space reduction will continue for law firms and other businesses.  Law firms and few other businesses have yet to embrace, in any meaningful way, telecommuting and hoteling concepts. These could eventually reduce, even further, the real estate footprint of businesses if they take hold.

Thus, in addition to the sublet space we’re seeing in today’s market, there is a lot of “shadow vacancy” within the real estate market that will only be shed down the road.  What does all this mean for the future?

What to Expect

With the foregoing in mind, here are some thoughts and predictions about the future of commercial real estate:

  1. Tenants will seek shorter term leases and/or more contraction and termination rights so they have more flexibility to adjust to unexpected changes in their business.
  2. To minimize capital expenditures, Tenants will settle for less bespoke work environments and, instead, try to re-use existing improvements or lease pre-built spaces. Designs will be exciting and contemporary but will reflect more generic layouts so that they have residual value to the landlord and future tenants (i.e., like co-working space designs today).
  3. Tenants and landlords will collaborate to design more flexible workspaces that can be modified by furniture changes as opposed to bricks and mortar.
  4. Larger tenants will design their space with exit strategies in mind in case they need to jettison excess space. Thus, a tenant with floors 20-30 in an office building may design floors 20 and 21 as self-contained spaces that can be easily returned to landlord or sublet to third parties without (1) requiring the tenant to reconfigure the rest of its space or (2) requiring a subtenant to build in needed amenities to make that floor self-sufficient (i.e., it may be designed to have a reception area and conference and pantry facilities to support that floor as opposed to being a special use floor like a conference center, café or records storage area that is essential to the rest of the space or unusable to any potential subtenant).
  5. Rents will increase in order to amortize needed build out costs over a shorter lease term and compensate landlords for the loss of long term certainty.
  6. Lenders will need to change their underwriting criteria as buildings will not be anchored by as many long-term leases. There will be even more focus on landlords’ abilities to retain their tenants and how the inevitable shedding of tenants’ excess space will be addressed.  Marketing plans that distinguish the building and ensure retention will be critical.
  7. As tenants gain more freedom to move and are less financially anchored to their real estate, landlords will need to create more compelling communities that emotionally anchor tenants to the buildings or provide unique value for being in that building.
  8. Co-working spaces will become more popular as more large companies seek the flexibility these options provide. As co-working operators continue to pursue larger, more traditional office tenants, Landlords will start to see them more as competitors to their business as opposed to saviors soaking up vacant space in their buildings.  The larger co-working operators will start to buy their own real estate rather than paying retail rents to compete with landlords.  The larger landlords will get into the co-working business.

Conclusion

With business changing today at an ever-increasing pace, planning is becoming more difficult and riskier.  A lot can and will happen over a 10-15-year period that was never anticipated when the lease was originally signed.  The increase in sublet space and shadow vacancy that we are seeing today reflects these unanticipated changes being faced by tenants.  As subletting is rarely a profitable or breakeven proposition, tenants will need to change the way they consume real estate going forward. And that means commercial real estate is in for a wild ride.

 

 

 

 

 

 

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