Almost every office user I speak to expects rents to be lower than they have ever been. Read the newspapers, they say. Look how high the vacancy rates are. Every landlord wants my lease desperately and we can negotiate very hard and get a very cheap rent. They are licking their chops at the opportunity so save significant dollars on the second largest expense in their business-occupancy cost.
I am in the market every day. I (and many others) consider myself to be an expert in the
Westchester market. I speak to building owners and their leasing representatives. I speak to my broker colleagues who represent both buildings and tenants. We all talk about the market, deal velocity, and the roadblocks to doing new deals today.
Here is what the realities are:
Our market is shrinking-a lot. Since I got into the commercial real estate business almost forty years ago, our office space market has shrunken from about 32 million square feet to about 25 million square feet-about 25%. That is what today’s statistics show. And it continues to shrink as obsolete office space is either demolished, converted to residential use, or repurposed to medical use. The boom in speculative office building construction was the mid-1970’s to the mid 1980’s, so our stock is all more than 40 years old and mostly functionally obsolete. No new buildings are or will be built as long as demand is low. And the costs of building a new building now would likely mean that leasing in them would cost more than twice as much per square foot as existing/old product.- Demand for office space is down-no question about it. But so are the space opportunities available to tenants. The costs to configure new office space for tenants has skyrocketed in the last 5 years. What used to cost $40 per square foot to build now costs $80 per square foot. Admittedly, some of that is due to the fact that tenants today expect some higher levels of finishes in their space, as well as more interior glass than ever before. But most of it is plain old inflation in materials and labor costs and now tariffs.
My job is primarily to represent my clients, the tenants and buyers. That means I have an obligation to achieve the lowest costs and best terms and conditions for them in any lease or purchase. But in order to negotiate the best deals, I need to understand what landlords are facing as well as what my clients are facing. In addition to buildout costs, landlords have faced (like any homeowner) increases in real estate taxes and operating costs.
The costs to a landlord to do a new lease transaction is roughly 3 ½ to 4 years of gross rent. Here is how it breaks down:
Let’s assume a tenant is paying $27.00 per square foot for our normal Class B
suburban office space. At $80 per square foot to build standard space, the construction
cost is about 3 years of gross rent $27 rent per square foot x 3 years = $81) But the landlord pays about $15 per square foot to operate the building (heat, air conditioning, electricity for common areas, general maintenance and repairs, landscaping, snow plowing, insurance, etc.) So out of that $27 per square foot, it nets about $12.00.
Out of that net income, it needs to pay its debt service in the form of its mortgage and any secondary debt. And the cost of borrowing the $80 per square foot to build out the new space. They also need to pay me for my services by bringing them the tenant and negotiating the transaction. And they need to pay the brokers that represent their
buildings, who market those buildings and negotiate the transaction on the landlord’s side. They need to pay their attorneys to prepare and negotiate new leases. Unless you are renewing a lease with no work, landlords cannot afford to a deal of less than 7 years, based on the math above, as it will not be profitable or add to the value of their building. To some businesses, that is an eternity, and they cannot project what their space need will be over that time period, particularly in this era of hybrid work. Many landlords cannot afford to do new leases at all, as they do not have and cannot borrow the capital required. So, they can only recycle old space with paint and carpet (and even that costs about $10 per square foot or more today). Occasionally that works for a tenant, but not often. And short term subleases can be relatively inexpensive, but who wants to move after 2 or 3 years, and no intelligent landlord will commit today to set rental rates at the end of that sublease.
There is less inventory than ever before. And less of it is of the quality that many tenants want or need. In this era of hybrid work, offices need to be nicer and aligned with today’s workstyle to attract employees to come to them. And I think most people agree that being together in person is the best way to run a business, to learn, to collaborate and to stimulate ideas and enthusiasm.
Almost all of the Westchester market demand is comprised of tenants of under 10,000 square feet. Yet the trend is for large companies to vacate large spaces that are designed to fit large tenants. These are very deep spaces (i.e., long distances between entry doors and the window line) and cannot be easily or economically divided. Our inventory is not in synch with our customers, and these large spaces will likely sit on the market for long periods of time. I have seen this cycle many times before, but this time it will take much longer to correct than in the past.
Our office market is actually very tight. Those buildings that have the financial strength to transact leases are few and far between. Buildings are being repurposed or demolished for higher and better uses. Costs are high, and rents have risen only a tiny bit in real dollars since I entered the business, while operating costs and real estate taxes have risen significantly. It takes creativity, market knowledge and solid relationships with fellow brokers and owners to uncover opportunities and capitalize on them to create new homes for our businesses. Forget about what you read in the newspapers. This is the new reality.