In the office leasing market, the landlord-tenant tug-of-war has flipped to favor landlords, empowering more to combine smaller office spaces into larger blocks to capture bigger, more stable tenants.
In the past few years, landlords often broke up large spaces into smaller ones to attract affluent financial services companies, such as hedge funds, brokers said. Now, the worm is turning.
As the financial services sector — which this past spring accounted for more than 35 percent of total Manhattan office leasing activity — evolves, brokers said they anticipate seeing more and more smaller spaces, many of them pre-built ones, combined into larger spaces to attract affluent tenants.
“We’re at a maturing point in the market where the little financial services firms are getting pushed out of the market — many are getting hurt these last few weeks — but the more mature companies are now no longer 10,000-square-foot tenants,” Stephen Gordon, a senior managing director at PBS Real Estate, a boutique commercial real estate services firm, said. “They’re 40,000- and 50,000- and 70,000-square-foot tenants. It’s now the landlord’s responsibility to accommodate these super-successful funds.”
The Empire State Building is a prime example of the trend favoring larger spaces. A $400 million capital and aesthetic improvement plan announced late last year for the 2.6-million-square-foot landmark tower on 34th Street includes an aggressive strategy for consolidating its many tiny offices. In mid-2006, there were 545 office tenants in the building, and there are currently 452, said Stephen Eynon, the director of leasing for the building’s leasing agent, CB Richard Ellis.
The goal is to shrink the number of office tenants to about 250 over the next five years while increasing the number of full-floor tenants from the 11 that were in the building in September 2006 to 26, Eynon said.
“A lot of the larger, more sophisticated landlords are doing it,” said Fred Posniak, a senior vice president for Wien & Malkin, the management company for the Empire State Building. Posniak is also the asset manager for the W & H Properties portfolio, which includes eight office buildings in addition to the Empire State.
Consolidation of pint-size office spaces “is actually a portfolio-wide program that we implemented in 2003, even before the market got as white-hot as it is now,”
Posniak said. “In some of our buildings, we’ve had an enormous number of smaller 200-, 300-, 400-, 500- and 1,000-square-foot tenants. That creates a lot of management-intensive work.
“Plus, when the economy’s not so good, these smaller tenants have a large rollover.”
At the Lincoln Building at 60 East 42nd Street, for instance, there were at one time almost 700 tenants in the building, Posniak said, but they have been reduced to slightly more than 400 thanks to office-space consolidation.
“At the same time, we’ve increased occupancy in the building,” he said. In 2005, the occupancy rate was 89 percent, and in
August, it was 95 percent, Posniak noted.
Consolidation, capital improvements and market forces have also driven up rents. “The average rent in 2005 was $36 a foot; today, it’s $73 a foot,” Posniak said.
Historically, companies were often smaller and had smaller requirements for office space, so tiny slots for offices made sense, said Daren Hornig, a managing partner of Saxa, a development and investment company.
Changing mindsets
“Harry Helmsley had the mindset that more tenants is better, because you diversify your risk among a larger tenant pool,” Hornig said of the legendary New York City landlord. “And going back 40 or 50 years ago, the market was [more] smaller companies.
“However, landlords today, without a doubt, look at it with the feeling that ‘less is more,'” he said.
The current strong office market, in which landlords have the upper hand, is enabling them to bide their time and wait for smaller leases to expire to combine office spaces, brokers said.
“The rents are so good now that landlords aren’t under as much pressure to renew people as they might have been,” said Simon Wasserberger, a senior vice president at CB Richard Ellis. “They can let a 5,000-square-foot lease expire, then let another 5,000-square-foot lease expire, and then go re-lease it at 10,000 square feet. They have that much confidence in their ability to replace these tenants with larger tenants.”
Gordon of PBS Real Estate agreed: “The landlords in premium buildings are looking at 25 to 30 percent increases in their asking rents in the past year, so it was to a landlord’s advantage to wait for the right tenant for a full floor.”
Better view, higher price
Brokers said that landlords will often try to consolidate space for a number of reasons. One is to capitalize on the views of smaller offices.
“If there’s a smaller unit that has a nice view, and if there’s a unit adjacent that doesn’t have the same view, landlords like to combine them to bring value to more of the floor,” said Robert Emden, a principal at PBS Real Estate. “That will
always command a higher price.”
In fact, instead of fetching the average of the rents for the two combined spaces, the entire unit would garner a rent closer to that of the unit originally offering the views.
“If the unit with the Central Park view is $150 a square foot, and the other unit with no view is $120 a square foot, by combining the units, the larger unit isn’t worth the average of those numbers, but rather $150 a square foot, or a slight discount from that,” Gordon said.
Also, converting a floor with many tenants to a full-floor office enables the landlord to do away with the wasted space of a common corridor, making operations more efficient, brokers said.
“If you have a multi-tenanted floor, the landlord has to build a common corridor, and he has to maintain that corridor,” said Bob Stella, a principal and executive vice president at Cresa Partners, a corporate real estate advisory firm. “There’s a hallway that gives everyone access to the passenger elevators, service elevators and bathrooms. The landlord’s responsible for cleaning it, doing repairs, keeping it air-conditioned.
“Now, if he puts a full-floor tenant in there, he doesn’t have to do any of that,” Stella said.
Cutting costs through economies of scale
Another incentive for landlords to go big is exorbitant construction costs, which may be putting a damper on some plans for smaller pre-built office spaces, brokers said.
“In construction, there are economies of scale,” Wasserberger said. “To build out a 20,000-foot floor, let’s say it costs $80 a foot. To build out 1,000 feet, it may cost $150 a foot, because it’s so small, and there are certain irreducible costs in construction. It’s another reason there’s a disincentive to have smaller spaces.”
Two deals at 590 Madison Avenue illustrate the trend. There, the owners broke up a 24,000-square-foot floor into several small pre-built units last year and leased them quickly, said David Emden, a managing director with PBS Real Estate, who was not the leasing agent on the transactions but has worked with the landlords in the past. However, when PBS asked them to break up another floor, the landlords steadfastly refused.
“They sat with the full floor a little bit longer than they did [with] the pre-builts, but in the end, they came out winning,” said David Emden. While the landlords started with average asking rents of $120 a square foot a year ago, in August they ended up achieving an average rent of $175 a square foot for the floor in its entirety, he said.
As a result of the current trends, smaller companies will face a tough time finding space, especially in Midtown Manhattan, brokers said.
“It’s tough to find space period in this market, but we’ve had a couple of smaller 3,000- and 4,000-foot requirements, and there are not as many options out there for them as there are for some of the larger companies,” David Emden said.
Also, there is little new construction of office buildings taking place, and what is being built is not designed to accommodate smaller tenants. However, in some buildings, such as 7 World Trade Center, which has large, 40,000-square-foot floors, the landlord has set aside some smaller offices for five to seven years, where the larger tenants can eventually expand.
Those smaller offices, typically pre-built, may provide a short-term option for some smaller companies.
“I think the small- to mid-size opportunities are going to be harder and harder to find, because no new buildings are being built for that type of use,” Hornig said.