Confused About Where the Leasing Market Is Going?

Join the club. In today’s commercial leasing world, to say there is confusion would be an understatement.

There are a few key scenarios that are influencing the direction or maybe one can say, the misdirection of the market. These include:

Recovery from the recession
Changing demographics of the workforce

First, it is not #RocketSurgery to understand the economics that hit the market from 2008 through as late as 2015 in some markets. Tenants were scrambling to keep above water. So, the first thing tenants did was to go to their landlords begging for some relief. In many cases, landlords were agreeable to reduce the rent in turn for a lease extension, commonly known as a “Blend and Extend.” While the rent was reduced for the remaining term, the Landlord made up for the upfront loss of revenue by extending the lease at a new lower market rate but not having lost revenue by having down time or the need to add thousands of dollars for tenant improvement work. Win-Win.

At the same time, rents on Class A buildings were reduced for new tenants. Often the result was firms that successfully navigated the recession started to upgrade from Class B to Class A space since the rates in those Class A buildings were now similar to what they were paying in their Class B property.

However, as those leases expired in 2014-2017 many landlords jumped on the positive economic news and increased rent. In July 2015, here in Orange County, CA, rents in many properties suddenly jumped over 150% thus leaving tenants in a lurch. Go back to a B space or absorb the new higher rents.

Each week it seems respected publications such as Bloomberg’s publish articles (we have reposted and blogged about these in the past) about the impact of the Millennials on the leasing market. At first it was driven by a desire to make urban offices more “user friendly” by adding amenities favored by millennials. However, as the millennials start aging, getting married and having school age kids, the urban life is converting to suburban life…better schools, affordable housing or even back yards.

These two dynamics are creating a very different model than we’ve seen. Over our years in the commercial real estate business we have seen periodic shifts where tenant go from Class A to Class B and back to Class A as the rental market shifts. This time things may be different. As Class B urban properties and, in particular, Class B suburban properties also invest in amenities to retain tenants, those landlords seek to get a return on that new investment. Will this be reflected in higher rates for those Class B properties? Will the Class A properties start dropping rates as their existing tenants flee to the suburbs or other urban B spaces?

Real estate is a market driven rather than a product driven phenomenon. If it costs $12.50 to make a shirt (I was in the apparel business for years), it sells wholesale for $25. The store then sells it for $50. Simple. However, if a landlord needs to get $2.50/SF/Month for a space to make a profit, if someone is willing to pay $3.50 for that space, guess what? We have a new market.

How will the market change in the next several years? The super collision is threefold.