By Taylor Williams
Success in today’s office sector is all about creating incentives.
Some companies, from small professional services outfits to tech giants like Salesforce and Airbnb, have completely capitulated to remote work and have aggressively slashed their office footprints. Others remain dogged in their commitments to nonresidential (and nonretail) workspaces. What works for one company may not work for its competitors, and there remains a fundamental need for at least some traditional office space across all major markets.
Against this backdrop, what separates the winners from the losers is the ability to create a draw, to give people legitimately good reasons to get up earlier, spend more time getting ready, endure traffic, put costly mileage on their cars, then deal with whatever quirky goings-on define their office experience. Needless to say, this can be a tough sell, especially for employees with families and suburban commutes.
Which is why owners, both of businesses and of the office buildings that house them, are getting creative. These corporate leaders and landlords are working in tandem to ensure that the spaces meet the precise needs of their workforces, from design and layout within the suite to access to onsite amenities and surrounding retail, restaurant and entertainment uses.
In order to achieve this goal in a high-cost construction environment, users are asking for — and generally getting — higher tenant improvement (TI) allowances to undertake customized buildouts of their spaces. In exchange, building owners, who are also allocating dollars toward those initiatives in the form of curating top-notch amenity packages, are asking tenants to commit to lengthier terms.
Of course, what qualifies as “lengthy” in today’s market — call it anywhere from a seven- to 12-year term, on average — was relatively standard in the pre-pandemic world. But the severity of the shock waves that COVID-19 sent through the office sector ensured that many new or renewed leases that were set to be executed in 2020 and 2021 were tabled or modified to reflect shorter terms. As we close 2022, the 12- and 18-month terms of many of those “kick the can” deals are expiring, setting the stage for a return to more traditional leasing structures.
“With the exception of a company here or there that’s relocating from the East or West Coast and doesn’t really know what’s happening in Texas, we are no longer seeing tenants be term-averse,” says Matt Schendle, managing director of agency leasing at Cushman & Wakefield’s Dallas office. “Many of the short-term extensions that were granted during the pandemic have become five-, seven or 10-year renewals.”
The flight-to-quality trend remains entrenched within the Dallas office market, Schendle says. For this reason, landlords, particularly those with older buildings, are very committed to working with tenants that are up for renewal — a sort of unspoken “thank you” for sticking with the building during the dark days of COVID.
Sources also say that the trade-off between TI allowances and lengthier terms is perhaps the most visible evidence of this shift — or reversion to the mean — in office leasing activity.
“Tenants that commit to a consistent, physical office presence understand that high-performing employees excel in environments centered around in-person, team collaboration and face-to-face interaction with leadership,” says Kelly Whaley, director of leasing at Harwood International, which owns the 19-block Harwood District in Uptown Dallas. “Harwood is seeing tenants invest in those environments to attract and retain those top performers.”
“To help offset a portion of the costs associated with that investment, tenants are signing long-term leases and receiving the corresponding TI dollars,” Whaley continues. “In the past, a TI allowance of $8 to $9 per square foot per year of term was an eye-opening amount in this market. But construction costs have gotten so volatile that the question of who pays for a retrofit or buildout has increased in importance. So landlords are working with tenants to facilitate their long-term operational strategies.”
Harwood recently signed Winstead PC to a 20,678-square-foot expansion at Harwood No. 2, bringing the law firm’s total footprint within the building to roughly 150,000 square feet. As a tenant at Harwood District for the past decade, Winstead was able to negotiate a TI package that allows the company to custom design its new space on the second floor.
If a tenant values flexibility and opts to deliver the kind of customized space that best suits an employee base with hybrid, ever-changing schedules, that company is in effect making a long-term ideological commitment to the office. Because the only way the tenant is going to get the landlord to cover a significant portion of the design/build costs is through a significant commitment. This dilemma can become a major gamble, particularly for smaller users that identify rent as a major driver of overhead costs.
Sources concur that this quandary exists for both new leases and renewals.
“We see tenants relocating to new buildings that provide spaces that entice their employees to return to the office, and even with renewals, tenants still want to revamp or reposition their spaces,” says Rhett Miller, managing director and co-head of the Dallas office leasing team at Stream Realty Partners. “Either way, that requires a significant amount of capital investment. So whether it’s a relocation or renewal, tenants have to commit to longer terms in exchange for the dollars to build out new space to entice their employees back to the office.”
Again, the definition of “long term” can and does vary from deal to deal. But within the context of the Dallas market, the concept of lengthier commitments generally refers to a minimum term of five to seven years. The wording also implies that tenants and landlords are steering clear of “Band-Aid” deals that proliferated during COVID, in which key long-run leasing decisions were delayed until more clarity prevailed.
Further, the tradeoff between greater TI allowances and lengthier commitments is something of a chicken-or-egg situation. Tenants need the snazzier spaces to justify their occupancy costs, and landlords need the extended lease terms to justify their TI costs. The impetus for compromise goes both ways, and the staggering cost of construction is the mechanism that brings the two perspectives together.
“We’re seeing businesses and companies display a lot more confidence in conventional leases, and a large part of that is tied to construction costs,” says Matt Wieser, managing director at Stream’s Dallas office and Miller’s co-leader of the office leasing team. “Tenants with 25,000-square-foot requirements simply can’t sign a five-year lease and build out space unless they’re willing to substantially come out of pocket.”
Stream’s office leasing team regularly reviews reports on costs of construction materials and labor, a factor that Wieser says has had visible impacts on how office leases are structured.
“If it cost a tenant $50 [per square foot] to build out a space pre-pandemic, it’s probably $75 per foot now for the same space,” he says. “Larger companies can find some economies of scale within that cost structure, but so many of these smaller companies are having to reinvent themselves to get people excited about coming back to the office, so we’re seeing these types of increases across the board.”
Other Factors
In making these difficult leasing decisions, tenants must rely on a wide range of inputted pieces of information: employee-specific demands, short-term cash flow projections, historical market analysis and a healthy dose of gut instinct.
Or maybe that’s overthinking it. What if the answer is much simpler and time-tested and can be encapsulated in a single word: location?
Evaluating office leasing decisions through this classic framework ensures that on some level, companies are actually thinking about the individual best interests of their individual employees. And that’s a good frame of mind to be in when trying to convince people to do something that benefits the company.
“When we speak to decision makers and executives on building tours, they routinely talk about commutes and drive times,” says Miller. “They’re battling to get people back to the office, and they’re thinking about how for months these people didn’t have commutes. With that in mind, we’ve seen that buildings with great access to major thoroughfares and infrastructure are among the highest in demand.”
Wieser concurs with this assessment. “If your building isn’t commute-worthy, then you’re sort of in the ‘have-not’ category,” he says.
Whatever the approach, the decision-making process is further complicated by an economy in which inflation shows no signs of meaningfully abating. Further, the possibility of imminent recession raises short-term questions about just how much space is really needed and whether taking that space qualifies as good use of company funds.
There is evidence, both empirical and anecdotal, to suggest that this question is legitimately worth asking. According to the annual Emerging Trends in Real Estate 2023 report from the Urban Land Institute, industry experts generally concur that somewhere between 10 to 20 percent of the U.S. office inventory will be need to removed or repurposed in the coming years to meet evolving tenant requirements and restore a healthy supply-demand balance.
Landlords are working to devise solutions for their tenants with those conditions in mind, says Lucas Patterson, executive vice president at Bright Realty, an owner-operator based in metro Dallas.
“While we are seeing an uptick in leasing activity and requests for space, flexibility is the top tenant demand,” he says. “That means we have to structure deals so that tenants can grow into their spaces as more people come back to the office or as the company experiences organic growth.”
Patterson acknowledges that that sword cuts both ways, meaning that flexibility should also account for a potential downsizing of spatial requirements. To cover that base, landlords can offer tenants the right of first refusal if the tenant aims to grow or the option to commit to spaces that are already spoken for — in other words, to sublet or assign their lease to another tenant.
Patterson also says that the vast majority of office leases that Bright Realty is currently negotiating all carry lease terms of five years or longer. Longer deals often include an early termination right for a fee, which will usually account for unamortized tenant improvements and commissions — another means of hedging risk while securing a long-term commitment.
Pictured is Crown Centre I, a 104,713-square-foot building by Bright Realty. The design allows tenants to tailor spaces to their needs, which is a common request in today’s market. In addition to a deli, fitness facility and conference facilities, the four-story building also caters to modern office demands via water features and green space with outdoor seating.
Flexibility can also be a top priority beyond the four walls of the office suite. Over the last two years and change, the pendulum has swung from emphasis on the vibrancy of the surrounding neighborhoods to health and wellness features within the building as the primary marketing tools that companies use to attract and retain talent. But with the pandemic now largely in the rearview mirror and the work-from-home trend threatening to dismantle growth and profitability in the office market, some tenants are reverting to hyping the external, nearby offerings as the biggest draws of their workspaces.
“We have a tenant at The Realm [at Castle Hills] whose major consideration goes back to the pre-pandemic want of a walkable environment with shopping, dining and entertainment,” says Patterson. “Especially for younger members of the workforce, having that surrounding vibrancy and density is incredibly important.”
With health and wellness, Patterson draws a distinction between features and amenities, noting that the latter has supplanted the former in terms of importance. “Today, we get fewer inquiries about air filtration and HVAC systems than we do about flexible common areas and outdoor amenity spaces,” he says. “While we still focus on our buildings’ air quality and cleanliness, the tenant focus has shifted from how the building can keep people safe to how the amenities and mixed-use components can attract employees and incentivize them to come into the office.”
Schendle of Cushman & Wakefield agrees that the amenity offerings are as important as ever in guiding the leasing decisions of office users, and that companies’ evaluation of these packages exists solely through the lens of enticing employees to show up.
“When we do tours with C-Suite executives, we ask what their goals are and listen, and most of the time the answer is, ‘how do we get our folks back in the office?’” he says. “That’s where the flight to quality and the amenities arms race comes into play. But the amenities have to be done right and methodical — you can’t just check a box and stick in a fitness center or conference center and think that’s going to do the trick.”
Naturally, the definition of “ideal” working space varies considerably. For some organizations, design with an eye toward enabling collaboration is paramount. This makes sense, given that one of the primary talking points among corporate leaders trying to get employees to return to the office involves interpersonal engagement. Such accommodations can take the form of flexible, portable seating and furniture and updated technology that is particularly well-equipped for group meetings and presentations. For other tenants, aesthetics reign supreme.
“The tenant lounge, fitness center, coffee bar, cocktail lounge — all those things were really important prior to the pandemic, and they’re even more important now,” says Wieser. “If you owned a Class A office building that had proximity to food-and-beverage concepts and had all of those amenities, you probably did well pre-pandemic. But now, there’s a new level of separation between Class A product and true best-in-class assets that really get people excited about coming back to work.”
To that end, it’s crucial that office owners know and accept the limitations of their buildings, as well as what’s feasible in terms of renovations and expanded amenities.
For example, green space has been widely lauded in recent years as both an antidote to COVID-laced indoor settings and as a simple way to enjoyably break up a workday. But not every building can have pocket parks and mini-plazas seamlessly and gracefully integrated into their existing designs. Owners of those properties must look to leverage the utility, comfort and flexibility of other common areas and amenity spaces — assuming that’s what their employees want.
If it’s not, they’d better start asking different questions.
— This article originally appeared in the November 2022 issue of Texas Real Estate Business magazine.