Office landlords are getting more mixed signals about the future of office demand. First, the global work-from-home phenomenon prompted by the onset of the COVID-19 pandemic caused many to panic that the office had become fully obsolete. Since then, many major tech players like Google and Amazon started shelling out to buy multiple office buildings, signaling confidence in the market despite a shift in work attitudes. But now, some occupiers seem to be getting comfortable with longer leases while others shun lengthier contracts altogether. So what gives?
Once upon a prime (property)
Commercial office space, at least before the pandemic came along and disrupted everything, was generally rented for periods of 5, 10, or 15 years. Most office deals from major companies hit around the 10-year mark. Once in a while, however, a longer commitment would appear. One of the most famous examples of this was when Condé Nast, a global mass media company that primarily focuses on luxury upmarket magazines, famously signed a 25-year lease for 21 floors of One World Trade Center in New York City.
On paper, long leases have the potential to make everybody happy. Landlords receive a stable and predictable cash flow, and occupiers have more leverage to negotiate a better deal. But “long leases” usually refers to a lease contract that spans the 5-10 year range, not 25. That’s because office landlords bank on their property value increasing so they can push asking rents for the next tenant. “Landlords typically hope that rents increase over the long term,” said Chris Okada, CEO of New York-based firm Okada & Company. According to him, only investors who would get a very good deal or 100 year-old companies that aren’t looking to grow or downsize would even consider agreeing to terms that long. “The only person that would really want that would be the broker,” he laughed. “Brokers make more money with long-term leases.”
Even Michael Lirtzman, Head of U.S. Office Agency Leasing at Colliers, almost never sees leases longer than 20 years. “The only users I have ever seen on leases of this length are long-term corporate headquarters in single tenant build-to-suit assets,” he said. Incidentally, that was the exact case with Condé Nast. The company wanted to relocate from their old offices in Times Square and Silverstein Properties needed an anchor tenant for their new trophy asset. Even though Condé Nast would be locked into downtown Manhattan until 2039, they would also be locked into a discounted rate of $60 per square foot, a move that seemed smarter with each passing year. So the world’s snazziest publishing company built out its twenty-plus floors and ushered in their 18 magazines (at the time) and the creative presence of Allure, Vogue, Vanity Fair, and even Bon Appétit breathed new life into Fulton Street.
Lirtzman added that “having the right to sublease is a must” for a company willing to buckle in for 25 years, and looser sublease restrictions turned out to be in Condé Nast’s favor. Condé Nast had some bumpy financial quarters when their print ad revenues dropped, so in 2018, the company announced that they would be subleasing a third of their office space. By the end of 2019, not only had the company cut down their operating costs, they were saving a bundle on their lease as asking rents for Class A+ in Manhattan had swelled to $101 per square foot. But, as Condé Nast came to find out, unusually long leases can be punitive when the unexpected crops up. Like, for instance, when a virus strong enough to shut down the world appears.
By the first quarter of 2020, the national average term length for offices was 8.9 years. But COVID-19 had just begun shoving the office market into a downward spiral, and Condé Nast realized why most occupiers avoid lease terms that are that long as their revenue plummeted. By the end of the year, the national average lease term had dropped to 6.7 years, and Condé Nast was in a standoff with their landlord, withholding millions of dollars in rent until they could renegotiate their rent and square footage. Eventually, Condé Nast conceded, paid their back rent, but also managed to collaborate with their landlord about subleasing more of their vacant floors. Rumor has it that the publishing company is eyeing new offices across the Hudson River in New Jersey.
During the pandemic, even the offices without long leases struggled. As one year of pandemic pressures turned into two, office markets continued to face headwinds and more economic strain. Companies delayed their return-to-office dates with each new variant, remote working cemented itself into normalcy, and survey after survey revealed that employees would be willing to quit their jobs should they be required to come back into the office full-time. With uncertainties about when to reopen persisting and a workforce with a historic amount of leverage wanting to remain at home, many companies mulled over the idea of abandoning their offices altogether. But businesses opting to shed their space spells bad news for office landlords who are already contending with a record amount of lease expirations on the horizon.
Derrick Morton, CEO of Seattle-based gaming company FlowPlay, told The Seattle Times that so few people were coming into the office that he wasn’t sold on fully extending the lease when it came time to renew. So he did what many occupiers did: kick the can down the road when the lease was up and only extend for one year. In Morton’s case, the landlord offered a discount to entice FlowPlay to stay put. The discount was so steep that Morton ultimately agreed. “[FlowPlay] is paying less now than we ever have,” he said.
Reports of these shrinking leases are on the rise as indecisive operators temporarily extend their leases as they try to calculate how they should handle their office footprint. With people only coming into the office three days a week, AstrumU, a Washington-based software company, is only looking at one-year lease terms as well. Chances are with the state of the market, AstrumU’s landlord will let them. With more lease expirations around the corner and one-year renewals becoming the norm, commercial office leases in the Seattle-area have dropped to an average lease length of 58 months, seven months less than the beginning of 2020.
Even though a medley of companies across the U.S. are demanding leases as short as one year, JLL’s Q2 US Office Outlook says that nearly half of all deal volume for offices in the U.S. is 10 years or more. While we’re certainly not seeing any leases as long as Condé Nast’s being signed, deals for the textbook “long” lease are still happening fairly often. The current average term is 8 years on the dot. Granted, this was a slight drop from the previous three months, which had an average of 8.2 years, but what’s really interesting is that, according to the report, short-term expansions (meaning those one-year lease renewals) stayed below 20 percent of office leasing activity. Sublease activity only ticked up 1.3 percent, a rate of growth well beneath 2020 and 2021.
While most companies aren’t indenturing their addresses for 25 years like Condé Nast did, the growing number of tenants shortening their leases doesn’t necessarily indicate that the office market is taking a dive bomb. The practice of companies only extending their office leases for only one year was a survival tactic for the pandemic which ultimately turned into a normalized concession from landlords as the market recovered. One-year leases could persist in the short-term, as companies figure out how to pivot to hybrid work schedules or hub-and-spoke models, but longer leases are still driving deals.