As the Market Turns
At some point, the economy will improve to the point where equalibrium will return to the office market. Richards defined equilibrium — usually at about 10% vacancy — as the point where there is a balanced playing field between landlords and tenants. At that point, landlords can ponder bumping up the monthly rental rate and pulling back on free rent.
The million dollar question is: How large of a time window do tenants have to negotiate better deals?
In about 12 months, Richards believes job creation will start to intensify, and economic activity and leasing activity will begin to pick up. “At that point is when I think the optimism starts to actually turn into revenue and net income, when the expansion starts to occur and when you start to eat up some of that vacant space,” Richards said. “I think being in the upper teens with vacancy, we’re a long ways away from market equilibrium, so we have a substantial amount of time until landlords have a little bit more power.”
It may take another 12 months after that, Richards added, before landlords actually can start dictating lease terms.
Rikkers’ timetable is similar. Outside of a couple of tenants, he said most of the larger blocks of space are being contemplated by existing users. In looking at a market without a real net absorption, he indicated that a one-year window is too optimistic.
“I think probably we’re in this trough for 18 to 24 months,” he said, “but that does not mean deals aren’t getting done.”
Whenever the market reaches that point of equilibrium and tenants no longer have the upper hand, don’t expect property owners to be obstinate. However, the nature of the tenant-landlord relationship will change.
“There’s really a culture out there, in my opinion, when it comes to real estate transactions,” Gelbach explained. “A lot of the landlords are looking at the client, who they are, what kind of credit they have, and what’s the long-term future of this particular client? And then they’re going to work that transaction and see how that fits with their building.
“So I don’t ever really think they are obstinate, I just think they’re realistic on what’s going on. How badly do I want this client? How well does this client fit in my building with the type of improvements they need? Certain clients are just a great fit with the layout, and they don’t have to do as much build-out, so they may not be giving as many incentives. It’s still a business. They still want their buildings to be full, so they’re still giving incentives for the right client.”
For Rikkers, it’s a simple supply-and-demand issue. If there’s enough demand and little supply, a landlord is going to give less. “Look at the laboratory market today,” he counseled. “You’re looking at about a 4% vacancy, except when a couple new buildings come on line. So there are fewer concessions in the life sciences world, but even when you’re doing deals in that arena, if the tenant is presented well and if they know what they want and understand the marketplace, and they treat it like a business transaction, you can get deals done.
“Landlords are still, if not appreciative, they at least are professional.”
In contrast, Richards doesn’t think the market is ever going to get to a point where the landlords can just say, “Unless you’re willing to pay full rent and all that stuff, we don’t need you in our building.
“I think what you’ll find is that, as the vacancy starts to hedge a little bit lower, new buildings will start to pop up,” Richards said, “and the new buildings will have that higher lease rate. And certainly if those start to fill up quicker than they have in the last two years, all of a sudden you’ll start to see those fringe buildings that were maybe built in 2006, they’ll start to hedge up their lease rates as well.
“So I think once we head closer to that point and vacancies start to diminish a little bit, rents will increase again. That’s just the way things work. As good as the tenant market is right now, as the landlords start to get a little bit more power, that starts to build up again as well. So some of those concessions do diminish.
“Is that saying you’ll never get free rent at market equilibrium? That’s not the case. You’ll certainly still get some of those things, but you might not get one month’s free rent per year, that sort of thing.”
Unusual User
According to Richards, one comparative bright spot is the industrial sector. From an industrial standpoint, the market is pretty strong in Greater Madison area, even though like retail, it’s a lot more difficult for an industrial tenant to downsize. “Certainly on the far west, you’re looking at vacancy of probably 5% to 6%,” Richards said. “I’m not even sure it’s a bright spot as much as it is more or less status quo.
“It’s not seeing the aggressive downturn that the office market has seen.”
With regard to office, industrial, and retail markets, Carpenter said that you almost have to break them up and compartmentalize them. “With retail, you just can’t move to different locations and get the same benefit from the office,” he said. “You might be able to go in the same office park and it makes no difference what your business is.”
Retail tenants, in fact, are never really in the driver’s seat with their landlords, especially if they’re at the hot corner of a great intersection. In that case, Carpenter said they might not be able to draw a line in the sand on lease terms because the landlord knows it’s a prime location, and that they can quickly find another tenant.
While tenants in general have more leverage today than they did a couple of years ago, there are still instances where they don’t, Rikkers said, especially the case of an unusual user. They may need to occupy a large block of space, but there only are a handful of them on the market. Perhaps they are a laboratory user, and there’s not a lot of space remaining for labs. Maybe they have a need for specialized HVAC or fire suppression or another little niche that would make them an unusual user.
“It’s important for every tenant out there to, number one, understand their requirements, figure out who they are, what they are, and where they want to be, but also understand the marketplace,” Rikkers said. “There is nothing worse than going in and thinking that you’ve got the world by the tail and it turns out you don’t. So it’s important for tenants to be educated about what is really out there.”
Gelbach also pointed to limitations in tenant power, even in a so-called tenant’s market. She noted that tenants should not neglect the opportunities they have to impact the bottom line outside the context of their lease. “I think that, with this economy, when everyone feels that they should be sure of their costs, that they’re looking at everything, their overhead, their insurance, their salaries, their rent, whatever the case may be, and I think it’s smart business,” she said. “No matter whether it’s a bad economy or a good economy, I think you should always be watching your costs, but thinking you can just go to your landlord and say, “You need to give me some breaks” isn’t a realistic goal.
“I think you need to really look and see, use a real estate professional and see where you are in the marketplace.” she added. “If you really are paying quite a bit over what someone who comes into the building is paying, you should be renegotiating. But you need to also be realistic and say, ‘Okay, if I’m paying market rent and I’m a financially sound business, I don’t think there’s room to renegotiate unless I’m willing to give the landlord something, whether it’s a renewal or something of that sort.
“I’m getting this question about wanting to lower my rent, but yet I look at the rent and they’ve got a very good deal, so there’s really not room [to negotiate]. I’m just saying look at the long-term, look at it as a business transaction, and know there’s a businessperson on both sides.”
Current Snapshot
Asked about the most challenged Madison submarket in terms of space, our experts had different answers.
Gelbach cited the downtown, a market identified with high-rent, Class A office space, and Rikkers cited “the near west side” of downtown, where there are properties that are not at their highest and best use. “They’re torn down, they’re refurbished, and new products are added,” he said. “Block 89 is a perfect example.”
On the near west side, Rikkers said there is a lot of product on Odana Road that has seen better days. “It should be knocked down, increasing density, so we can add square footage even in places that do not appear to have square footage now,” he stated.
At the end of 2008, which probably will go down as one of the most tumultuous periods for the American economy since the Stock Market Crash of 1929, Grubb & Ellis/Oakbrook reported that the vacancy rate for the Greater Madison office market had grown to 15.7%, and the general consensus is that it has reached the high teens in 2009.
Richards, a research analyst for Grubb & Ellis/Oakbrook, doesn’t expect any big surprises in the company’s next report on the Madison office market, which is due out this month, but he said the report is likely to identify “as high a vacancy rate as we’ve seen in the past.”
He stopped short of predicting that the market has experienced a negative absorption rate. That would be a true rarity, but given the pessimism that persists, it’s also something Rikkers believes is a distinct possibility.
Richards disagrees. “I think, since we’ve started our research, we’ve never had a period of negative absorption,” Richards said. “I don’t think we’ll see negative absorption at this point, but I think we’ll be very close. I think we’ll be under 100,000 square feet of actual absorption, and when you compare that to the 600,000 square feet that came online last year, there’s a difference of 500,000 square feet that just adds to that vacancy figure.”
Richards said it’s important to understand that the commercial office market has its ebbs and flows, just like other markets, and wise tenants pay attention to those shifts. “I think it’s important to note that a lot of what we’ve discussed has been not negative but certainly somewhat pessimistic with the fact that we’re probably still 24 months away from things really starting to pick up, but it is cyclical,” he said. “Landlords in the Madison area and developers in the Madison area are smart enough to know when supply is significantly outweighing demand, and what we’ll probably see in the next couple years is limited speculative commercial construction.”
While that’s a sometimes skeptical refrain in a sluggish market, Richards said there are only three office buildings under construction in the market, and they are non-owner occupied. Even though he represents a leasing organization, he does not consider that to be a negative development.
“I’m speaking strictly from a private perspective of three new buildings that I know of right now that are coming out of the ground,” he noted, “and I’ve had people and landlords say, “I talked to so-and-so from XYZ Construction Company, and they think the market’s going to implode because there’s no new construction.” To me, that’s healthy. That’s an understanding that we’ve overbuilt.”
In Richards’ view, the overbuilding was not the result of poor planning but the swiftness and the severity of the current recession, which he said caught developers off guard. “There was construction already out of the ground,” he noted, “and there was no way to stop it or stall it. And I think what we’ll see is that it’s healthy for construction not to be occurring right now, and once this space gets eaten up, then you’ll start to see some more buildings out of the ground.”
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