Rising Construction Costs Cause Ripple in CRE Office Sector’s Lease Term Length

Written by Robert LaCoure, Principal at Lee & Associates – Houston

The commercial real estate market is complex and has many caveats that go unnoticed by most; however, those minute details change the fundamentals for every single transaction. Since the last oil boom in Houston during 2012-2014, we have seen construction prices on the rise. During that time, the demand was so tremendous that subcontractors were naming their price just to get the attention of whatever contractor needed them the most and could afford to pay their ransom. With the shortage of labor and a construction crane on every block, the overall price of construction increased rapidly.

The office sector of commercial real estate has one big fundamental difference that sets it apart from the retail and industrial sectors. Typically, the tenants are not funding much, if any, of their tenant improvement allowances. This unique difference has been coddled by landlords and banks for years because they are savvy and typically more institutional owners. They realized long ago that adding the improvement allowance into their rental rate effectively increases the value of the asset. So, the landlord is willing to give the allowance and the banks to fund it for them, so long as the tenant is deemed credit-worthy.

With a standard improvement allowance back in 2008 for shell condition, first generation space, you could expect to spend $35-40 per square foot, which is easily $65-75 per square foot in today’s market.  Funding for today’s larger improvement allowances are still being offered by landlords, this can only mean one thing fundamentally when you talk about amortizing something into a “market” rental rate… the lease term needs to be longer. Tenants are finding once they start their negotiations what those prices are and are still of the same position, especially here in Houston in a soft market, they should NOT be paying for the improvements themselves. Thus, what does this mean for a small tenant in today’s world who cannot predict how much space they will need or what part of town they want to be in in 10 years? It likely means they will have to take second generation space that may only need slight modifications to their requirement and they will not be occupying first generation space unless they are willing to take big risks or fund some of the improvements themselves to get a shorter lease term.

There are a few ways to combat this pinch. A good construction manager can assist with “value engineering” the space to some degree and can help the tenant with obtaining multiple competitive bids for the work. Also, the landlord may offer solutions in the lease such as termination options with a penalty equal to the unamortized costs plus a few months of rent. Making sure you have a good team with experience is critical to navigating this process because there can be creative solutions offered with solid landlords who understand this and want to make a deal.

Inevitably, these longer lease terms could hurt landlords and tenants alike. Landlords will see tenants move out before their lease expirations because they need more, or less space. Tenants will have growing pains and will certainly feel the effects of FASB accounting principles more strongly on their books due to the increased obligations. For both sides to come out ahead in this situation, there must be flexibility in the lease document to account for the what ifs.

About Lee & Associates – Houston
Lee & Associates – Houston is a fully-integrated commercial real estate company with unrivaled capabilities and an unwavering dedication to integrity. Our business-minded brokers specialize in office, industrial and land real estate investments. As the fastest-growing broker-owned firm in the nation, with more than 59 office locations in North America, we are uniquely qualified to support our clients’ real estate needs in the local, national and international markets. For more information, visit www.lee-associates.com/houston/.