REAL ESTATE - Carlini's Comments

KRYPTONITE IN COMMERCIAL LEASING: RISING VACANCY RATES

Filed Thursday, October 30. 2008

When vacancy rates go up in metropolitan areas, the first response is often to lower rates. That, though, is the wrong approach.

If all you are doing in real estate is selling space, then lowering the price is a tactical action that you can do to just hope for the best. If you are selling something more than just space, playing the commodity game is wrong and will minimize your return.

Vacancy rates for downtown office space are going up in places like Manhattan, according to Crain’s New York Business:

In the next year, commercial vacancies for the New York metropolitan area will surge to 17.6 percent (up from today’s 12 percent rate), according to a revised forecast issued Monday by Property & Portfolio Research. That’s considerably higher than the 13 percent peak that the firm projected just three months ago.

It’s just a matter of time before downtown commercial markets like Chicago and others follow. The metropolitan Chicago area is already feeling the rise in vacancy rates:

The direct vacancy rate, which doesn’t count space available for sublease, edged up to 19.1 percent in the third quarter [of 2008 as] compared with 18.6 percent in the second quarter [of 2008], according to commercial real estate services firm Jones Lang LaSalle.
Today’s rate is more than 2 percentage points higher than a year ago when it stood at 17 percent. When sublease space is included, the vacancy rate in the suburbs [of Chicago] is 22.5 percent [as] compared with 20.6 percent in the third quarter [of 2007].

That being said, real estate property management companies can do one of two things:

lower rates and go into a commodity-based bidding war of “who has the cheapest space” or
start looking at focusing on other strategies aside from the outdated (yet traditional) strategy that hurts those who have quality buildings.

Are You Selling a Commodity?

The vast majority of major real estate and property management firms are stuck in an earlier era of real estate marketing. As one person pointed out to me in a real estate discussion, people in real estate have this to say about change: “Change is good. You go first.”

They are focused on the wrong elements of marketing real estate. Traditional amenities like parking, HVAC (air conditioning) and security are a given. Traditional amenities, though, don’t make a unique location.

Giving away free rent is part of this strategy as well. As noted in another Crain’s New York Business article, the owners are giving away a year’s free rent to try to beat the others in the market to a potential tenant. That works until the guy down the street offers 18 months free on a five-year lease.

There is no end to this “commodity” strategy. It hurts those that have a better building than the competition down the street. The traditional brokers often follow this strategy like lemmings. Few understand that this is an outdated strategy (except those who understand intelligent amenities).

This was the same “strategy” used by brokers in Silicon Valley back in 1985 and 1986 and it was obsolete then. The market had a 40 percent to 45 percent vacancy rate in commercial buildings. Everyone was falling over each other and trying to give more discounts and free months on a five-year lease.

When the market does that, it creates a downward vortex of pricing that commoditizes everything else in the buildings (no matter what else was installed).

What Makes a Better Location Today?

As I keep mentioning at conferences and seminars, the three most important words in real estate today are “location, location, connectivity”. This is not where real estate is headed. It’s where it’s at today. Sophisticated corporate tenants have connectivity on their amenity check lists. Here are five things to look for in buildings:

Green capabilities (lower energy costs and lower operating costs equal a lower rent)
Broadband connectivity (gigabit or more connections to the central office)
Dual connections to network carriers (not one carrier) provide redundancy
A redundant power source provides reliability (power from two different power grids)
On-premise backup generators (a business continuity amenity)

It should be common knowledge that older and inefficient buildings are going to become less desirable as other buildings provide lower operating costs and lower rents. Older buildings are more technologically obsolete and that will also affect their marketability. The same goes for industrial and business parks.

Most office building and industrial park owners don’t understand how much money it will take to retrofit a building. With the markets the way they are, they will be choosing the lesser of two evils. They will spend millions of dollars to retrofit or take a chance by seeing what they can get for the building or park from another investor.

Real issues that should also be looked at are those focusing on power and connectivity. Dual power feeds to separate substations (or better yet separate power providers) provide a higher level of redundancy that more corporate site-selection committees want. They are already looking for broadband connectivity as a given for corporate sites and many people leasing space don’t even know this.

In looking at one commercial market, there were 60 class “A” buildings available in one county. Leasing space there would be a “commodity” strategy. Who has the cheapest space? If the potential tenant is looking for broadband connectivity as a given amenity in that same market, though, the selection of buildings dropped to five buildings.

That’s more than a 90 percent reduction in competition. Some real estate firms don’t yet understand that some of their vacant buildings will remain vacant for a long time because what they have to offer is below the market’s new expectations.

Carlinism: In sales, if you don’t create the yardstick to measure others, others will measure you by theirs.