High Vacancy Rates Lead to Sweet Deals for Office Tenants

Attorney David Brewer figured it would be a good time to shop for a new office lease--but he had no idea it would be this good.

Brewer’s law firm is about to renew its lease at an upscale San Diego office building for 15% less rent than it agreed to three years ago. The deal will cap months of shopping and dickering with eager-to-please landlords in the overbuilt San Diego office market.

The bargaining paid off: Brewer’s firm is also getting an above-average interior improvement allowance and the right to expand to an upper floor and connect it with a stairwell.

The deal signed by Brewer’s firm is hardly unique. Southern California office tenants large and small are signing very favorable leases these days, capitalizing on the region’s severely overbuilt office markets. And deals could get even sweeter amid expectations that vacancy rates will rise even further in the near future as new office buildings come on line.

Compounding the pressure on landlords is the declining economy and cutbacks among prime tenant groups, such as banking, accounting and legal firms. As a result, landlords have lowered rates and dangled even more financial incentives to hook tenants from the shrinking pool of prospects.

“Kickers” being offered to prospective tenants include several months of free rent, moving allowances, athletic club memberships, lease “buy-downs” or assumptions, extra parking spaces and even signing bonuses to large tenants worth hundreds of thousands of dollars.

“If you are looking to sign a lease, there are better deals to be made today then there have been for the last several years,” said Derek Thomas, director of real estate consulting at the San Diego office of Kenneth Leventhal & Co., an accounting firm.

“People are less likely to move now, and so, to entice people, landlords have to offer better deals. It’s the age-old supply-and-demand story. There is tremendous supply and demand . . . That’s why it’s a tenant’s market,” said Brewer, whose firm, Saxon, Dean, Mason, Brewer & Kincannon, will soon double its office space to 36,000 square feet at the Regent’s Square building in the University Towne Center area of San Diego.

The implications of the rent slashing are already visible in the financial problems of insurance companies, which own many downtown high-rises across the country. Many less-capitalized developers have defaulted on loans or gone bankrupt. But brokers say the goal of most landlords remains, above all, to cut whatever deals necessary to fill their buildings in advance of what could become an even worse economy.

Given the grim prognosis for the economy in general and for commercial real estate in particular, some experts think rent concessions could last for years.

The Southern California office market generally has been soft for much of the past decade, with waves of new office construction keeping vacancy rates at double-digit levels. Current vacancy rates in the region--18% in downtown San Diego, 23% in Orange County and 21% in downtown Los Angeles--are close to all-time levels and heading up.

In downtown Los Angeles, for example, an office glut is expected to get worse as several new buildings are being completed.

The few tenants out shopping for sizable leases are getting the full-court press from building owners and their brokers. Within Southern California, this deal-making is perhaps most evident in San Diego, where office vacancies in some areas of the city are running close to 40%.

One tenant benefiting from this largess is Transamerica Insurance Group of San Diego. It will soon sign a lease at close to 40% less than the landlord’s original asking price for the company’s new 14,000-square-foot office in San Diego’s University Towne Center area.

“Once the word leaked out we were looking (for new offices), we had quite a few brokers come to us with deals,” said Michael H. Scott, Transamerica’s resident vice president in San Diego. “So we saw twice as many buildings as we anticipated. That was the true clue that the market was soft.”

A major factor in downtown rents staying cheap is the overbuilding of offices in many suburban markets and the threat they pose to downtown landlords of luring tenants out of city centers. As a result, owners of major downtown buildings have had to cut rates to compete, said Joel Mayne, marketing director of Tishman West Cos. in San Diego, owner of the 250,000-square-foot Bank of America building in downtown San Diego.

As a result of all those market factors, “effective” office rental rates--the term for the entire lease-financing package that takes into account all financial incentives, including free rent--are at the lowest levels in recent memory in many Southern California cities. A tenant signing a five-year lease these days is likely to get one year of it free, said Dennis Cruzan, principal of Centremark, a San Diego development firm.

And the great deals--which not so long ago were available only to powerhouse, multifloor tenants, such as banks, law and accounting firms--are now out there for firms large and small, Thomas added. That’s because the larger tenants these days are as likely to be shrinking than growing, Thomas said.

“The major downtown tenants are banks, law firms and accountants, and we are seeing major cutbacks in staffing” at those kinds of firms, Thomas said. “Accountants Laventhol & Horwath just went into bankruptcy. That’s an indication that CPA firms in general won’t be aggressively growing and taking large amounts of space.”

John Messner, president of Meridian Capital Management of San Diego, said his firm was “surprised at the clout we had” in negotiating with downtown San Diego office landlords. “We’re only 2,000 square feet, which is not that large.”

Nevertheless, Messner’s money management firm negotiated a five-year lease renewal at “more than 15%” less rent than he signed for five years ago.

Good office lease deals can be had throughout the region. In Orange County’s prime office district--located within a three-mile radius of John Wayne Airport--rents are typically $1.65 to $1.85 per square foot per month, 20% less than three years ago, said Scott Perley, vice president and branch manager at the Irvine branch of Cushman & Wakefield of California, a major commercial real estate brokerage.

“Generally speaking, office rents are have been declining 5% to 10% a year (in Orange County) for three years,” Perley said.

In downtown Los Angeles, monthly rents at top-class office buildings range between $1.50 and $2.50 per square foot--about 15% less than two years ago, factoring in all concessions, said Carl Muhlstein, executive vice president of Wilrock National of California, a commercial real estate brokerage with offices in Los Angeles.

Downtown Los Angeles office rents will get even cheaper next year, Muhlstein predicts, because the district will be flooded over the next 14 months with a new crop of buildings now under construction totaling about 6.4 million square feet of space. That’s more than three times the office space leased in a typical year, Muhlstein said. Thus, vacancy rates in downtown Los Angeles will approach 30% by the end of 1991, Muhlstein predicted.

But brokers say no major Southern California city has more of an office glut than San Diego, where vacancy rates range from 18% in the downtown district to 25% in the Mission Valley area to higher than 35% in the University Towne Center and Sorrento Mesa areas in the northern part of the city, said Russ Stai, a commercial real estate broker with John Burnham & Co. in San Diego.

The bloodletting among developers has caused one of the city’s largest, Naiman development, developer of the Naiman Tech Center in the Sorrento Mesa area, to default on a $70-million loan to HomeFed Bank. That Naiman is now quoting rents at $1.10 per square foot per month, down from $1.75 per square foot when the project opened in 1983, is just another example of the competitive climate in the city.

Tenants aren’t complaining. Pacific Bell still hasn’t made up its mind among five “finalist” locations for a multifloor block of office space it wants in downtown San Diego. But wherever it is, Terry Churchill, the phone company’s San Diego-area vice president, said he expects to ultimately pay at least 15% less in annual rent than he would have had to pay three years ago.

Churchill, who admits to “playing one landlord off another” in his lease negotiations, said he has seen a new kind of incentive dangled before him in the current round of lease negotiations: the right to cancel a lease earlier than the specified term.

That kind of escape clause is attractive to many tenants because “most businesses are downsizing due to the economy and automation. So companies, not just specifically Pacific Bell, are not as interested in making long-term commitments until the market conditions changes or firms up,” Churchill said.

Just how long the current oversupply of office space--and attractive lease deals--will last is subject to debate. While most industry officials agree that few new office projects will be started because of the scarcity of financing, others insist that the huge amount of office space already under construction and coming on stream over the next year or so will create an “overhang” that could keep the office market soft for years.