Landlords Caught in Dot-Gone Web
Bankruptcies and consolidations by Internet companies are having far-reaching effects on the Westside office market, creating headaches for some, opportunity for others--and providing the first tests of leases crafted to protect landlords from dot-com failures.
The dot-com downturn has emptied perhaps as much as a million square feet of Westside office space. For landlords, the shakeout means struggling to collect rent or security deposits from failed or floundering companies while prospecting for replacement tenants.
For businesses seeking Westside offices, it means space is available where none was before.
For real estate brokers, it often means trying to find new tenants for spaces they filled with online occupants only a year or two ago.
The empty dot-com domains represent only about 2% of the office space on the Westside, which totals 40 million to 50 million square feet, depending on whose definition of the Westside is used.
San Francisco and the Westside are among the California office markets most affected by the dot-com shakeout. In San Francisco, between 2 million and 3 million square feet has been abandoned by dot-coms, real estate brokers say. Both markets were choice destinations for freshly funded start-ups eager to attract top talent by locating at the most prestigious and hip business addresses.
The Westside space emptied so quickly that it surprised even those who had predicted that the dot-com office leasing juggernaut would stall. Six months ago, Internet companies fought over prime Westside office space. By the end of 2000, the bidding frenzy was ending as several dot-coms closed their doors.
The sudden shift prompted concerns about the impact of dumping up to 1 million square feet on the market that has long commanded the highest rents in Southern California.
Part of the answer came last week when one of the biggest blocks of office space to be vacated by a dot-com tenant was filled. Landlord Arden Realty signed Vivendi Universal Interactive Publishing to a 10-year lease for 100,000 square feet at Howard Hughes Center in Westchester that was vacated in December by IXL Inc.
Another large block of space on the market is the 151,000 square feet leased by failed online retailer EToys at Kilroy Realty’s Westside Media Center in West Los Angeles. Kilroy reported last week that EToys has defaulted on its rent and that Kilroy has drawn on two letters of credit totaling $15 million that EToys posted as a security deposit for its lease.
EToys, which said Monday that it will lay off its remaining workers after laying off 700 of its 1,000 staffers last month, is attempting to sublease its space, said Matthew Miller of Cresa Partners, EToys’ broker. EToys occupies most of the 151,000-square-foot building, he said, with the remaining 38,500 square feet subleased to Razorfish.com.
A number of other former dot-com offices on the Westside have been leased to new tenants, and still others are on the market, in most cases only a year or two after their original Internet-related tenants signed long-term leases.
One of the biggest challenges for landlords is continuing to collect rent, or security deposits in lieu of rent, while they look for replacement tenants for the defunct dot-coms.
When dot-com companies negotiated their leases during the last few years, landlords were concerned that these start-ups might not survive for the full five or 10 years of most office leases. To protect property owners against financial losses, the landlords’ lawyers asked that dot-com tenants put up letters of credit rather than traditional cash security deposits when renting office space.
The reason for the switch was that letters of credit, unlike cash security deposits, don’t get frozen in bankruptcy court, explained real estate attorney Paul Rutter of Gilchrist & Rutter in Santa Monica.
Landlords learned a painful lesson in the early 1990s, Rutter said, when many tenants filed for bankruptcy and property owners had to wait until the bankruptcies were settled before they could collect their cash security deposits.
“A letter of credit is a separate obligation of the bank that issues it, not an obligation of the tenant,” Rutter said, “so the tenant’s bankruptcy has no impact on the landlord’s ability to draw on the letter of credit.”
Thanks to the dot-com leasing frenzy on the Westside, landlords that his firm represents now ask for letters of credit in about 30% of the leases they sign, Rutter said, compared with about 2% in the pre-dot-com years.
Letters of credit are replacing cash security deposits in most major real estate transactions, regardless of whether they involve dot-coms, said attorney Alan Pedlar of Stutman, Treister & Glatt, which specializes in bankruptcy law.
There are several problems with cash security deposits in the case of a bankruptcy, Pedlar said. Besides being frozen along with other assets in a bankruptcy proceeding, cash security deposits are subject to a number of provisions of bankruptcy law that can limit how much of the deposit a landlord recovers.
Los Angeles-based Arden has letters of credit as security deposits on all of its leases with dot-com tenants, according to Robert C. Peddicord, the company’s senior vice president of leasing. He said dot-coms occupy less than 1% of the 18.7 million square feet of office buildings owned by Arden.
Historically, letters of credit have been honored by the banks that issued them, but it’s possible that an issuing bank could try to drag a letter of credit into bankruptcy proceedings in the case of a failed dot-com company, said Michael Abrams, a bankruptcy specialist with Gilchrist & Rutter.
“Given the large amounts of dollars at risk, I could see some of the smaller banks trying to get out from under the liability [of a letter of credit],” Abrams said. Some bankruptcy lawyers think such a tactic could succeed in some cases, though others consider it unlikely.
Letters of credit are helpful, but they don’t mean a landlord’s headaches are over, noted Doug Marshall, a broker with the Klabin Co.
The Horowitz Family Trust collected on a letter of credit for a year’s rent, or about $800,000, Marshall said, when MValue.com went out of business last year and vacated its offices at 3654 Lenawee Ave. in Culver City.
“The landlord still has brokers’ commissions and other expenses to make up for,” said Marshall, who is now looking for a new tenant for the property, one of many Culver City warehouses that were converted to offices described as “creative space.”
Property owners were concerned about the solvency of dot-com companies from the start because, by custom, landlords incur a number of upfront costs to accommodate a tenant. These include office alterations or remodeling required by a tenant.
Landlords expect to gradually recover the cost of tenant improvements, brokers’ commissions and other expenses over the customary five- or 10-year term of a lease, attorney Rutter pointed out.
But when a tenant goes out of business in the first year or two, the landlord doesn’t have time to recover much of those costs and is likely to lose money unless the tenant has posted a substantial security deposit or the landlord can quickly find another tenant at an equal or higher rent.
This concern about dot-com survival prompted some landlords to negotiate unusual terms in some leases.
“In one case, we got the tenant to pay out-of-pocket for all of the commissions and tenant improvements on the deal,” Rutter said. “Then we structured the rent to reflect that the tenant had paid for these costs.”
