Corporate real estate executives face an on-going paradox, constantly being asked to deliver on two conflicting portfolio objectives. First, reduce occupancy costs which – since real estate costs are inversely correlated to length of term of the lease – usually means committing to long-term leases or even ownership. Secondly, also ensure there are short-term and flexible occupancy strategies that provide agility in the face of rapid change.
The supply-side of the industry values long leases with good covenants. The sources of capital for developers and funds managers price their funds based on the security of income streams. Long, secure income from rated entities is prized. These are the key ingredients to driving maximum profit out of the latest real estate-backed investment products.
So why would the supply-side want to provide flexibility and make office accommodation rentals variable costs? Imagine tenants being able to commit and exit from accommodation as their variable needs change cycle-by-cycle, project-by-project or week-by-week. If this was the norm, the real estate investment market would collapse.
Emerging intermediaries
Enter the intermediaries. Most operators in the market are by now familiar with the flexible serviced office model. If you want one office for one week, it’s yours – and fully furnished to boot. If you want two floors of project office space for a few months – with a little notice, it’s yours. Need a meeting room for two hours? Provided you have booked, it’s yours. Need access to a range of temporary offices across Asia – it can be done! But this all comes at a cost.
Is this the solution to the flexibility needs of major corporate users? Some global organisations believe that it is. Companies in the electronic consumable goods industry have up to 30 percent of their portfolio in arrangements with serviced office operators. Their products have extremely short life-cycles – measured in months, not years – so this approach makes sense.
Although notice periods may be measured in three or six month periods and fit-out solutions may be fairly generic, the pricing structure for these companies is still more attractive than the norm. Even if a premium rental is paid, with a sudden restructure or department closure, there is no lease tail to contend with, no un-depreciated fit-out to be written off and no make-good obligations. Maybe this is operating cost nirvana.
Balanced flexible portfolios
The key to cost effective flexibility and using covenants to drive down rental structures is structuring portfolios that are appropriate to accommodate demand volatility. The core stable demand space in the portfolio should be generic in design and configuration. Business units can then be moved with minimum disruption and cost. And with modern communication technology, there is less need for specific locations for the various functions within an organisation. The monopoly of location no longer rules supreme. Flexibility to accommodate fluctuating demand is then factored into the portfolio at the margins and is not required across the whole portfolio. Depending on the nature of the industry, the portfolio may comprise core space representing 70 to 80 percent of overall requirements.
This will be based on owned premises and long-term leases with staggered lease expiry dates and market rentals with fixed rental review patterns.
A further 15 to 20 percent of accommodation may be more flexible, based on shorter-term lease arrangements, and more expensive. This will be backed up with call or put options linked to option payments to secure flexibility on relatively short notification periods.
And finally, serviced office space may represent 5-10 percent of total requirements in short term arrangements with shared amenities and a variety of configurations and locations. This expensive rental option will provide significant flexibility and mobility, depending on terms agreed. The general rule is that the more volatile the industry and the operation being accommodated, the less core space should be contained in the portfolio. For example, a sales office for consumable electronic goods or a project office for an IT consultant would tend to require maximum portfolio flexibility and therefore have minimal core space.
Back-office processing functions may be far more stable with few changing demand patterns and this portfolio will mainly comprise core accommodation.
Duration matching
Both ownership and leasing are investment decisions in productive capacity. Own versus lease is basically a financing decision. Investment duration is a measure of capital at risk in real estate commitments. The duration of a lease arrangement is the initial term with flexibility represented by exercisable options. The duration of ownership is the effective life of the building.
Supply duration is the aggregated, committed accommodation, usually graphically illustrated by stacking the quantity of premises – owned and leased – in a time chart reflecting lease expiry dates. Call and put options are reflected as additional flexible stacking possibilities. The demand patterns are the aggregate accommodation requirements with growth projections. To reflect future demand scenarios, this is usually plotted as a number of projections based on various forecasts. Duration matching is then based on mapping the projected demand against the committed accommodation supply. With this technique, future accommodation shortfalls and flexibility needs rapidly become evident.
Contraction and expansion
Investors and developers are not enthusiastic about options. Be they in terms of duration or quantity, for expansion or contraction, options are viewed as being in the tenant’s favour, no matter how the rental clauses and terms are worded. Options, properly worded, give tenants real rights. No options means the landlord has greater flexibility in negotiating with other parties in the market for the premises. Contraction or cancellation options create havoc with a landlord’s funding arrangements – and will command heavy premiums or harsh penalty payments. Options to extend lease terms at market rentals are accepted as a norm. Options with pre-determined rentals favour tenants – and are seldom encountered.
Expansion options for additional floors at set dates (and even worse, with pre-determined rental structures) limit the landlord’s ability to lease out the designated spaces. Marketing to interim tenants with limited lease duration rarely works – particularly with the cost of fit-out. Thus creative solutions are required for expansion options to be included in new leasing arrangements – and these will generally attract premium option payments. To date there is little evidence that these real options, for expansion or contraction, are priced appropriately and consistently.
In the meantime, it is unrealistic to think that office accommodation rentals can be structured as true variable costs across a whole portfolio. Using portfolio planning techniques, and matching demand variability against committed lease duration patterns, will indicate the flexible accommodation requirements at the margins. This will provide accommodation as a variable cost where it matters most – at the point where flexibility is needed.
