Why Office Leases Are Getting Shorter And What That Means For Valuations
Tenant demand in the office market has been increasingly favoring shorter-term lease deals, a trend that complicates how much buildings are worth.
This shift has created more flexibility for tenants who don't want to be locked into a long-term lease, and it has helped landlords fill spaces in their buildings that may otherwise sit vacant.
Despite the move toward shorter-term leases, office buildings still achieve higher valuations when they have the stability of long-term leases, and landlords have had to work to make lenders and investors more comfortable with the flexible deals their tenants crave.
Lease terms can have a variety of effects on a building's valuation, but experts agreed that buildings with longer-term leases are consistently more valuable than ones with shorter deals. But as the market evolves, some see a growing acceptance of lease flexibility that could increase the perceived value of more flexible leases.
Short-term leases can make a building more valuable by allowing landlords to raise rents and fill space that may otherwise have sat empty. But when landlords try to finance or sell a building, they face institutional capital sources that want the assurance of long-term cash flow.
The trend toward shorter lease terms for smaller deals has been occurring for years. According to Cushman & Wakefield, the average lease term for all deals under 10K SF in the U.S. decreased from 81 months in 2015 to 75 months in 2019, and for the first half of this year, it has been 73 months. These small deals make up a majority of the market, with 74% of all office leases since 2015 measuring 10K SF and below.
The coronavirus pandemic has accelerated the trend toward shorter lease terms across all deal sizes as companies are more uncertain about the future of their business and their workplace arrangement. According to JLL, the average lease duration for all deals in the U.S. office market dropped from 6.4 years in the first half of 2019 to 5.4 years in the first half of this year, a 16% decrease.
"What we're seeing is tenants staking a very defensive leasing posture given the level of uncertainty," JLL Senior Director of U.S. Office Research Scott Homa said. "Deal sizes are shrinking, the duration of the commitments is compressing, and transaction volume is down considerably."
In many cases, these short-term deals are signed in pre-built spec suites or shared workspace areas that landlords have created in response to the coworking movement. Tenants taking these spaces will often ink three- to five-year leases, rather than the traditional 10- to 15-year deals.
Cushman & Wakefield Senior Managing Director Lynda Gallagher, who leads the firm's Valuation & Advisory Group in the D.C. region, said she started to see the trend toward spec suites with shorter lease terms about five years ago. At that time, she said it was difficult to get underwriters and financial partners to feel comfortable with the deals because there wasn't much market evidence to prove the concept works. She said that is now starting to change.
"From the underwriting side, there is much more of a comfort level now," Gallagher said about spec suites with short-term leases. "As it has become more acceptable with the market, there are more and more buildings that have it. I'm now surprised when I see a building that has availability that hasn't gone that route."
The shift toward spec suites and shorter-term leases began largely in response to the explosion of coworking, which showed tenants the appeal of a flexible office deals, Newmark Knight Frank Executive Vice President Jane Diven said. She said this was especially true for Class-B tenants that don't look for trophy space with top-of-market rents.
"What I was starting to see was part of the tenant segment of Class-B were being attracted to coworking space because of the perceived flexibility that coworking could give them," said Diven, who is a leader in NKF's valuation and advisory team. "To become more competitive, many of these property owners were beginning to do spec suites with common areas clustered around a common tenant lounge area."
The push for shorter-term leases also happened because tenants saw how rapidly their office needs can change with the advent of new technologies, said CohnReznick principal Patricia McGarr, who leads the firm's Valuation Advisory Services team.
"Shorter-term leases is a trend we're seeing, and part of it is because there has been this shifting in attitude about how things are changing and you don't want to be locked into a 15-year lease when five years out, they invent something new and you don't need all this space," she said.
Tenants have been asking for shorter lease terms for more than a decade, MRP Realty principal Zach Wade said, and he said landlords were hesitant because the capital markets preferred longer lease terms. But now during the pandemic, he said the majority of tenants looking for space are seeking short-term deals, and landlords don't have a choice but to accommodate them.
"A lot of companies are in flux and trying to figure out what their future is," said Wade, who leads the developer's office arm. "The only longer-term deals currently in the market started pre-COVID ... If you want to be relevant, you have to meet the market."
While shorter-term leases don't offer the future stability of their longer counterparts, they do have several benefits for landlords that can help boost a building's valuation.
If average rents in the office sector are rising, short-term leases give landlords the ability to bring their properties up to the market rate every few years, rather than being stuck with a long lease that becomes more of a discount over time.
This is especially true when signing leases in an economic downturn, like the one the market faces today. Weak demand in the market creates downward pressure on rental rates that could leave landlords with much worse deals than they could get after the market recovers. Average office rents nationwide decreased by 0.2% during the second quarter, according to JLL, and are expected to drop further.
"There is a positive that when you have short-term leases and they're going to roll two to three years from now, depending on where rents are. This allows owners to realign rents to the market," Gallagher said. "The market right now is soft, and so a lot of deals are being made that will be below market in a couple years."
Not only can short-term leases allow landlords to adjust to the market more often, but they are often leased at a rent premium, Wade said. Four years ago, MRP launched its Town Hall concept in response to tenant demand for more flexibility. The concept offers a series of office suites with common amenity spaces, and the leases typically have three- to five-year terms, Wade said.
"When you are accomodating a tenant's request for a shorter-term deal, whether two or three years, they should pay a little bit of a premium for that flexibility, and we've seen that," Wade said. "We've also seen rents go up in Town Hall on the turn of the space."
With elevated office vacancy in many markets, these short-term leases are often filling spaces that would have remained vacant. While longer leases may be better for a building's valuation, having a short-term lease is much better than having no lease at all.
CBRE Vice President Matthew Solomond, part of the firm's valuation and advisory group in Northern Virginia, said he thinks the trend of spec suites with shorter lease terms came in response to elevated vacancy in the market.
"Landlords are sitting on a lot of vacant space," Solomond said. "If they can build some of it out and get it rented and increase the occupancy of the building, that's better for valuation."
Tenant improvement allowances have become increasingly expensive for landlords, and building out spec suites with shorter lease terms can help them keep those costs down, Diven said.
"If a property owner builds out spec suites, they have more control over construction costs, and instead of doing $100/SF in TI, they may be able to do a suitable space with a $75/SF build-out," Diven said. "If it does roll and the tenant doesn't stay, they can refresh and at that point still control the cost."
Despite the benefits of short-term leases for landlords, they still lead to a lower valuation than having a long-term lease in the same space, because investors and financiers prefer the latter. But some experts say they foresee short-term leases becoming more accepted as the market evolves.
Office buildings are valued based on the average weighted lease term of their full rent roll. Solomond estimated that an office building with an average lease term of 10 years would have a capitalization rate around 50 basis points lower than one with a five-year average term.
"It's really difficult to finance deals with short-term leases due to the increased risk and re-tenanting cost," Solomond said. "More often you have to re-lease the space, and it costs you more in tenant improvements, commissions and downtime. That's why [investors] look for longer average lease rates."
Many of the investors that buy office buildings are large institutions that are seeking to park their money into a stable asset with little risk, Homa said, leading them to prefer longer leases.
"You have these offshore entities and sovereign wealth funds and pension companies and insurance companies that drive property markets and view real estate as a bond. They just want stable cash flow," Homa said. "It's just a different place within the risk spectrum to be accepting of these shorter-term commitments and variable cash flows and higher volatility."
Lenders also prefer long-term leases, Diven said, making landlords want to keep their average term high if they are looking to refinance a building.
"I know from conversations I've had with institutional owners, they would really prefer not to do short-term renewals," Diven said. "Buildings are much more financeable when they have longer average lease terms, so it's a balancing act."
Cushman & Wakefield Executive Vice Chairman Bill Collins said institutional investors can be comfortable with a certain level of short-term, flexible leases in a building, but they typically do not want that level to exceed 10%.
"Would you want your entire building to be three-year leases? No. But some portion of it is good," Collins said. "I think 10% is a no-brainer. If you've got 10 stories, you have one floor you can build out and put leases in there and make it flexible, and they may morph into long-term leases."
Wade said MRP has had tenants in the town hall space sign longer-term deals after their initial short-term period expires. But he also said these flexible deals shouldn't fill an entire building.
"There is a limiting factor on how much of the shorter-term deals you can have in the building, and we do try to keep it within 20% or less of our assets," Wade said.
But Wade thinks that could increase as capital sources become more comfortable with short-term leases. If a landlord can prove their ability to consistently re-lease space with little turnaround time, he said financiers can have the same type of confidence in short-term office leases as they do in apartment buildings with 12-month leases.
"In the future, I think there will be a component of the office assets that will be valued similar to apartments and hotels in that they will look backwards on revenue instead of just looking forward on cash flows," Wade said. "They'll look at your performance on the flexible side and make projections based upon that ... as the office building evolves, I believe it will become a component of how buildings are valued."