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"Improving Situations"

March 27, 2006

Daily Business Review's South Florida Office Leasing Guide, March 2006

By Terry Sheridan

"Improving Situations"

Health Benefits Direct’s lease of a 50,000-square-foot Deerfield Beach office building was more than just a sizable deal at more than $10 million for 10 years.

The lead generator for health insurers got about six weeks of free rent and $750,000 worth of equipment and furnishings under the agreement reached last month.

But times are changing — fast.

In the tightening office market where take-it-orleave-it landlords are increasingly driving tougher bargains for dwindling space, Health Benefits Direct got a great deal. Cofounder and senior vice president Dan Brauser had no comment on the lease.

Paint, carpeting, new furniture and office remodeling may seem like insiders’ mundane details.

But the cost of tenant improvements rapidly is becoming a key negotiating point that can make or break deals in the South Florida office market, and dipping vacancy rates in locations across the region have given landlords the upper hand.

In Miami, six prospective tenants are vying for four floors in two buildings at the Waterford Corporate Park at Blue Lagoon near Miami International Airport, said Richard Neve, senior vice president of the Hogan Group. The company manages the 1.6 million square foot complex for owner TIAACREF of New York.

Hogan has cut back on freerent offers, lease rates range from $18 to $19 per square foot triple net. The complex is 80 percent occupied, Neve said.

TIAA executives are planning another 247,000-square-foot, 10-floor building when occupancy hits 90 percent in the existing buildings, Neve said.

“We’ll know for sure in June, but I’m confident with the strength of the market that we can start this year. The market’s the strongest I’ve seen in six or seven years,” he said. “If you don’t have the space, tenants aren’t waiting around.”

Landlord broker Greg Martin of Cushman & Wakefield in Fort Lauderdale is so confident of tenant demand that he’s promoting rental rates in the low $20s per square foot at the 220,000-square-foot Royal Palm II under construction in Plantation.

That’s high for a suburban market, but the building and twin Royal Palm I next door look like downtown buildings and include a parking garage.

“We’ll see what the tolerance is,” Martin said. “There are few large blocks available, so a tenant coming in for 50,000 to 60,000 square feet of spacedoesn’t have many options.”

Noconces - sions will be offered, and tenant improvements will cost $25 to $30 per square foot, he said.

For second-generation tenants, those moving into someone else’s old quarters, many landlords are paying only a portion of improvement costs unless the newcomer is a major national company or very creditworthy.

Lesser known companies may get a helping hand with improvements if they settle for higher rents for longer time periods. Even then, they’ll likely shoulder part of the expense.

“Because of the 40 percent increase in construction costs over the last 18 months, there’s a crisis of perception between building owners and tenants,” said broker Ken Morris of Morris Southeast Group/Corfac International in Plantation. He represented Health Benefits Direct’s landlord, FG 2000 LLC.

In the late 1980s, $20 per square foot was considered a big landlord expense in building out office space for a tenant, Morris said. By 2000, it was up to $25 per square foot.

Now “it’s closer to $35 to $45 per square foot, and the problem is that landlords are still running their numbers based on a $25 per square foot TI [tenant improvement] allowances,” he said. “You can’t build anything out for that.”

Escalating construction costs have turned lease negotiations into a struggle. Tenants weigh the benefits of renewing leases against moving to other space or waiting for completion of the small supply of offices being built. Some tenants are opting to buy office condos instead.

Landlords, in turn, are scaling back on interior finishes. In new buildings, they’re setting aside several floors of small offices to compete with condos.

“Tenant improvements have really changed the complexion of leasing,” said broker Rod Loschiavo, senior director at Cushman & Wakefield in Fort Lauderdale.

The tight market is driving up rents and feeding the construction of new buildings that may not be ready for another two years. Rising land and construction costs will drive up lease rates in those buildings, which will nudge up lease rates and improvement costs in existing buildings as well.

“Tenant improvement costs are becoming a bigger part of the equation because of the rising costs,” Loschiavo said.

The balancing act for landlords is in retaining and attracting tenants to keep a building as fully leased as possible and boost its value. Lose too many tenants and replacement tenants likely will want space improvements that will eat into a landlord’s bottom line.

Still, new tenants asking for renovations in existing buildings are finding landlords increasingly less accommodating, said Jonathan Kingsley, managing director and executive vice president for Grubb & Ellis in Miami.

“In a tenants’ market, the landlord would start all over again and build out the space for the new tenant,” he said. “Now, tenants who may have relocated are saying, ‘Let’s just stay put’ and get $5 to $10 per square foot for basic improvements like carpet and paint in their existing location.”

A prominent tenant expanded in its downtown Fort Lauderdale building but got an improvement allowance for only half the cost and for the expansion space only, Kingsley said. He declined to identify the tenant or building.

Three or four years ago, landlords more desperate for tenants would have eaten the costs.

Some landlords worry prospective tenants are ignoring new buildings unnecessarily.

Tenants are getting the wrong idea that leases in new buildings are enormously greater than in existing buildings, said Tom Kates, president of Stiles Realty in Fort Lauderdale.

“It’s a fallacy,” he said. Stiles’ new five-story, 140,000-square-foot Lakeshore Plaza in Sunrise is leasing for $18.50 per square foot triple net. Stiles is answering one company’s proposal request for 50,000 square feet and has letters of intent for another 35,000 square feet.

Tenants elsewhere in western Broward County who signed leases five years ago at $16.50 per square foot are now paying more than $20 because of escalation clauses in lease agreements, Kates said.

“There are a number of tenants in Sunrise, Plantation, Weston and Miramar who are paying above what we’re asking for new Class A space,” Kates said. “A lot of people are under the impression that there’s sticker shock when they go out and look at [new] space.”

The underlying issue is that most tenants don’t want to use a former tenant’s space, he said.

“That’s why a lot of tenants end up in new buildings,” Kates said. “The only way a tenant will save money in reality is if they accept someone else’s space, take it as-is and save the landlord dollars.”

A tenant who wants refurbished offices will pay a premium that Kates said will be at least as expensive as a new building.

Meanwhile, some landlords are looking over their shoulder at the growing office condo market. Though there are doubts about the long-term strength of commercial condo values, particularly if interest rates rise, some landlords like Scott Brenner of Brenner Real Estate are offering traditional office space while converting some offices to condos.

At Emerald Hills Executive Plaza in Hollywood, a fully leased 60,000-square-foot building that Bank of America anchors is adjacent to a 70,000-square-foot office building being converted to condos. The building was half empty, but Brenner said half of the condo space has been reserved.

In downtown Fort Lauderdale, Stiles will compete with nearby Museum devoting two floors to small office leases in its new 200 Brickell building, Kates said.

The two floors totaling about 40,000 square feet of space will be carved into offices ranging from 1,500 to 5,000 square feet.

“To build out shell space for a 1,500-square-foot office could cost $50 per square foot,” he said. “To build out the entire floor will probably cost 20 percent less. It’s a risk factor, and you hope you’ve built the right size offices. But we did this at Las Olas City Centre, and it worked well.”

Office condo prices currently compete well with rising lease rates. Whether that holds true as interest rates climb is a growing concern.

“The higher the interest rate, the higher the debt service that a purchaser pays,” said Cushman & Wakefield’s Loschiavo. “That makes office condos less desirable.”

On the other hand, everrisingland and construction costs mean lease rates are less predictable. A condo buyer can pin down occupancy costs with more assurance, he said.

“It insulates them from rising rental rates,” Loschiavo said. “But you don’t know if it’s a good investment ultimately until you sell it.”