San Francisco Office Sales Soar

THE BEST DEFENSE IS A GOOD OFFENSE

Law firms can employ a number of proactive strategies to insulate themselves against rising costs. The suggested strategies correlate to the length of the law firm’s existing lease obligation.

• Firms with less than three years remaining on their leases should explore the following:
  
  Investigate space alternatives in buildings that have not sold recently. If an office building has not sold in the past three years, it is likely that the ownership’s cost basis sits in the $150 to $300 per square foot range versus the new reality of $400 to $800 per square foot. A landlord with lower financial covenants typically has more latitude to structure new leasehold transactions at or below prevailing market conditions. Conversely, a newer landlord is constrained � for the next one to three years if not longer � by very high financial underwriting, triggering an increased rental rate mandate whether the space demand exists or not. Jones Day and Sedgwick, Detert, Moran & Arnold have used this strategy and consequently enjoy leaseholds substantially below market conditions.
  
  Proposition 13 protection � A “show stopper” lease negotiation issue. Historically, Class A landlords have been very reluctant, if not obstinate, in granting tenants Proposition 13 protection. Proposition 13 shields the tenant from real estate tax increases that occur when a building is sold or refinanced, thereby causing a property valuation reassessment. Presently, due to the large number of properties sold, 75 percent of Class A tenants will be subject to an average real estate tax increase of $3 per square foot per annum.

  Charts San Francisco Office Space Occupancy by Industry Group Recent Class A San Francisco Office Building Sales

  
  
  A law firm may want to consider making Proposition 13 protection a “show stopper” negotiation point in order to protect itself from future unexpected and expensive occupancy increases. Please know that this tactic would be aggressive and somewhat unconventional. It would also eliminate many higher quality buildings from consideration. However, it could mitigate future rental increases of $1 to $6 per square foot per annum. Firms like Kirkland & Ellis have benefited from this strategy in San Francisco.
  
  Target law firm sublease spaces � existing or hidden. While the landlord community determines whether or not its inflated rental expectations are achievable vis-a-vis tenant demand, one way to avoid this “bullishness” is to target existing law firm sublease space. Some opportunities may be readily available; but more often than not the most desirable ones � well-located offices with highly functional layouts and long sublease terms � are somewhat “hidden.”
  
  A law firm may have excess space but not immediately address the issue for a variety of reasons. To the extent one can become aware of this dynamic, oftentimes a “win-win” solution can be structured, whereby the subtenant can enjoy a competitive rental rate and substantially reduced interior construction costs, while the sublandlord mitigates its occupancy cost exposure and insulates the transaction from the landlord community’s market perspective. Firms that have benefited from this strategy are Sedgwick, Dertert; Perkins Coie; and Haight, Brown & Bonesteel.
  
  Buy a smaller building and become an owner/user. Another way to control one’s office environment and associated costs is to buy a smaller office building (i.e., 200,000 square feet or less). The value proposition explicit to this approach is rooted in finding a property that is largely if not entirely vacant. Even in an investment environment exhibiting “irrational exuberance,” the leasing risk associated with a vacant building usually brings some sobriety to its valuation and corresponding negotiation. Once purchased, the owner/user law firm is insulated from the volatility of the San Francisco commercial real estate market.
  
  Buildings that fit this profile will usually be older, non-Class A properties. If the cash outlay exacerbates intergenerational issues among partners (who may have conflicting operational and financial priorities due to varying retirement horizons), the law firm can pursue a credit-leveraged leasehold strategy rather than outright ownership. This approach essentially provides a predetermined fixed yield to the law firm’s landlord partner in lieu of a corresponding fixed and predetermined rental rate and tax structure.
  
  

• For those firms with five-plus years left on their leases, these strategies may be applicable:
  
  Grow outside San Francisco. For some firms, a cost-effective real estate strategy may be to simply grow outside of San Francisco. Decentralizing law firm support and administrative functions like finance, IT, marketing, human resources and word processing (and even attorneys, depending on practice type and client location) can result in significant savings when compared to heightened San Francisco rental expectations. Examples of firms that have employed or are employing this strategy include Orrick, Herrington & Sutcliffe and Sedgwick, Detert.
  
  Proposition 13 protection now as a precursor to future tenancy. In this volatile investment sales environment, a longer-term lease should not necessarily preclude a law firm from approaching its existing landlord and requesting Proposition 13 protection. Although the vast majority of landlords will not welcome this request, it’s still a reasonable negotiation point, particularly if the law firm is predisposed to remain in the building after its initial lease term expires. There may be acceptable trade-offs to both parties. Larger law firms are likely to make this strategy a new priority.
  
  Hedging strategies to mitigate future occupancy cost risks. Not unlike one’s ability to hedge the future direction of the equities markets via derivatives � i.e., “calls,” “puts” or “futures” � larger law firms could use similar strategies and tactics within office leasing markets to smooth market volatility and mitigate future financial risk. This more sophisticated approach hinges on a firm’s confidence in its market forecasting techniques and the perception of risk that may come from that forecasting. Look for firms employing more than 100 attorneys to begin investigating this approach in cities like San Francisco, Washington, D.C., and New York.
  Another way to hedge against escalating office space costs is to, in fact, “buy into” the prospective upside � through purchasing stock in a public real estate company that’s a potential buyout target. For example, Equity Office Properties’ stock rose 22 percent from the point of Blackstone’s first buyout offer. This is a particularly effective strategy if the law firm’s own landlord is a public entity, such as Boston Properties.