In recent months, there have been promising economic signs with interest rates stabilizing, the debt ceiling debate settled and an ever-increasing number of employees returning to the traditional workplace. Will this cumulatively result in an uptick in commercial leasing activity during the second half of 2023? Or, are companies still spooked by the talk of a looming recession and developers worried about the possible pain of refinancing assets at uncomfortably-high interest rates?
Offering their perspectives on the current leasing environment in the central Maryland area are Gail Chrzan, Senior Vice President, Blue & Obrecht Realty; Henson Ford, Vice President, MacKenzie Commercial Real Estate Services and David Fritz, Principal, KLNB.
Tenant personalities and lease flexibility
Gail Chrzan (GC): “During the pandemic, companies held attitudes about what was best for their employees including allowing remote work situations, creating cube spaces and collaborative environments, with the health and wellbeing of its staff the main priority. That has not changed but, as leases expire, we are seeing companies searching for buildings that better fit their personalities. This is especially true among tech groups, but also happening in the professional services sector. Organizations are seeking spaces that their employees can embrace both internally and externally. This is good and bad news for owners of Class B buildings. For those that invested into making their assets interesting and added modern amenities, they were successful in attracting leases. The Class B building that did not keep up with the times saw an exodus.”
David Fritz (DF): “Companies are taking a different approach to their search for office space. Adding a Force Majeure clause to remove liability from the lease for unforeseen events was an early ask, but many landlords showed resistance and it did not often find its way into the final document. This originally started after business and retail owners were impacted during the Baltimore City riots, and companies wanted protection from similar circumstances like COVID-19 or other government-mandated shutdowns. We have all learned from those events and, in combination with ongoing economic pressures, believe we have now arrived at an inflection point. Tenants want flexibility with their lease structure – with shorter terms to mitigate risk– but high tenant improvement costs have created a stumbling block to change. Seeing a lease three years or less is very rare unless the tenant leases the premises in as-is condition.
Henson Ford (HF): “Across the board, we continue to see downsizing among corporate-type tenants, seeking lease terms more frequently at five years compared to the typical seven-to-10-year length from a few years ago. Landlords are showing creativity in their attempt to attract companies with the addition of unique amenities such as golf simulators, pickleball courts on rooftops and programming that encourages engagement. With some excess parking due to less people coming to work, landlords are searching for secondary uses of this space. But it has been a difficult process. To recruit new and lure existing employees back to the workplace, companies are looking to upgrade their existing space and create separation from their competition. That is good news for landlords because it signals to willingness to remain and hopefully renew.”
GC: “The amount of sublease available in both the urban and suburban market spiked beginning in 2020 and we are seeing little relief from this situation. For companies engaged in new office space searches, this situation is creating some confusion as it presents an inexpensive, although somewhat complicated, option. True, companies do not have to invest significant tenant improvement dollars into the space, but they are also fairly locked in to the existing configuration. The sublease competition is forcing certain landlords to lower lease rates.”
DF: “Sublease space is a low-cost alternative for some occupiers as this does create flexibility. We are especially seeing this situation playing out in all submarkets especially with many DC law firms. The amount of sublet space available has created a dark cloud in the suburban and urban submarkets. We initially thought this situation would subside a bit in 2023, but that has not been the case. There is so much uncertainty in the office asset class. Owners of Class B or C buildings, with large amounts of space available, are considering transforming their asset to a different, non-office use, which would require the buy-out of existing leases.”
HF: “I think you can compare the availability of sublease space to the spec suites concept, which is more common in the DC market due to the prevalence of government-related end-users that need to ramp-up operations rapidly. It always makes sense for landlords to present options and I recommend owners to have a few spec suites available in their back pocket to possibly salvage an office search. But my advice is to only have a few spec suites and the space should be in the 3,000-square-foot range or smaller. It takes the right end-user, in the perfect situation, to go in this direction and current activity does not support a large investment.
The office footprint
GC: “The medical office sector is bucking the trend of diminished office footprint, particularly in Howard County, where rental rates are also rising including some in the $30 per square foot, triple net range. The same can be said for the behavioral sciences and education industries, where it is not all doom and gloom.”
DF: “Overall, there is certainly retraction taking place as companies, led by professional services groups, continue to decide which positions are essential to have working in the office. Howard County-based defense contractors and medical practices are one sector that seem immune from this conversation and we believe there is a turning of the tide with employers demanding a higher worker presence.”
HF: “We are also seeing strength in the behavioral sciences sector, particularly groups working with autism patients, and there is significant private equity backing these efforts. The sentiment among many groups we are working with is that in-office activities will eventually revert to near-normal conditions and they are not ready to downsize from their current footprints.”
Survive until 2025
GC: “The greater Baltimore metropolitan office market has always been steady and consistent market, while also susceptible to the economic and real estate cycles. As my colleague Ritchie Blue frequently says, Baltimore’s real estate market is all about the Feds, Meds and Eds. The diversity of industries including medical, education and federal government maintains its buoyancy and prevents our lows from becoming too severe to recover from.”
DF: “Borrowing from the wisdom of a well-respected developer with a slight rewrite, many are adopting a ‘survive until 2025’ perspective. Economic uncertainty, including the prospect of continuing inflation, is causing some paralysis in the marketplace and dampening space showings. If a building is available for sale with today’s interest rate envorionment, many are questioning why and assuming there are possible financial problems lurking. The looming office debt situation is creating more indecision. That all said, we will eventually emerge from these present-day conditions.”
HF: “The state of Maryland and federal government is planning to enforce the in-person work schedule, which will increase daytime traffic to the benefit of retailers and restaurants. All boats will rise with this activity. We predict continued pain in the Class B market and some landlords need to get creative and become the low-cost provider to win deals. That is sometimes a tough message to deliver to owners and investors.”