Heartland Real Estate Business
By Kristin Hiller
As a result of COVID-19, landlords have implemented rigorous health protocols and responded to tenant needs. Now they await the next move by space users.
The work-from-home model that became the “new normal” for most office workers in 2020 as a result of the COVID-19 pandemic has stymied leasing activity and altered tenant strategies. Many space users have opted for short-term leases in response to the uncertainty triggered by the virus.
According to JLL, U.S. office leasing volume in 2020 totaled 125.6 million square feet, down 47 percent from the prior year. Of the lease renewals inked in the fourth quarter, 43 percent were for five years or less. As a result, the average deal term dropped to 6.7 years for leases larger than 20,000 square feet, well below the pre-COVID average of 8.5 years.
While office owners remain bullish on the idea that the workforce will return to physical buildings, many questions remain regarding timelines and capacities.
In the meantime, landlords are steadfast in their attempt to keep the lines of communication open with tenants and ensure their properties are as safe and welcoming as possible. Heartland Real Estate Business spoke with owners across the Midwest to gauge their pandemic responses and outlook on what’s to come.
Health, safety protocols
Daniel Cooper, partner with real estate investment manager 90 North Real Estate Partners LLP in Chicago, says his firm quickly recognized it needed more than just face masks and social distancing signage when the pandemic took hold.
“We began brainstorming and thinking more holistically about health and wellness, resulting in a great deal of research on the subject,” says Cooper. “We do see the importance of providing opportunities for healthy options for meals, exercise, time outdoors, air filtration and cleaner water.”
The company’s research led it to seek the WELL Health-Safety Rating, which is a third-party designation given by the International WELL Building Institute (IWBI). The certification verifies that a building has followed best practices for facility operations and management to reduce the risk of contracting COVID-19 and other viruses. The cost is $4,200 for standard buildings, and $12,600 for high-volume buildings accommodating more than 10,000 people daily, according to IWBI.
So far, 90 North has received the WELL rating on two of its office buildings. (The company’s portfolio totals 2 million square feet across Chicago, Cincinnati, Philadelphia and the Netherlands.) Moving forward, Cooper says that 90 North will evaluate new acquisitions based on its ability to receive the WELL rating in addition to traditional due diligence.
Accesso Partners, which owns roughly 16 million square feet of office space in major markets, hired additional staff to clean touchpoints such as door handles and elevator buttons, and installed hand sanitizers in entryways and lobbies. The company posted signage from the Centers for Disease Control & Prevention and incorporated touchless fixtures in its restrooms.
When the pandemic began, the occupancy of Accesso’s buildings plummeted to around 5 to 10 percent, according to Paul Gaines, managing director of asset management. That occupancy rate has grown to roughly 20 to 25 percent now. “With vaccines starting to pick up, we expect we’ll be a lot further along by summer,” says Gaines.
Brian Atkinson, managing director with Hines in Chicago, echoes this sentiment, saying that late summer or Labor Day is when a lot of the larger tenants are making plans to come back to the office. Smaller-size tenants are likely to come back sooner than large institutional users.
“Tenants are really talking to their peers and trying to understand what others are doing,” says Atkinson. “I think there’s some reluctance to be first in the space when it comes to bringing people back.”
Whenever they do come back, Hines will be ready. The company, which leases or manages roughly 12 million square feet in Chicago’s central business district, revised its cleaning protocols and placed particular focus on adjusting the amount of fresh air being circulated into buildings.
Another company active in Chicago, Riverside Investment & Development upgraded its air filtration to MERV-15 filters for hospital-grade filtration, according to Christy Domin, senior vice president. MERV refers to minimum efficiency reporting value, which measures how effectively a filter stops dust and other contaminants from passing through the filter and into the air.
The higher the MERV rating, the more effective the filtration system is considered to be. For the same 10-by-20-by-1 size filter, a MERV-8 costs $7.56 each while MERV-13 costs $12.16, according to Grainger, a sup-plier of maintenance, repair and operating products. Costs increase from there as filters get larger or deeper.
Additionally, Riverside added supplemental filtration systems such as bipolar ionization to neutralize viruses and bacteria, says Domin. The firm also installed air-quality monitoring sensors and responsive HVAC systems for all common areas.
Riverside’s current portfolio spans 4.3 million square feet across three buildings — 150 N. Riverside, 110 N. Wacker and 320 S. Canal, which is un-der construction.
“Tenants appear to be more comfortable about returning to the office as COVID vaccines become more widely distributed,” says Dan Park, senior vice president and asset manager for KBS, which maintains $7.7 billion in assets under management in major markets. “As a landlord, it is our job to try to ensure that our tenants feel safe and comfortable coming back to the workplace.”
In some of its properties, KBS has employed Maptician, a cloud-based software that assists in creating space configurations and provides pre-screening tools such as temperature checks and contact tracing.
“Looking ahead, we believe that companies will likely continue to want more space in between employee workstations, increased sanitation throughout the building and clean air technology,” says Park. “It’s in our best interest to keep tenants and employees healthy — whether it is from COVID-19 or any other viral illness — so these measures are likely here to stay.”
Tenants seek new terms
Today, there is not a one-size-fits-all answer to the question of what tenants are looking for in terms of their office space, says Ryan Biery, senior vice president of brokerage for Kansas City-based Copaken Brooks.
“We are finding some tenants are reducing the amount of space they are utilizing and seeking shorter-term leases and more flexibility,” he says. “However, others are sticking with the same square footage they had pre-pandemic and are signing longer-term leases.”
Copaken Brooks’ office portfolio consists of more than 2.2 million square feet of Class A space in metro Kansas City. Mark Thomas, senior vice president of asset and property management for Copaken Brooks, believes that owners will need to invest in their properties to offer amenities that retain and attract tenants since some companies have been questioning their need for physical office space as employees work remotely.
“Tenant lounges, fitness centers, conference meeting rooms, high-tech security systems — while currently in place at many locations — will take on a higher degree of importance,” says Thomas. “Those amenities will need to be refreshed and merged into an overall marketing message of what the building represents.”
Regardless of whether they are downsizing or expanding, tenants are seeking flexibility. “It is challenging to forecast space needs when there is uncertainty about how many people will actually come back to work in the office,” says Domin.
Zack Cupkovic, partner with R2 Cos., says tenants will prioritize out-door spaces and flexible spaces that “feel more like home and less like an office.” The days of the densely packed office are over.
Cupkovic says that despite the overall drop in office leasing activity, there are tenants in the marketplace that have leverage and are seeking to lock in longer-term deals at dis-counted rates. Furniture designer and retailer Blu Dot recently expanded its headquarters to 60,000 square feet within Crown-Arts Center, a building owned by R2 in Minneapolis. The tenant is expanding its onsite retail store and adding creative office space for employees.
With offices in Chicago, Minneapolis and Milwaukee, R2 owns roughly 5.2 million square feet across 42 buildings.
Gaines of Accesso says that flexibility has definitely been at the forefront of discussions with office users. He says tenants are unsure of how much space they need and how many employees will come in on a given day. For instance, some may implement a “hoteling” model, meaning certain employees come in three days a week and alternate with those coming in twice a week.
While Accesso has completed some short-term extensions and reconfigurations of tenant spaces, the company is betting on flexible shared space as a solution for its tenants. This way, there is opportunity to bring in more employees should a large project arise.
“If a tenant downsizes and can’t accommodate all employees at one point, we’ll have additional space for them that they can rent on a short-term basis for a short assignment,” ex-plains Gaines. “This way, they’re able to reconfigure their space the way they want, but also know that the landlord is working with them to provide temporary space in the same building if they need to bring more people in for a certain period of time.”
Accesso is also attempting to design its office spaces so that they are more responsive to today’s tenant needs. “We were doing big open spaces and spec suite plans and thought it was perfect, but now people are going back to needing more private offices and areas that are spread out to social distance,” says Gaines. “We’ve gone back to architects to design some spaces that are more responsive to what’s going on in the market.”
For Gaines, the pandemic was an eye opener in terms of the need to constantly assess the current environment and be prepared for any changes. Simply put, “the status quo doesn’t work.”
Atkinson of Hines says it is likely that tenants will seek greater flexibility in their lease terms as a result of the pandemic. This could come in the form of expansion or contraction rights. Many are also looking to complete short-term leases so that they can delay making a more permanent decision about their space needs, a trend that is expected to continue in the near term, according to Atkinson.
Pent-up demand to complete leasing and investment sales transactions will likely come to a head near the end of this year and early 2022, says Atkinson, “as those tenants who delayed decisions return to decision making mode and those tenants that have natural lease expirations in 2022 take their normal course of action.”
Sublease space balloons
Adding to the challenges currently facing office landlords is the amount of sublease space on the market. In its fourth-quarter U.S. office report, JLL wrote that the rapid expansion of the sublease market was the most prominent effect of COVID-19 on the office sector. Over the course of the pandemic, the sublease market expanded by nearly 47.6 million square feet, or 50.7 percent, according to the broker-age firm.
“It’s a natural challenge and a recessionary condition that we’ve seen in the past,” says Atkinson. “The pandemic accentuates it.”
While the amount of sublease space is of some concern for landlords, there are small sublease spaces with short lease terms that are getting snapped up, says Biery. The larger, long-term subleases are the ones that tend to sit longer on the market.
For Domin, the large amount of sub-lease space available is expected, given the pandemic. The question is how much of the space is really available and what tenants are willing to write off in a sublease situation.
Cooper does not see reason for concern on the landlord side if there are tenants seeking large floor plates. These users want to design their own spaces, which requires an investment in tenant improvements, he points out.
“It is more efficient in this case to sign a longer-term lease and have the landlord fund these costs,” says Cooper. “Large tenants do not want to be subjected to continual inefficiency of turning space, renegotiating and moving. It is far too disruptive to their business and ultimately their cash flow.”
Furthermore, not all sublease space is created equal, says Cupkovic. “Probably 25 percent is high-quality space that is easily re-leasable, but the other 75 percent will have leasing challenges, such as very specific de-sign and funky lease terms.”
Additionally, tenants put a lot of sublease space on the market as an opportunistic attempt to save money. But that doesn’t mean they are going out of business or not returning to their space, he adds.
The issue with sublease space is that the new tenant has to be accepting of the lease length and space configuration. For instance, if a tenant is seeking a five-year deal, selecting a one- to two-year sublease would prove undesirable since the tenant would have to renew at a point when rents are likely to jump considerably, says Gaines.
The amount of sublease space on the market should decrease as the pandemic subsides, says Park. “Ten-ants’ confidence levels in returning to the office are rising, and the economy will continue to improve as vaccines are increasingly distributed.”