CFO Magazine

A Tale of Six Cities

Cross-town or cross-country, the search for better real estate deals is on.

Alix Stuart
CFO Magazine

December 1, 2007

When Erik Prusch joined Borland Software Corp. last year, his top priority was making the company profitable after two years of losses. Critical to achieving that goal was the relocation of company headquarters from Silicon Valley to "Silicon Hill," otherwise known as Austin, Texas, where the company already had a research presence. "We built out too many facilities, and now we're trying to get down to the critical few," says Prusch. The move, which involved laying off most of the finance team in California and replacing them with 60 new employees in Austin, will save an estimated $6 million in annual real estate and labor costs, he says. And although rents are rising in Austin, Prusch is hopeful that the glut of new office construction he sees around him will give him good options for years to come. "The viability of managing long-term real estate costs looks good for us," he says.

Few CFOs can say that. A frenzy of investment in commercial real estate — much of it by private-equity firms committed to a strong payback — coupled with little new construction has left many corporate tenants feeling squeezed. Nationally, rents have increased an average of 11 percent (close to 2000's record 12 percent), and for trophy properties in major cities rents have doubled or even tripled.

That means CFOs are "playing a central role in assessing real estate as a global portfolio — focusing not only on facilities but on how labor and operations might be redistributed to reduce costs and improve productivity," says Sandy Apgar, senior adviser to The Boston Consulting Group. While companies don't often relocate, their strategies for expansion or shifting back-office operations are now more likely to be influenced by real estate considerations. They are also more likely to rethink how much space they really need, as many adopt remote-work and desk-sharing arrangements.

If real estate is to be managed as a portfolio, then it's clear that locations must be evaluated on a wide range of considerations. In some markets, such as Austin and Chicago, tenants still wield a surprising amount of power. There are also deals to be had in up-and-coming markets like Las Vegas and Charlotte, North Carolina, which offer tax breaks and other incentives to woo new business. In the hottest markets, namely New York and San Francisco, there is little room to negotiate, but the talent pool and power of proximity may justify the astronomical rates.

And even for those who are stuck in the high-rent districts, 2008 brings some hope. The advantage is likely to swing back to the tenant side, if only slightly, as new construction reaches the final stages in many big cities and private-equity owners face the prospect of leasing (or selling) at a discount if they can't refinance short-term loans, many of which come due in the first quarter of 2008.

New York
As the biggest real estate market in the United States, with some of the most aggressive landlords, New York City is easily to blame for many of the recent trends. For one, rents in the metropolitan area climbed about 20 percent over the past year, likely the highest increase in the nation, according to Jeffrey Havsy at Property & Portfolio Research (PPR). With metropolitan-area vacancy rates the tightest in the country, rent for the toniest Class A space in Manhattan surpassed $200 per square foot this year. Those numbers mathematically boost the national average rent, and can have "an important psychological effect" as well, since "people base expectations on them," says Sam Chandan, chief economist at Reis Inc., a national real estate investment research and analysis firm.

New York is also the home of many of the private-equity players that are skewing the laws of supply and demand across the nation. Goodwin Procter's Alex Randall, a real estate attorney and head negotiator for the firm's office space, experienced this firsthand last year. After six months of negotiations, he was on the verge of signing a lease for a former Equity Office Properties Trust (EOP) building in Manhattan when The Blackstone Group acquired the site and demanded a 20 percent increase in rent, amounting to $4 million annually. "They literally told me on the phone, 'We spent a lot of money for this building, so we have to charge high rents,'" says Randall. "I'd never heard that logic before." Months later, he was looking for space in San Francisco and found the same phenomenon, with rents doubling as buildings on his short list were acquired by New York private-equity firms like Broadway Partners and an arm of Merrill Lynch. "It was the same dynamic, with out-of-town funds and investors buying the office towers, holding them off the market, and raising the rent, irrespective of supply and demand," says Randall.

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