Companies with Excess Office Space Find A Challenging Sublease Market

The New York Times published an important article about the large amount of commercial office space in New York City that is leased but not being used. Many companies survived the economic downturn by a combination of cost cutting, consolidation and reduced product and service offerings. These actions led to companies no longer needing thousands of square feet of office and industrial space that is part of a long term leasing obligation. In past markets many tenants would pursue a subleasing strategy. This may no longer be effective or easy to do.

As reported by Julie Satow in The New York Times,

"Despite rosy news about job growth in New York and the prospect of a rebound in commercial real estate, the market’s recovery could be delayed by a large amount of vacant office space that would normally be sublet or otherwise absorbed in a healthy market, new data show.According to the research firm CoStar Group, nearly 18 million square feet of unoccupied office space in Manhattan has not been factored into the market’s vacancy rate. This so-called shadow space consists of individual desks as well as entire floors that are empty after layoffs and consolidations. Because these vacant areas are not for rent, they are not recorded anywhere and so are hard to pinpoint.

As the economy improves and employment picks up, tenants will spend the next several years backfilling these shadow spaces before venturing into the leasing market. That will postpone a rise in commercial rents and drive down building values.“There’s no doubt that shadow space is going to mute a recovery,” said Robert L. Freedman, the chairman of the tristate region for Colliers International, a commercial real estate firm. Mr. Freedman said he expected that rents would not rise for at least three years. The amount of shadow space will also weaken the investment sales market, said Robert A. Knakal, the chairman of Massey Knakal. Vacancy and positive absorption — a net increase in demand for space — “are two of the most important metrics” for building values, he said.

CoStar determined the amount of shadow space by taking the unemployment figures in New York City from the first quarter of 2008 through the first quarter of 2010 — roughly 104,000 jobs lost — and multiplying this by 250 square feet, the industry standard for how much space each employee uses. This resulted in 26.1 million square feet that should have been vacated during the downturn. Instead, only 8.5 million square feet was put on the market — a 17.6-million-square-foot discrepancy. This results in a vacancy rate of 11.2 percent rather than 7.9 percent, with roughly 15 additional quarters of growth needed to fill that space, according to CoStar.

James P. Stuckey, a dean at the Schack Institute of Real Estate at New York University and a former executive vice president for the developer Forest City Ratner, agreed. “These figures make sense. Shadow space is always an issue during downturns as companies grapple with how best to handle it.”

It is normal for tenants to hold on to some shadow space, typically maintaining a 5 percent vacancy to give them flexibility for hiring or layoffs. The extent of the job losses in the city over the last few years, however, has pushed the shadow inventory to 10 percent for many tenants, leasing brokers said.

There are several reasons companies hold onto this excess space, one of the most common being the difficulty of subdividing it and creating a contiguous block for lease.

“If you have one million square feet spread across 25 floors, that shadow space may be a few seats here, a few offices there,” said Robert J. Alexander, chairman of the tristate region for CB Richard Ellis. “It would be really expensive to consolidate this.” In addition, with office rents low, it is not clear that the tenant could even recoup their costs should they put the space on the market.

Perhaps an even larger factor driving companies’ decisions is the financial write-downs incurred when subleasing vacant space. When a tenant puts sublease space on the market, it must set aside a financial reserve to account for any projected losses between the rents they are paying and their sublease terms. This reserve depresses short-term earnings, something that many companies, especially those already under financial duress, are reluctant to do.

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While it is nearly impossible to determine the magnitude of the write-downs for individual tenants, it is “a very important component when big companies make decisions. They won’t make a major strategic real estate decision until they understand the financial implications,” said Robert Goodman, an executive managing director at Colliers International who spent several years at Merrill Lynch and specializes in financial firms.

In addition to subleasing shadow space, it is also possible to pay the landlord to get out of a lease term. This can be difficult to negotiate, since landlords are often unwilling to take a chance on finding a replacement tenant.

Still, several tenants are now venturing into the market, and if they are successful, it could burn off some shadow inventory. Citigroup, for example, is offering more than 130,000 square feet on three floors at 111 Wall Street, a building they own, according to CoStar. In addition, the CIT Group is putting some 130,000 square feet at 505 Fifth Avenue on the market while JPMorgan Chase is looking to shed in excess of 300,000 feet at 245 Park Avenue, said Cynthia Wasserberger, a managing director at Jones Lang LaSalle.

Perhaps the most vulnerable area is Downtown Manhattan, which has roughly five million square feet of space available. “Generally, downtown is going to experience more of an impact from all this shadow space than Midtown,” Ms. Wasserberger said.

For example, Goldman Sachs is vacating several buildings to move into its new headquarters, Bank of America is giving up a huge block at the World Financial Center, and both the American International Group and JPMorgan Chase are shedding offices. And there will be new space coming online at the World Trade Center.

“Shadow space is difficult to determine, but any way you slice it, it is a significant factor in the recovery,” said Benjamin F. Kursman, a partner at the law firm Herrick, Feinstein who specializes in leasing deals. “Even as we see some green shoots in the economy, this is definitely going to be a drag on the resurgence of the commercial real estate market.”