May 30, 2016
Interviewed by: Zoe Hughes
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Death of the 10-Year Office Lease

As office investment adapts to the rising number of new and smaller tenants entering the U.S. market, is the 10-year lease also coming under pressure? GreenOak co-founder Sonny Kalsi and Hodges Ward Elliott managing director Will Silverman discuss whether there is a structural shift taking place in leasing and what it could mean for landlords in terms of attracting tenants, pre-built space, TIs, cap-ex and future rental rates.

As office investment adapts to the rising number of new and smaller tenants entering the U.S. market, is the 10-year lease also coming under pressure? GreenOak co-founder Sonny Kalsi and Hodges Ward Elliott managing director Will Silverman discuss whether there is a structural shift taking place in leasing and what it could mean for landlords in terms of attracting tenants, pre-built space, TIs, cap-ex and future rental rates.

Death of the 10-Year Office Lease

Zoe Hughes, Privcap: Hello. Welcome to Privcap’s webinar, looking at the US office market and trends in the leasing and tenant appetite. My name is Zoe Hughes. I’m the Real Estate Editor of Privcap. Now, we build this webinar, The Death of the 10-Year Lease. Controversial, perhaps a slightly sensational title, I grant you, but one that does hit on an emerging challenge facing many office investors and managers, large and small across the US. And that’s the increasing prevalence of new tenants in the marketplace, not least startups and those in the tech world.

With us today, we have a fantastic panel of experts and I’m just going to introduce those. But first I want to kind of summarize what we’ll be looking at. With this rising number of new and smaller tenants, are we actually starting to see the pressure being put on the traditional 10-year lease? We, as we’re beginning to see a structural shift in office leasing, that will actually accommodate shorter leasing terms or is this actually an issue more about the changing face of office tenants?

I’d love to introduce our speakers now. GreenOak Real Estate Cofounder, Sonny Kalsi and Hodges Ward Elliott Managing Director, Will Silverman. Gentlemen, welcome and thank you so much for joining us here today.

Unison: Thanks for having us. Thanks, Zoe.

Hughes: Not a problem. Now, I’d love you to kick off with introductions. So Sonny and Will, why don’t you both introduce yourselves and your firms to the audience? Sonny, let’s kick off with yourself.

Sonny Kalsi, GreenOak Real Estate: Okay, Zoe, thanks. Good afternoon, everyone. So my firm, GreenOak Real Estate, we’ve been in business for about six years. We are an investor in probably eight to ten places around the world, cities – half dozen or so in the US, London, Madrid, Tokyo outside of the US primarily. We’ve raised about $5 billion of equity just under. And we are primarily a value-add investor. We do have a credit business in Europe, but I would say our main business is value-add real estate investing and New York City has been our single biggest area of focus. I think that’s probably the context in which Zoe wanted us to participate in this today.

Hughes: Absolutely. And Will, can I get you to quickly introduce yourself and your firm?

Will Silverman, Hodges Ward Elliott: Sure, Zoe. I’m Will Silverman. I run Hodges Ward Elliott’s commercial real estate division. The firm was historically one that was associated with brokerage and capital advisory work in the hotel space for the last 40 years. I’ve been an investment sales broker in New York City for the last 15 years and my job was to transition the firm from a pure hospitality shop to one that worked in my traditional areas, which were office, retail, multifamily and land in New York City. I transacted, I think, $6 or $7 billion worth of properties in New York City in those areas and I’ve had a long-time specialization in a lot of the nascent office markets in the city.

Hughes: Fantastic, Will. And thank you both very much for joining us here today and to all the audience. Before we jump into the discussion, I want to let people know that this is a very interactive conversation. As a listener and participant, you can pose questions directly to our two speakers.

You can type them into your Q&A section on your screen. You can find the Q&A box on the bottom right. Enter your question into the question field. Hit send. It’s as simple as that. Those questions will come through directly to the three of us and we will actually field those questions throughout the conversation and not just at the end. So really do keep this coming.

Now, of course, let’s get to the crux of the issue and I’m going to go straight for the jugular, as it were and the question that’s actually posed in the title of this, Will, Sonny, are we about to see the death of the 10-year office lease? Sonny, let me open this up to you.

Kalsi: I really don’t think so. I feel like there are clearly some trends which have been happening in the last several years. I’ll call it the, for lack of a better term, the [we work] effect. I think that has been pushing, you know, certainly giving tenants other options. But by and large, as we look at, you know, as I look at major markets in which we operate, London and New York has two examples. There still seems to be a strong preference on the part of tenants and surely on the part of landlords to have some duration to their leases.

Certainly, in my mind, when you think about the capital costs involved with these, what’s required in a B+ or better building, it’s pretty significant. So I sure, [acting] as the landlord, want to have some duration there to offset some of those costs against.

Hughes: And Will, let’s get your thoughts on this, the broker in the house. Is the 10-year lease dead?

Silverman: No, I think it’s still very much alive. I think the interesting disconnect in the marketplace is that, if tenants were to express an overwhelming preference for the shorter lease term, which many do, lenders would actually have to be on board for it and be okay, otherwise there would be a substantial correction in property values because you wouldn’t be able to finance as aggressively.

I think the irony is that the types of tenants that want the types of spaces, meaning I would say hospitality-style driven spaces that have been renovated to that spec, particularly in markets like New York, they’re more likely become available when the owner is somebody like Sonny, who is going to have a modern capital stack that includes a reasonable amount of debt on the property as opposed to somebody who is a generational owner that might have the actual financial flexibility to do it without a lender looking over their shoulder, but that’s not someone who is going to offer the style of experience that that tenant would be looking for.

Hughes: So you’ve both killed the subject of my webinar. So thank you both very much for that. But no, I mean one of the, the crux of the thing that I actually wanted to get to, and I think increasing conversations in this industry is whether we’re actually seeing perhaps pressure on the lease terms. Do you both see whether tenants are actually putting pressure on one or to actually be a little bit more flexible in how they actually look at a traditional leasing lens. Sonny, are you getting that pressure as a GP in the industry?

Kalsi: Yeah. Look, things have clearly changed, right and I think that, and sorry to have not been more nuanced in response to your question on the 10‑year office thing.

Hughes: That’s fine. This is an open conversation, so go ahead.

Respondent: No, things have definitely changed. I mean I think that, if you look at, and I think it’s from two different directions, one of which is clearly from a tenant demand standpoint. I think that we could have a whole separate discussion about millennials, and I think that sometimes we talk about them too much and I think sometimes we may not talk about them enough. But certainly, from the standpoint of it’s not just millennials, right.

If you think about what tenants are looking for out of their space, one, there’s no question there’s a huge movement towards tenants taking less space. So whether it’s because they want shared office space, work space or whether it’s because people aren’t getting offices or it’s what the law firms have been doing for a while, tenants are taking less space. That’s a fact and I don’t think that’s isolated to just [TAMI] tenants. That’s number one.

Number two, other amenities matter a lot, right. And, you know, I’ve got to tell you, I’m definitely not a millennial. We’ve got outdoor space in our office. I really like it, right. We’ve got outdoor space. We’ve got a gym in the building and stuff like – I think those amenities are also really important. And so, if you think about.

Hughes: I think. I’m sorry. Carry on Sonny.

Kalsi: Zoe, I was going to say, so if you think about those factors, which ultimately come down to cost, for sure tenants are asking for more and, if I look at trends, the eyes have definitely gone up as a result of that, number one. Number two, you know, tenants, they factor, those in New York City as an example, since we’re all sitting here, you know, cool has become much more important than it used to be, right.

I mean, no one really cared that a Midtown office building on 6th Avenue or Park Avenue was not cool. It didn’t matter. It was all about location. I think the emergence of Midtown South is a big part of that. It used to be because it was cool and cheap. But it’s still interesting even though it’s not cool – maybe it’s still cool. I don’t know, but it’s not cheap anymore, right. So those kind of factors are definitely out there. Zoe, where I have not seen a change, we have not seen pressure on lease term yet.

Hughes: And Will, one of the things that I do wonder is are we actually talking about the changing face of tenants more than perhaps lease terms? What are your insights into this?

Silverman: I think that’s absolutely right, Zoe. And I think that Sonny hit the nail on the head with many of these quote-unquote millennial preferences turning out to be things that everyone likes. And I would actually take it a step further in terms of the way these tenants are thinking about space.

There’s an old trope in the retail business. Whenever there’s a super expensive store on 5th Avenue with a really, really high rent, people always say, “Well, I suppose that maybe they’re not making as much money on the store, but some of the rent is in their advertising budget.” I think there’s an analogous phenomenon developing with these types of tenants, which his that they’re using their real estate space, albeit rented space, as a recruiting tool.

And the workers, and there’s plenty of research on this, the workers are actually willing to, in many cases, accept a little bit less money or work slightly long hours to work in, as Sonny put it, these cool or well-amenitized spaces. And there’s an arbitrage there, which is, to the extent you can get people to take less money by paying more rent, you’re not paying payroll tax on the additional rent. So you’ve accomplished recruiting without having to spend more money, which is terrific. And I think that’s the orientation.

And those tenants are willing to pay up if the landlord is one that’s deemed to be delivering the style of experience that they want, like Sonny described, with his building that has outdoor spaces that are available to tenants, a gym and so on and so forth.

Hughes: I know Sonny said that this is not just about tech tenants, but in all the conversations that you have in the industry, there is an assumption this is all being fueled by tech and TAMI site tenants. Are you seeing it? Are the TAMI tenants kind of leading the way? And I kind of ask that because when you look at leasing activity actually in Manhattan, I’ve actually just put a slide up about that, the first quarter saw, I think, TAMI tenants are really fueling the market when it comes to living in Manhattan. What are you seeing kind of across the board? Will, make that kind of…

Silverman: To me the most telling statistic is that if you look at employment in New York City by industry, 20 years ago, I think about 15% or 16% of New York City was employed in the so-called FIRE sectors, the finance, insurance and real estate. And that’s down to almost below 10% at this point. And when you look at the various categories that have been making up the difference, it’s absolutely these styles of tenancies.

But that’s only telling half of the story because it’s not only that there has been the rise of those tenants, it’s that everyone else is trying to be more techy in their own approach to things, right. You famously have the CEOs of many non-tech companies describing their firms as tech companies. So I think it’s the techy-fication or the TAMI-fication of most tenancies that aren’t in that sector and the growth of that sector.

Hughes: And, Sonny, give me a sense because, obviously you’re doing repositionings. I know on one of your assets, 285 Madison, it’s more creative office space. What tenants are actually walking through the doors of your assets today? Is it more TAMI, tech or financial? Who are you actually seeing? What kind of changes have you seen in people coming to you?

Kalsi: Yeah, look, I think that – I’ll tell you before I start with who we haven’t seen. We haven’t seen what I’ll call traditional financial services, right. So I think that has been back to Will’s statistic. You know, that’s been the big change, right. Who’s taken that space up? I mean, obviously, there are TAMI tenants and other tenants, but I look at this building, 285 Madison you reference, we have hedge funds, we have family offices, we have some technology tenants.

I won’t name their name, but we have an old world industrial company that’s trying to rebrand itself as a tech company, back to, you know, they have advertisements all over the place about it. So I think we position the building this way, not necessarily to say, “Do we want to get tenants from Midtown South?” because I don’t think Midtown South tenants, if they really want to be in the meat pack industry can afford to live in Madison, but really do appeal to that tenant that is looking for a highly-amenitized building, but doesn’t want to pay $120 a square foot for it.

But I don’t think it’s just TAMI. Look, I think it’s broader than that. I think it’s small and mid-sized businesses. Definitely businesses are catering to younger employees and, look, I think that’s a trend that’s going to continue.

Hughes: And, Will, in terms of kind of who are you seeing kind of really being the driving force today? Is TAMI just going to remain a very, very impactful force in the leasing market?

Silverman: I think it is. I think it’s certainly here to stay. I think landlords are trying to figure out the right strategy to deal with it because I’ve heard of some landlords voice the complaint that they feel like, when they run a building that’s filled with these tenants, it’s like running a venture capital firm without the upside because they’re waiting to see which ones are going to pop and take over the rest of the building while the other ones blow up.

And so I think the buildings that have been the most successful and the most warmly received by the investor committee are the ones that offer the best credit within that world, however, ones that aren’t sort of overloaded with one or two exposures. I’ll give you an example.

Last year, I worked on the sale of a leasehold interest in a building at 114 5th Avenue and that building had a couple of floors leased to Capital One’s tech division, another couple of floors to MasterCard’s tech division and a few other tenants, including Mashable and Gawker. Now, the Gawker one’s a whole other story because maybe Hulk Hogan are on their space soon.

But in general, what investors liked about that property was that it was a high-end property that catered to that tenancy, but it offered them diversity without overexposure. And I think that’s sort of the tightrope investors are feeling like they’re walking because I think a lot of them are fearful because, you know, you’re talking about the 10-year lease, really.

A lot of these tenants haven’t existed for the amount of time that’s equal to the forward commitment in their lease, right. You’ve got three-year old tenants signing 10-year deals. As a landlord, that’s got to give you a little bit of pause. So I think it becomes a more challenging game and I think that’s why you’re going to see more and more landlords seeking diversity.

Hughes: [crosstalk]. Sonny, carry on.

Kalsi: No, I was just going to say – no, no, no I was going to say I think that that’s why something like a WeWork has been so well received, right, because it’s an aggregator and it is helping disperse, if you will, the credit risk of any of those underlying tenants by pulling them together and providing certainly better credit.

You can have a whole debate about WeWork’s credit, but it’s clearly better credit than any of the underlying tenants beneath them. And so that disintermediation, I think they’ve addressed a big need. I mean Will might know, I mean they have millions of square feet of space just in New York City. And, you know, I think that they’ve been, I think there’s been a real marketplace for that.

I think one of the questions which you can start asking is, “Gee, okay, they’re taking a pretty big scrape in the middle. Do you think the landlord might try to disintermediate that?” Look, we’ve thought about it and I think part of the issue for us is, honestly, at the end of the day, we’re not sure it’s worth it, right. From the standpoint of just the comment that Will just made, the credit risk you’re taking, how you think about how you build out and manage space for such small tenants, etc., our view is, you know, it’s not worth it.

And the reality is WeWork and people like them in their space have been very happy to sign longer term leases. In fact, they want the longer term leases, right. They want to know that they’ve got the space tied up.

Hughes: One of the things I do want to kind of pick up, if I can on actually a couple of questions that have actually come in and there are two questions that are actually addressing this. One is in relation to the DC markets, but there is a wider question in relation to this? Have we seen a significant increase from our tenants for early termination options on five-year leases? Will, what are you seeing in relation to early termination options?

Silverman: I haven’t seen that much of a change, but Sonny’s probably closer to that one than I am.

Kalsi: Yeah, Zoe, we haven’t seen it either. I mean, you know, part of it is, and I think this is going to be actually a bigger issue for markets where you have traditionally seen shorter term leases, right. So DC is one. Boston’s another where five years is more the norm whereas New York is 10 years and San Francisco, it’s 10 years. So I think, when you get those shorter durations, you’re going to see underlying tenants looking for more flexibility there.

I will tell you, I think part of the reason we, as an investor, have stayed away from office markets where there are shorter duration leases, I don’t really like five-year leases, right. I kind of feel like you’re on a treadmill. You know, your NOI yield on cost might look somewhat attractive, but your net cash flow yield on cost, between paying the brokers like Will and then paying for your TIs, you’re always on a treadmill with five-year leases.

When you start seeing tenants asking for termination rights inside of that, that’s a really tough place to be. I think you’re really taking that much more credit risk, right when you’re thinking about who you’re leasing to. In half those cases, I’m sure those tenants are terminated because they’re growing and half those cases, they’re probably terminating because they’re failing, right. And so we have not seen the trend yet in New York.

I think that one benefit of a market like New York  is you’ve got such strong institutional ownership here, and as long other people will disintermediate that risk for the landlords, I don’t think you’ll see the landlords move a whole lot and we just haven’t seen it yet.

Hughes: I do want to question, if I may, in relation to TIs and kind of rent concessions. And I pick this up because I did see some very interesting statistics. Will, apologies, it was actually from Colliers, that actually said, in terms of tech firms in Manhattan, they’re actually getting like 9.7 months of free rent, almost a month more than other firms.

Sonny, give me a sense as to what you’re doing, what GreenOak is doing in relation to kind of TIs and free rent. What are kind of some of the trends that you’re seeing in the market? Is this becoming less of a burden for landlords? What’s kind of the negotiating power that you have at the minute?

Kalsi: Well, I’ll take them separately. Look, free rent is just, it’s just moves with the strength of the market, right. So that’s up and down. I haven’t seen anything – I haven’t noticed anything where any one subgroup of tenant is looking for, you know, more free rent or not. I think, look that’s a – look, concessions kind of get squeezed down when markets are good and strong and landlord-friendly and then they expand when they’re not.

TI is a little bit of a different story. You know, I think again, back to the point we were talking about before, ironically, if you want to build out space with a concrete polished floor and exposed ceilings, that’s more expensive than dropping down carpet and putting in, you know, dropping a ceiling, which makes no sense, right, because it started that way because it was cheaper, right. And so this is, you could, you could argue this is just a racket from all the service providers.

But because that space is more expensive to build because the amenities we talked about before are more expensive to build, tenants are asking for and getting higher TI allowances for sure than what we’ve seen. So I would say that, you know, base rents are moving up and have consistently moved up for the last few years. Tenant improvement allowances are moving up as well. And I think that’s very much driven by the tenant expectations.

I think there’s a little bit of selection bias there. I think there’s a selection bias there because I also think that your more mature tech tenants are specifically going to be seeking out the types of buildings that are owned by the types of landlords that might be merchant developers who are interested in buying up the rents and they’re less likely to go to what I would call the family paint and carpet crowd, who aren’t giving big concessions or any concessions at all because they’re just managing for cash flow because those family owners are probably a little bit less likely to be the ones providing the rest of the amenities their tenants are seeking.

So it could just be the result of a selection bias.

Hughes: Well, one thing, when I originally came up with this title, Death of the 10-Year Lease, obviously very much a journalistic title, one of the thoughts that I actually wanted to address was related to the capital that you spent on building improvements. And, Sonny, you obviously raised this in the first place. Why would you do short-term leases when you’re obviously, you know, the capex is going into a building.

If leases are coming under pressure then there’s a huge question of how much money you actually put into your office space, whether you pre-build, whether you keep it raw and obviously kind of some of the TI that you’re doing. So let me move onto kind of the building improvements. And I think this is a critical question. Do you keep it raw or do you pre-build? Sonny, in your experience, what would you do in today’s market? Given the dynamics, rents and everything, what’s your preference?

Kalsi: Look, my preference would be to keep it raw. I’d have to come out of pocket to build it, for sure. I think the reality is, if you’re targeting smaller tenants, right, so whether they’re TAMI or otherwise, if you’re targeting smaller tenants, you’re probably going to have to do some degree of pre-leasing because many, look, you know, if you’re leasing space to a big Fortune 500 company, they have their own internal  leasing, you know, they have their own internal real estate group. They have a very strong view of what they want. They’re looking for their space two to three years in advance. It’s a very different dynamic.

If you are, you know, working with these smaller tenants, 5,000 square foot, 10,000 square foot tenants, they don’t have that, right. And so, whatever you can do for them and show them on a turnkey basis, obviously there’s room for some modification, it could be the distinction between whether they go to your building or somewhere else. So we have definitely done more pre-builds, I would say, in the last few years than we did in, you know, forget the years before that. We’re coming out of the bottom of the cycle.

If we think we’re in a late cycle right now, but still a relatively strong fundamental market, we’re definitely doing more pre-builds now than we did in ’05, ’06, ’07.

Hughes: I’m actually quite surprised to hear that. Will, what are you kind of seeing and what kind of advice do you give for landlords in today’s markets: pre-build or keep raw?

Hello, Will.

Kalsi: Did we lose him?

Hughes: Hello. Oh, I think we did lose Will, unfortunately. I’m afraid he can’t hear anything. So we’re going to get Will to dial back in. Sonny, let me just move onto one question that you did also raise earlier and that was also the amenities. And could you give me a sense as to, a little bit of a controversial question, is the industry simply overspending on amenities? Has it just got too crazy?

Kalsi: Well, maybe we’re moving in that direction. I don’t think we’re quite there yet. Look, I think the cost of a lot of these amenities, I would measure it less than what it costs to put a ping-pong table in to some shared meeting space and more just what are you using that space for and what would it otherwise have been used for, right. So I think a lot of landlords are activating space that would otherwise have been rented for very little money or not rented at all and trying to do that. So I would say, look, I think that’s part of it, Zoe.

I also think that, you know, look, it’s important, right. And I think, as you’ve looked at just the entire urbanization trend that’s been happening and if you look at where people are and how they want to live, work and play relatively close, in relatively close proximity. I wouldn’t know if they’re spending more time in the office than they used to, but they’re definitely spending more flexible time in an office environment than they used to. They might be here later, they might be here whatever. So I think it’s important. It hasn’t, in my mind, gone overboard yet, but it’s clearly changed very significantly.

Hughes: And, Will, what’s the minimum amenities package that you think you can actually offer the landlord today to attract tenants? And even on the kind of sales side, when you’re obviously repositioning an asset?

Silverman: I think people want to see – and I’m sorry. I had to jump off and jump back on for a second there. I think, if you’re repositioning a building, I think you’re going to want to see some sort of shared spaces. I think you want to have outdoor space. I don’t think it’s indispensable, but I think it’s a very, very important thing to have.

I think things like gyms, bike rooms, anything that you’d find – let me put it this way. Anything that you would find in a modern apartment building or a hotel as an amenity is probably something that you will get a nice response on in an office building. And I think there’s just sort of a convergence of uses in that way and I think people are spending more and more time at the office because, I mean, I’ve sold – I remember working on the building where tenant’s like Newton and Yelp were.

And you could by those faces at, you know, 10 or 11 o’clock and even though it was all a party, everybody was still there, working late. And so I think that that’s part of the use of those amenities. So I think it can vary by building, but I think anyone renovating a building right now would do well to focus as much as possible on common and shared amenities.

Hughes: Do you think though that people are actually overspending, that they’re actually offering a little bit too much. I mean obviously this is perhaps more for the tenant putting [the slides in and beer on tap]. Obviously that’s one of the things at WeWork. But do you think that there’s just too much money going in on the amenities side of things. Is this just a fad?

Silverman: No, I don’t think so. I think this is a secular shift in preferences in the way people engage with space. I think that people find a lot of things desirable and, to Sonny’s point earlier in the call, these aren’t just millennial preferences. These are things that I think a lot of people like.

Now, will the pendulum swing back a little bit on things, like everything being an open-plan office? Sure. I think that could happen, but I think the premise of shared amenities in office spaces and improved amenities in office spaces is probably one that’s fairly sticky. Now, I’m sure there’s somebody out there who’s going to dramatically over-improve and try to put a putting green next to a parapet wall and maybe that guy will get a little too aggressive, but otherwise, I think it’s a secular shift.

Hughes: And one thing, obviously the call dropped, but there’s one question that’s come in, actually from Liquid Space in regard to raw and pre-build. So let me bring this one, let’s bring the conversation back a little bit to answer this question and that’s in regard to how do we define pre-build. Sonny, if the tenant wants creative space, are you actually changing what it means, what pre-build means today.

Kalsi: Yeah, I guess so. I mean we’re not doing a lot of pre-builds where it looks like your father’s office space. You know what I mean? We’re not doing pre-builds with a bunch of extra offices and, you know, carpet everywhere and dropped ceilings. I mean I think it’s probably some degree a hybrid.

If you look at one of the buildings we renovated a few years ago, we did our main floor that we used for marketing had three different buildouts in it. And depending upon what your personality was like, you gravitated toward the right, the left or the center, in terms of what the – it’s an all-in-one space right next to each other.

So, yes, look, I think I would say that, if I look at most of our pre‑builds, there’s some degree of hybrid to them, right. We don’t want to over-invest and go one direction because we may end up changing some stuff, but there’s no question, if we’re leasing space and I’ll give you a real example. We own a building in Manhattan where our biggest tenant is, Uber’s East Coast headquarters. We aren’t going to do a pre-build for them. Theyre going to decide exactly what they wanted. They’re going to build it out to their specifications, etc.

By the same token, you know, we’ve got a building where we have a bunch of, I don’t know what to call them, the small financial investment firms, whether they’re hedge funds or small PE firms, etc., but it’s 10, 20 people, a couple of hundred million under management, you know, there you could probably – you could do something effectively off the shelf, which is going to look modern and kind of make sense, but it’s definitely going to be different than the pre-builds of old.

Hughes: And, Will, do you think that our concept of what pre-build is has actually completely changed nowadays. And, like Sonny said, we’re actually seeing a hybrid between really kind of pre-build space and actually almost raw space. When you actually look at a lot of the kind of co-sharing spaces, they look pretty raw in their presentation. Do you think that that concept of pre-build has actually changed today?

Silverman: I think it’s changed a little bit. I would liken it to $200 ripped jeans, right. In order to achieve the true aesthetic that people are really looking for, it’s really hard to get that patina organically. And, to Sonny’s prior point, it can sometimes be even more expensive to nurse it along a little bit faster and go with that polished floor and the raw ceiling. So I think that the cost is going to vary, based on whatever it is you’re starting from, but I think that is what it is.

I think, with respect to the co-working spaces, you know, I think those buildouts, they look a little bit raw, but there are a lot of materials there. There is a lot of glass involved in that. And the amenity spaces they have in the centers of each of those floors are actually pretty rich with stuff. So I think I’m not sure that those are all that much more expensive than what the traditional buildout for those types of tenants would be.

Hughes: Thanks a lot. And we do have one question in here and, Sonny, I’m going to forward this one to you to answer, if that’s okay. And I’ll put it up into the slide area. Sonny, are you finding landlords are paying for the entire buildout providing the entire TI allowance and, if so, what kind of security deposit is being sought?

Kalsi: Yeah, look, I think we’re seeing more tenant requests for what I’ll call just a complete buildout. I think that, again, a lot of them are in a position to do it themselves. They don’t want to deal with it. They’d rather see it amortize into their lease. And, you know, I think the way we generally think about it, security deposit wise or otherwise is, you know, we’ll make a financial assessment about their credit. I’ll look at what their lease is and, you know, we’ll definitely get a bigger pro rata security deposit as a result of it.

I think, look, partly it’s because if they are in an industry where their cost of capital is perceived to be high, then they view this as something that’s going to be more easily provided by a landlord than, you know, if you think about it, like in a lot of our buildings, we will be able to borrow the TIs that we put into something. And clearly, our cost of capital for that is going to be lower than some tech firm’s venture capital is going to cost them and, if that means we can get a higher base rent and we’re comfortable with the credit, I think it’s a good tradeoff.

And look, I think, you know, if we control it, then we control the entire cost then, unfortunately, in the last few years, it usually means we’re dealing with the cost overruns, but in a market where there’s a little more equilibrium, it also means that we can control the cost and maybe we can actually save some money that way. But we’re definitely, we see it. No, I was going to say, we see more of it, no question.

Hughes: And when we’re obviously, in all of this conversation, you know, when we’re talking about the rise of short-term leases, TAMI, tech, everyone always assumes that we’re always talking about WeWorks and co-sharing and I think that’s a big part of this conversation. So I obviously don’t want to kind of skirt around the edges or avoid it. So let’s look at co-working and the co-working phenomenon.

We’ve actually had a couple of questions in prior to this. One of this was are we actually going to see larger, perhaps more established tenants utilizing co‑working spaces, mainly for options for kind of swing or kind of project space. Are you starting to see the bigger established tenants actually start using more of that kind of startup co-working space? Will, what are you kind of seeing in the market, as people embrace co-working?

Silverman: Yeah, I think there is validity to that comment. And the way I would think about it is that, if you think about the scale of sophistication of a tenant, let’s say you have a guy in his garage at zero and General Electric at 10, I think what WeWork has done has allowed someone to get to stage 3 or 4 before they need to start thinking about taking their own space, whereas, a few years ago, you would have had to start taking your own space when you were at stage 2 or three.

And so I think they’ve definitely expanded the potential audience of those tenants and I do see – and candidly, when I was opening my office in New York before our space was ready, I was in a WeWork office for two months and we did see some bigger name firms that were in there, precisely for that type of project-based work that you described. So I think there’s definitely something to that phenomenon.

Hughes: And, Sonny, do you think that those established larger tenants are actually starting to utilize, like you were saying, for swing, for project spaces? Do you see that the industry has actually embraced more of this co-working shared office space?

Kalsi: Industry in what sense, Zoe, do you mean embraced?

Hughes: Sorry, in terms of like more institutional, larger tenants, more established tenants. Are they starting to kind of use these spaces for their temporary needs?

Kalsi: I think before there was WeWork, there was Regis, right. And I think you’ve seen this over the years with Regis. You know, look, obviously I’m not sure I’d put GreenOak with the category of larger, more established firms, but we’ve used Regis office space as we’ve gone to new markets around the world and gotten going, more for flexibility than anything else.

But, you know, even when I was in my prior life at a big Fortune 100 financial institution, that firm used to use space like that when you go to new markets, before you knew whether you’re ready to make the big commitment that you needed to do, because it provided a lot of optionality and option value. Now, I’m not sure that I would see a traditional tenant, right, so a traditional type of company, not a TAMI company, taking a big chunk of space at a WeWork, partly because of style and approach.

I’m not sure that in a true co-working that they would do it, but I think there’s always going to be an opportunity for people that are looking for optionality and willing to pay that option premium for that optionality. But I think that’s existed for a long time.

Hughes: I think that that actually raises a few, or leads into a few very good questions that we’ve already had in, and please do send your questions. I’m going to turn it over to Q&A very, very shortly. One of those questions, actually from Liquid Space, do you envision building owners actually trying to lease out more directly the space within their own offices? Will, do you kind of see building owners actually going a little bit more direct and trying to kind of rent out their kind of co-working space?

Silverman: You know, many have tried that over the years and I think, to Sonny’s point, the [objective] factor in doing that will have deterred most. And especially since what you’ve got now is a few firms that have a pretty good lead on branding to really do it in a way that would make it worth doing, you’d have to get so much scale that you’re taking on more business risk than you’d otherwise want.

So I think many of them are actually going to be – I think you’ll of course see some of them doing it, but it’s nothing new to see landlords trying to get into that business. It’s just that I don’t think they think it’s the most expedient way to do it. And not only that. I mean, when I started 15 years ago, I remember there was a whole series of buildings in the market in New York that caters specifically to this style of tenancy.

You had buildings like the Empire State Building, the Chanin Building, the Lincoln Building that were all geared up for 1,000-foot tenants and 800-foot tenants and there were these rabbit swarms of tenancies when you got out on the multitenant floors. All of those buildings have been pursuing strategies of consolidation over the last 15 years. And so I think, part of what you’re seeing is that all the people who are running buildings like that decided it was easier to deal with larger tenants.

Hughes: So a related question, and I think this kind of picks up on tech, but the digitization really of the commercial leasing process, and that question from Chris at [Meddex]. Do you think that there’s an opportunity that exists for the digitization of the commercial leasing process beyond that space for search, but really for RFPs, LOI and lease documentation? Will, what are your thoughts on that?

Silverman: I sincerely do not know. I’m not sure – I mean it would imply – I think what that question implies is that the lease experience can be standardized to a degree that you could actually digitize it. I think there’s a lot of people really invested in keeping it not like that. And so I can’t foresee that happening because there are too many differences in the way buildings are run. You know, we’ve got five different ways we account for electric in New York City. So I don’t know that you could possibly standardize that.

I think obviously the search process can become a lot more digital, but I think that the actual leasing process, I think still needs the personal touch and attorneys, etc.

Kalsi: Yeah, I’m going to disagree with Will since we haven’t disagreed yet. So I’ll disagree with him. I think it will get shaken up. I really just feel like, you know, I’m a borderline baby boomer, Gen X so I’m definitely not a millennial, but I just look at how disruptive technology has been in a lot of old sectors, right. And I think there’s no question that, you know, something like Uber was disrupting an industry which doesn’t have the degree of personalization or specification that maybe office leasing does.

But, you know, you’ve seen a lot change, for example, on residential leasing in the last X number of years, both in terms of how to distribute it, but also on execution. And I think, look, I think there’s people, if the tradeoff, we just talked about how landlords would love to save some money by trying to figure out how to disintermediate WeWork. I guarantee you the landlords would love to figure out how to save some money, even if it meant some standardization, if they could figure out how to disintermediate the brokers.

So they’re never fully going to get there, but I just personally believe that our industry, as real estate, is one of the most archaic. And, you know, look, I think I’m just mad at myself I didn’t come up with idea for Airbnb or Uber or any of the rest, but there are a lot of smarter people than me out there, who are trying to figure out how to disrupt all these other industries. I don’t know if they’re going to. And maybe they might be working in WeWork shared spaces right now.

Silverman: I see it happening more in the sales market than in the leasing market because I feel like, to the extent you’ve got like your 1031 deal that’s a Walgreens outside of Tulsa, which I’m sure is a great deal, but to the extent that that’s what it is you’re doing, I think there’s a lot of room for standardization of those contracts. I think Auction.com or Ten-X or whatever it’s called now is probably going to be on the leading edge of that.

But I’ve always felt like that was the place where we’re going to feel the disintermediation first in terms of commodity sales product because I’ve seen too many situations where your lease, you know, you could be in what you think is the simplest building ever, taking 5,000 feet, but there’s something about the building that requires a little bit of nuance or negotiation, especially in New York City.

Hughes: Another question that we have in, which I think this could be a real challenge in terms of going back to the duration of leases and that’s in relation to the new lease accounting rules, which will obviously require tenants to bring most of the real estate leases onto the balance sheets. Do you actually think lease accounting rules may have a positive or negative impact on office lease terms? Sonny, put your kind of crystal ball…

Kalsi: Yeah. I don’t know. That’s a good question. I don’t know. I don’t know if it will ultimately or not. I think it could. I mean, I think it could, but I think that, you know, it doesn’t change any of the dynamics from the landlord’s side and I think it really just comes down to, you know, kind of the market. Will the market bear again? You know, there were some other questions which were asked about just, you know, what are they, allowances people are talking about etc.

And look, and Will and I are trying to come at this from more than just a New York City perspective, but look, in New York, if you’re talking about giving someone an $80 or $100 TI work letter, you know, you want some duration on that, right. And I think that something has to give. I think that, if all of a sudden, tenants in New York are coming to us and wanting five-year leases, we’re not going to give them that kind of work letter, right. We can’t afford to. It doesn’t make any economic sense to do it, regardless, at a certain point, even regardless of what the rents are.

So I think that, you know, no question that all these things are important and I think regulatory changes, accounting changes, for sure make a difference, but ultimately, it’s about dollars and cents.

Silverman: Right, and I think, Sonny, that ties back into the point you made earlier about the cost of capital for you to build it out, versus for them, which would be exacerbated in that circumstance.

Hughes: Well, I know we’re literally about to run out of time. So let me just quickly ask one very, very quick question because you did raise Airbnb, you raised Uber. And I think when we look at kind of tech and TAMI tenants and, like you said, you mentioned credit risk. One of the questions that we’ve got in is do you see office owners making – are we seeing a secular shift in the industry to actually taking on a little bit more credit risk with smaller tenants perhaps or less established tenants? And can the capital markets support that risk, going into the future, Sonny?

Respondent: Yeah, look, I wouldn’t single out TAMI, right, but just as a  sector, look, I think when you’re leasing to smaller tenants, you’re taking more risk. There’s no question about that, right. I think that, you know, I would be really happy if I leased every building I had to GE and IBM, you know, if they took the entire buildings and they paid the highest market rent possible, right. So look, that’s not practical.

So from a practical perspective, we do need to target smaller tenants. There’s no question that’s going to come with a higher degree of underlying credit risk and I think part of what we try to do is, you know, try to be as thoughtful as you can. I mean we’re doing stuff now that you wouldn’t have thought before. You know, we’re calling the guarantors on the leases.

Sometimes they end up being, you know, venture capital firms in Menlo Park and getting a sense for what people’s funding looks like and, you know, asking about how their series B is going and it’s stuff you hate to do, but I will say it’s still very different than for those of us that were around in ’99, 2000, 2001 where landlords were, you know, getting work and doing other things. And like I’d be lying if I said we didn’t fall into that trap some way back when. They go, “Gee, we’re going to lease this space and we’re going to make a million dollars on the warrant.”

Well, guess what, all that stuff was worth nothing, right. So I don’t think people – look, we’re not doing that. I don’t think people are doing that and I think, just like a lot of other market opportunities, I do think that, you know, not that this is meant to be a WeWork advertising call, but you know, I think there have been other people that have come to disintermediate that risk some, but I do think, if you lease to smaller tenants, you’re going to take more risk. There’s no way around it.

Hughes: And, Will, in regards to kind of that credit risk?

Respondent: Well, I think the only other perspective you can take on it is sort of a friend of mine likes to say, “I would never want to invest in a restaurant in New York City, but I would love to be the guy who sells them all napkins.” And I think the analogy there has some weight, which is, to the extent that you’ve got a building, and by the way, this would be an incredible pain to run, but if you’ve got a building filled with 50 different ones of these tenants, you might have mitigated the risk in exposure you have to any individual one.

And you can turn your bed from one on your individual tenants, which is the case if you have a building of, say, five to 10 tenants, into a bed on the sector in general and you’re a little bit more neutral on the success or failure of any given tenant, which again, effectively as we discussed at the very beginning, to bring it back to WeWork, puts you into an analogous business to theirs, but with hopefully a little bit more upside. So I think people are getting used to that idea, but to Sonny’s point, I think it’s not to be undertaken lightly or without people realizing the nature of the risk they’re taking because I think, with these tenants, you are taking a substantially bigger credit risk.

Hughes: Well, that’s wonderful. So we’ve run out of time and apologies for those questions that we didn’t get to answer. There were a lot that came in, but thank you very much for everyone who joined the conversation. Sonny, Will, thank you so much for your time. Very much appreciated. And here’s wishing everyone a wonderful rest of the day. Thank you very much. Thanks, bye.

Silverman: Okay, thank you. Bye-bye.

Hughes: Bye-bye.

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