April 3, 2016
Interviewed by: Zoe Hughes
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WeWork and the Rise of the Short-Term Lease

The traditional 10year commercial real estate lease could be a thing of the past, as the industry undergoes a ‘WeWork’ phenomenon with newer, startup firms demanding shorter lease terms of just two to three years. During a panel discussion, experts from Taconic Investment Partners, TIAA, and RSM warn there is a growing wave of firms asking for shorter lease terms, impacting how landlords and investors prebuild or retrofit office space, how much they spend on it, and how much of a premium owners can charge in rents.

The traditional 10year commercial real estate lease could be a thing of the past, as the industry undergoes a ‘WeWork’ phenomenon with newer, startup firms demanding shorter lease terms of just two to three years. During a panel discussion, experts from Taconic Investment Partners, TIAA, and RSM warn there is a growing wave of firms asking for shorter lease terms, impacting how landlords and investors prebuild or retrofit office space, how much they spend on it, and how much of a premium owners can charge in rents.

WeWork and the Rise of the Short-Term Lease
Real Estate Transformation And Value-Add Investing

Zoe Hughes, Privcap: I’m joined by Jason Sevier of RSM, Chris Balestra of Taconic Investment Partners and Kevin Smith of TIAA. Thank you all so much for joining me here today.

Unison: Thank you.

Hughes: Now when we talk about deals, it’s often in the abstract. We don’t really talk about the realities of transforming an asset. What sometimes works, what sometimes goes wrong. So let’s pick up on some deals and some experiences of what you’ve all done in the market. Kevin, I know one deal that you’d like to talk about is 475 Fifth Avenue.

Kevin Smith, TIAA: So we bought the building in late 2011. The building was pretty much mostly vacant – 97% vacant. We had one or two tenants still remaining. The building was in a state of demolition when we bought it. So we came in with a plan to redevelop the building, which is basically soup to nuts – taking out all the existing building system, putting in all new building systems, changing out the retail, repositioning the lobby, moving it to the side street.

We moved it to the side street to take advantage of the retail corridor. So it was a project that took about two years to fully complete in terms of the renovation.

And so I would say that we had both great things have happened on it, as well as some lessons learned. And some of the issues that we encountered as well were some of the old occupancies of those floorsand what we had to update them to, to meet today’s dense packing environment. But the great success stories that we’ve had is, is repositioning the retail which retail rents in that corridor – and it was never really known as a great corridor on Fifth Avenue for retail. The rents we’ve achieved have outperformed our pro forma by 30% of 40%. Our office rents have outperformed our pro forma by about 20%.

Hughes: I know one of the issues we’ve chatted about is positioning the space and thinking of the tenants that you’re going to attract into it. Is that actually a key challenge today? You think that you’re going to get one tenant because you’re in this location, but actually the realities are very different.

Smith: It’s definitely a challenge that we faced at 475 Fifth.
The Bryant Park submarket had been known primarily as a financial services market – boutique financial services, hedge funds, things of that nature. And the interesting thing was, is that we in some ways positioned some of our early space to be geared towards financial services type tenants. But the reality has been we’ve gotten more TAMI-type tenants in the building than we have financial services. We do have a mix, but it’s been more on the TAMI side which has been a little interesting. Thankfully it didn’t cost us a lot of dollars, but at the end of the day, could have went much different had we prebuilt a lot of space.

Chris Balestra, Taconic Investment Partners: Did you pre-build any space?

Smith: We only did one or two pre-builds during that time, and thankfully, we were able to get a financial services tenant to take those pre-builds and not have to spend any retrofitting money.

Hughes: Is there quite a big difference between the different types of tenants and what they actually want?

Balestra: Definitely, and even if you do a pre-build and you get it close, the tenant comes in and wants it something different. So we’ve prebuilt space over the years. We try not to because more often than not you end up ripping out this conference room, putting an office in or putting in cubicle where you had offices. So pre-building’s tough. You can do it for smaller tenants sometimes, but more often than no – even if you didn’t get the right type of tenant right – you didn’t get the layout exactly the way somebody wanted to come in and just use it.

Hughes: Are our leasing assumptions – do we have to sometimes throw out assumptions out of the window in terms of who we’re going to appeal to and how we’re going to design space?

Jason Sevier, RSM US LLP: I think we have to, if we want to be successful. I think, again if you rewound the clock 10, 15 years, you could say okay. This type of building, this location within the city, this is who you’re going to attract. So you could almost have a cookie cutter type building, and you knew that you had a good chance of getting a tenant that fit that profile. Today I think cities are trying to attract more and more businesses to come into their respective cities. And I think you have to look at your options differently now. And I agree with what Chris and Kevin said, the pre-build to me is almost out the window. I think it’s more about the space. Identifying who you think, and once you have them, look at your space, then you work and you retrofit it to how they want it. So I think you’ve got to rethink your leasing options.

Smith: So I think probably five years ago – the early start of the cycle – most pre-builds that we would see would be like 3,000 to 5,000 square feet. What we’ve seen, which has been interesting in this cycle, is because of the venture capital that’s out there funding these IT startups and I’ll call them technology – creative-type startups. What we’re seeing is, is that people don’t know what they’re future is, and people need to move fast in order to get up and running with the venture capital that they have. And they’re hiring so quickly. And so what we’ve seen, and there’s been a couple of key examples that I can point out, where buildings have done 15,000 and 20,000 square foot pre-builds and they’re leasing them up quickly. But they’re leasing them up to startups basically – startups that are maybe in their second round of funding.

Sevier: So it’s probably similar to if you’re in a city where you have a biotech park or you’ve got startups. You know that that’s the kind of space they need. They may not be there that long, but they need a place to operate and conduct business. They just need it temporarily maybe, and there’s a situation where you can pre-build.

Smith: Well the interesting thing too, this is the other focus and the impact that this has had is, is a lot of the types of firms that we’re talking about here are coming to us for shorter-term leases. I would call this the “WeWork affect,” where they’ve coming to us for three-year leases or two-year lease, which is interesting for an institutional landlord like us where you’re putting out a lot of capital. So it’s definitely causing an impact on how we look at what we spend on pre-build space.

Balestra: Are you able to get a premium for that space then on a three-year lease?

Smith: Typically. We have one building on Third Avenue which is not really catering to the same types of tenants, more financial services. And we’ll do 3,000 square foot or 5,000 square foot spaces, and tenants are coming to us saying we can’t sign a five-year lease cause it may be they’re a hedge fund. They don’t where they’re going to be in three years. So we’ll do shorter term leases, but we’re getting probably a 10% to 15% premium on the rents.

Sevier: I’m just going to add to that point. I think we’re starting to see some shorter leases and I think we’re seeing some owners who – back in 2009, 2010 when the market was really soft – were locking clients into ten-year, longer-term leases. And now they’re probably kicking themselves because they’d love to be able to rework those leases cause of the rents have gone so far up and the tenants who are in there still have three, four years left on the lease.

But I think depending on where you think things are going, I think you may in fact, start to see leases that are in shorter duration. I think the typical ten-year lease may not be the lease of the day anymore. I think you’re going to see different versions of the lease agreement.

Hughes: Now Chris, Taconic has been involved in some epic repositioning and ground-up developments. And one project that you’re involved in is New York City’s [Essex] Crossings on the lower East side. Now give me an overview of the project.

Balestra: Essex Crossing is 1.9 million square feet, 1,000 units of residential. Half of those are affordable, at different various levels of the affordable spectrum. Half are market rate. Some are condos, it’s mostly rentals. We’ve got 700,000, 800,000 square feet of commercial space. In that is 300,000 to 400,000 square feet of office space. So it’s truly a mixed-use development. It’s huge. It’s – the lower East side is a great neighborhood. These are vacant parcels that have been underutilized for years. I think it was the largest swath of underutilized city-owned land south of 96th Street maybe. So four sites are in the ground as we speak, planning two more hopefully for soon.

Hughes: Now you’ve obviously, as an operating partner, you’ve got plenty of lessons learned. What are the key lessons that you’re bringing into this project at Essex Crossings that you’ve learned over the years?

Balestra: Well I think that things don’t always go as planned. And I think that if you’re a good operating partner – and I’d like to think that we have been over the years. And why we’re successful is that honesty is the best policy. And if something isn’t quite going right, it’s better to deal with that sooner than later. So especially in ground-up development, it’s been smooth so far. Who knows? We’re going to hit some hiccup there, and you’re going to want to let your partner that hey, we’ve got to make these adjustments. And if you do that, and you do that upfront, things are usually okay. They don’t really like that when you just go make decisions without telling them, and they find out later.

Smith: So Chris, when does that deliver with the different phases of the residential and the commercial?

Balestra: So we started Phase 1 last year, in 2015. That’ll deliver anywhere from 24 to 36 months after the start so sometime in 2017, 2018 depending on building. Phase 2 we’re planning.

Hughes: Cause this is one, the key point that I did want to raise, the entire project won’t necessarily be delivered until 2021. And I think that this also shows with some of the other deals that Taconic have done – obviously let me pick up on the Google headquarters again. You bought that in 1998, but you didn’t sell it until 2010. Do you have to be longer-term owners of real estate today?

Balestra: I don’t think that you have to be, but I think that it’s beneficial to be able to take that mindset. And a lot of it has to do with your capital partner. A capital partner who absolutely has to get out in three or four years is not going to be a great partner if there’s a bump in the road, if there’s a downturn in the economy – to wait it out and to really see that value through. So we’re actually partners with TIAA on our building in the Meatpacking district with the Apple store.

We started that project in 2005. We stabilized it in 2009 let’s say. We had a great partner previously. They wanted out eventually. We said this is great real estate. It’s New York. It’s irreplaceable; we just want to stay in. It’s got good cash flow, let’s stay in for the long haul. We brought in TIAA who has a long-term holding vision on many of their assets, and maybe we’ll never sell it. Who knows?

Hughes: Now Jason, you’ve advised on many deals. I think one of the things that I’d love to ask is, we talk about repositioning, the millennials, all this trend. It’s all about mixed-use now. There are challenges though in terms of this trend that we’re seeing. And one thing I’d throw out there is perhaps infrastructure. We’re not all New York cities across the US. There are plenty of 18-hour cities, secondary, tertiary cities, markets. What are the key challenges that you see when we’re talking about these changing preferences and changing use of real estate?

Sevier: I think it’s a fantastic question. And so the area in which I live and work in Baltimore, there’s a big push for attracting business. Under Armour is now building its new corporate headquarters, taking on massive parcels of land, mixed-use.

Hughes: And this is a big campus that they’re trying to…

Sevier: This is a big campus. It’s going to be a massive campus, three million square feet. It’s going to have a park connected. It’s going to have mixed-use, commercial, residential, restaurant row. But that’s just one component, which is technically not in the business district. It’s outside the business district.

So the infrastructure issues are huge in a city like Baltimore. And to me, until those get fixed or at least there’s an adequate plan in place, I still think that causes a little bit of a obstacle to fully getting to where you want to be. And so those always questions whenever there’s a development, and you’re talking with developers. They kind of go hand in hand – well let’s talk about who we’re going to attract, but let’s talk about the infrastructure issues. So I don’t think you can talk about one without the other cause they’re so intertwined.

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