Some landlords turn to incentives to fill offices

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With office vacancies remaining stubbornly high in some submarkets, landlords in the Twin Cities and across the U.S. have been expanding their menu of features designed to make offices fun places to be. They have been investing in a range of nontraditional amenities, such as pickleball courts, golf simulators, and beer taps.

But landlords’ strategies also include more standard bargaining chips, such as free rent, tenant improvement allowances and more.

Pete Kostroski, co-founder and partner with the Rokos Advisors tenant rep firm, says he has been seeing significant increases in incentives such as tenant improvement allowances, free rent and flexibility on phased occupancy. Incentive packages “have grown drastically (compared to) the pre-COVID environment” when occupancy was generally high.

“The buildings that have been most successful are the ones that have not only been creating better incentive packages, but also making significant investment in common areas beyond their specific office spaces. Especially in downtown Minneapolis we’re seeing better conference areas, lounges, even mini golf and pickleball courts — amenities we never saw before.”

Kostroski has also been seeing more flexibility on lease terms, depending on what the tenant needs. “Pre-COVID, five to 10 years-plus was very standard. Now, more than five years is considered long term.” Downtown office tenants who are willing to sign long-term leases are seeing better incentives and also lower rents, he said.

The signing of one sizable tenant “can be a building saver for someone who was about to go back to the bank [to ask for refinancing] or someone who recently bought a building,” Kostroski noted. We’re seeing some record-setting packages.

“If you recently acquired a building, you may have a lower cost basis because the building is worth so much less” than it was with high occupancy.

Construction cost inflation is one reason landlords are offering more in other types of incentives. A tenant improvement allowance doesn’t go as far as it did in the past, meaning some companies may be more likely to accept space “as is.” “I know these companies don’t want to come out of their own pocket on real estate decisions.”

In the current office market, one mini trend has been landlords building out smaller office spaces on a spec basis. So there are more options for smaller users, 2,000 to 10,000 square feet, according to Eddie Rymer, a senior vice president with JLL.

The “flight to quality” that has been going on for some time is continuing, Rymer said. “Nationally, newer office buildings have done much better. Landlords can justify higher rents in those buildings because they are ‘right-sized.’” Rymer said.

“If you’re going to have commutable space, you’re going to want to have the least amount of friction as possible. Free parking, if possible. …. The space has to be easier to get to and with more amenities.” By adding fun features to the equation, “building owners are doing what the restaurants and hotels have been doing for a while,” Rymer said.

For office space users, “right now the most important thing is thinking through your workplace strategy, understanding how your employees are using the office,” Rymer said.

According to Jon Septer, leader of the real estate group at Maslon LLP, because a lot of office buildings in downtown Minneapolis were financed based on the economics that were in place at the time the building was purchased, the covenants in their loan agreements prevent them from offering incentives beyond a certain threshold. As a result, building values need to be “reset,” based on current economic conditions. “We’re not going to see dramatic decreases” in rent until buildings are able to “reset.” “That leaves landlords looking for other incentives to attract tenants.”

Of course, the deals landlords will offer vary by submarket. A suburban office landlord can leverage convenience and low cost of parking, which is often free in the suburbs. Any perception that downtown may be less “safe” due to crime can provide suburban office landlords with another selling point, if they choose to use that perception, Septer added.

In representing tenant clients in negotiations with landlords, Septer said he has found that “if landlords are willing to be flexible and provide options like expansion or contraction options, that can give a [prospective] tenant assurance that no matter, which direction the market goes in the course of a 10-year lease term, they will be ‘covered.’” That can be the deciding factor when a tenant is trying to decide whether to downsize, move to the suburbs or stay downtown, Septer said.

“It’s clear that as the market continues to move in the direction of more people wanting to work at home, having the options to contract a portion of the space and give it back to the landlord could be enticing for tenants.”

Septer, who led the Maslon firm’s negotiations with its Capella Tower landlords, said the law firm’s lease deal is indicative of current market conditions. “We wanted to have an office in an area that was fairly energetic. That means a fairly well-occupied building; Capella Tower was 90% occupied. Also, “there were several restaurant options nearby and a strong flow of people coming and going through the skyway every day of the week. It feels like the pre-pandemic energy level.”

Another factor that attracted the firm was amenities. Capella had recently built out a new common space in the building, with a number of space options for small and large meetings, seminars and other uses. And there are some non-work-related amenities: workout rooms and a golf simulator, Septer pointed out. “Those are the kinds of things that can really push a tenant ‘over the edge’ and seal a decision.”