After 15 years in the same building, Oricon’s landlord surprised the company by converting the space to biotech. But when the defense and intelligence software company started shopping for a new 40,000- to 50,000-square-foot headquarters, Oricon’s management received yet another shock.

“The timing couldn’t be better for us,” admits Tom O’Hara, vice president of finance, administration and human resources. “There’s an abundance of space out there, especially in Sorrento Mesa where we are, so we have a lot to choose from. And the rate structure has gone down dramatically since a few years ago. It’s going to be a hassle to move, but the timing is good.”

Commercial real estate is based on supply and demand, and right now there’s a surplus of supply. That surplus is due to a large number of downsizings, dot-com failures and companies putting expansion plans on hold, as well as the 2.3 million square feet of new space expected to be completed in 2002.

Since the terms for commercial leases generally run three to five years, each year between 20 percent and 33 percent of all commercial tenants will renegotiate with their landlords. For those tenants, this year could be dramatically different.

“The dynamics between landlord and tenant have gone backwards five years,” reports David Marino, executive vice president of Irving Hughes, a commercial brokerage company that represents tenants exclusively. “The reality is that most large landlords have had space on the market for a year now. It’s going to take a couple of years to absorb that space. These millions of square feet are going to drag the market down.”

But before those tenants begin celebrating, there are a few factors that must be considered before signing any commercial real estate lease.

Know The Submarkets

“San Diego County has so many submarkets and product types,” points out Randy Levinson, corporate officer and vice president at McMillin Commercial. “The vacancy rate is so market specific.”

The problem centers around the high-tech bust. In areas where high-tech and dot-com companies were densest, vacancy rates have soared. Burnham Real Estate Services reports several areas of San Diego are experiencing double-digit office vacancy rates. Hardest hit are Sorrento Mesa at a 26.7 percent vacancy rate, Carlsbad at 33.3 percent, Scripps Ranch at 18.9 percent, Rancho Bernardo at 15.3 percent and UTC at 14.4 percent. Overall, San Diego County’s vacancy rate is 12.4 percent, almost double the 6.5 percent of a year ago.

“The area from the 52 freeway north has been in a death spiral for the last year and a half,” notes Marino. “The tenants in that area are seeing rents down 15 percent. If the downward trend continues, they may drop another 5 percent or 10 percent and they may even go further next year.”

Tenants would be wise to study their market before beginning lease negotiations, as not every submarket has experienced a rate drop. In other areas, rents have remained flat or risen 6 percent to 8 percent. “They should get familiar with what the conditions are in the submarket they’re in,” advises Joe Bonin, chairman of ECP Commercial. “I’ve never seen anything like this before with the specific market area. In 1992, it was an overall crash. This is a market anomaly.”

Negotiate Carefully

Once the particular geographic market is taken into consideration, it also is important to consider a timeline. Most experts advise starting negotiations at least six months before the end of the lease. This leaves room for moving if an impasse occurs. That’s what happened to UTC-based Hollis-Eden Pharmaceuticals, which studied the market, then asked for a slight rate reduction and outside signage.

“We made what we felt was a reasonable offer,” says Bob Weber, chief accounting officer. “But the landlord did nothing to keep us, even though we’d been there five years. So we found a brand new facility for an extra 10 cents a square foot. It’s a totally different market than it was two years ago.”

When beginning negotiations, it is essential to remember that rent is only one piece of the pie. While some landlords aren’t as willing to reduce lease amounts, they often are agreeable to certain tenant improvements, known as TIs. These could include simple renovations such as new paint, new carpeting and signage. Or it could involve giving back excess space, bestowing expansion or renewal rights, naming a new base year for operating expenses, and perhaps discussing any property management issues, such as parking or security deposits.

“There’s always room for negotiation,” points out Allan Arendsee, president of Arendsee Real Estate, which specializes in brokering Downtown real estate. “A tenant has to pick out what’s important to them.”

Many landlords are focusing on tenant retention. With so much space available, commercial real estate has become fiercely competitive and landlords know the value of a good tenant. Replacing a tenant can involve a variety of expenses, from marketing and TIs to a long vacancy.

That’s why Arden Realty Inc., which owns 18 million square feet of commercial property in Southern California, believes service creates tenant loyalty. For example, the company recently retrofitted its buildings with energy-efficient lighting to minimize tenant utility costs. “We’re trying to show them that we’re committed to their tenancy,” says Andrew Sobel, executive vice president of Arden. “We don’t try to take the view of it being a tenant or a landlord’s marketplace every year. That’s a myopic view that changes with the ebb and flow of the economy. It’s always a tenant’s marketplace to us.”

That viewpoint is shared by others in this commercial real estate market, where tenants are no longer lined up waiting for available space. “A lot of landlords learned a lesson in the ’90s,” explains Stephen Dok, vice president of Carlsbad-based IPC Commercial Real Estate. “As landlords, they are investors in their tenant’s businesses, like it or not. So they have a vested interest in their tenants doing well. And that’s the name of the game in tenant retention, because it’s more cost effective to work with existing tenants than to improve the wheel. In today’s market, tenant retention is imperative.”

Explore The Options

When negotiations prove unprofitable, several options are appealing in the current climate. Relocation, while potentially expensive, can be offset by competitive rates and TIs. A recent study by the Fisher Center for Real Estate and Urban Economics at the University of California, Berkeley, calculates the average cost of moving from one 5,000- square-foot space to a similar 5,000-square-foot space in the same general area as costing $16.70 per square foot. That expense can be recouped if the rates in the new location are significantly lower.

“A company has to do a complete financial analysis,” recommends Alan Scott, president of Coldwell Banker Commercial. “The rental rates might be cheaper, but add in moving costs and it could be more. So it’s the balancing of various costs.”

Another factor in moving, beyond the relocation costs and the company downtime, is the employees’ desire to commute, since replacing employees potentially adds an expense to the financial equation. This is particularly important when chasing lower rents from one submarket to another. For example, when broadband Internet company Ecast Inc. outgrew its El Cajon office, its staff found better rental deals in other parts of the county, but decided to stay in the same area. “We have employees who are accustomed to coming here,” says John Noble, director of research and development. “Moving just a block away made our lives easier.”

Subleasing can be another cost-saving option, with rents often 10 percent below market. And with many companies downsizing or subleasing space they held for future expansions, sublease space is plentiful. In addition to the reduced rent, subleasing can offer several advantages. First, it can come furnished, which can save a significant amount of capital. Furnished space also can result in faster occupancy, another cost savings.

However, subleasing also has its downsides. The space might not be the most productive fit and the lease could be short-term. “The biggest risk is the credit of the lessee,” explains Marino. “If that company defaults on the lease, the landlord won’t necessarily honor the sublease.”

Act Now

While no one can accurately predict when San Diego’s economic slowdown will end, experts in the commercial real estate industry don’t expect it to last long. Right now, rates in certain areas are favorable and landlords are more willing to negotiate, but this window of tenant opportunity might not last long.

“I think we’ll be in a recovery period for the next 12 to 24 months,” predicts Scott. “Right now, it’s a tenant’s market. But it runs in cycles and two to three years is not a long cycle. I think after that, landlords will start nudging the rates up again.”

As pockets of the San Diego market struggle, some areas and industries continue to flourish. That’s the strength of the local economy and that strength should continue to drive the real estate market.

“It will most likely be a competitive marketplace for the remainder of 2002 and 2003,” predicts Sobel of Arden Realty. “We probably won’t see a positive absorption in landlord’s portfolio until 2003. But overall, San Diego real estate is still very strong.”