Jason Hughes, principal with the Irving Hughes company, says corporate tenants should always ask brokers they are interviewing whether they also represent landlords. (photo/lambertphoto.com)

With rents rising and vacancies declining in San Diego’s commercial real estate market, it must be a “landlord’s market.” Right?

“Hell no!” says Jason Hughes. “That’s a misnomer created by landlords and their broker agents to create a false sense of tenant paranoia. It’s an attempt to increase rents and decrease leasing concessions. San Diego still has millions of square feet vacant.”

Can Hughes, a partner in the Irving Hughes company — a firm that represents only corporate tenants — be any more blunt? Of course — when it comes to real estate brokers who represent both tenants and landlords in lease negotiations. “I have seen countless transactions where a naïve tenant was represented by a dual agent broker — and they ended up with terrible, and in some cases almost criminal, deals,” says Hughes.

Hughes blames investors for driving up leasing rates. “Rents are rising because the prices being paid by real estate investors have gone out of control,” he says. “If you pay $300 per square foot for real estate and you want a 7 percent return, you need $1.75 per square foot per month in rent in addition to all the expenses associated with operating the building like utilities, insurance, property taxes, maintenance and management fees in pure cash flow to make that return.”

Compare that to five years ago, says Hughes, when Downtown office investment prices were around $1.50 per square foot. It meant landlords needed to charge $1.62 per square foot per month in rent to achieve a 7 percent return.

Steve Holland of CB Richard Ellis says his company expects rents for Class A office and corporate headquarters/R&D properties to increase about 8 percent to 10 percent this year. “So for tenants with leases expiring in 2005, they will see their renewal rate increase by that amount. As far as annual rent increases for new and renewing tenants signing a lease, increases of 3 percent per year can be expected.”

Justifying a rent increase in today’s market is difficult, says Scot Ginsburg of The Staubach Co. “It all depends on the motivation of the landlord and how much leverage the tenant has with alternatives. Some landlords may have been lucky and just leased up almost their entire building and raised rates dramatically. Other assets, maybe inferior, may still be sitting and the landlord is still giving away the farm.”

Like Hughes, other real estate executives dispute the notion of a whole market friendlier to landlords than to tenants. But they believe corporate tenants seeking to renew their leases or to obtain leases on new offices should move swiftly and choose their brokers carefully. They contend that in most areas of the county, large blocks of commercial space are available and that landlord concessions are still available.

David Ferguson of Goldman Ferguson Partners calls San Diego a ‘renter’s market’ where tenants still have several alternatives. ‘In tighter markets, the tenant’s advocate will just have to work a little harder, be a little more creative,’ he says. (photo/lambertphoto.com)

“I don’t think there is really any such thing as a true landlord’s market unless vacancy rates are less than 2 percent or one landlord owns all the buildings in a given market area, which in San Diego isn’t the case,” says David P. Ferguson of Goldman Ferguson Partners. “Some market areas may be a little ‘tighter,’ meaning less space available and fewer options, or be more ‘in demand,’ but as long as a tenant has one viable option — an alternative space to lease — then the tenant should always be in control.”

Ferguson calls San Diego a “renter’s market.” “There is enough variation of building types, quality, location and availability that a typical tenant will have several alternatives all the time,” he says. “In ‘tighter’ markets, the tenant’s advocate will just have to work a little harder, be a little more creative.”

Andrew Ewald, a broker in the corporate services division of Grubb & Ellis/BRE Commercial, says vacancies have declined over the past quarter but opportunities still exist for companies seeking to relocate, renew or expand. “Mission Valley has new Class A buildings and large blocks of space that are still available,” says Ewald. “Landlords are very competitive for quality credit tenants. I would say the market is in a transition period, from a strong tenant market to one of balance.”

Ginsburg sees rents slowly increasing by 5 to 10 cents per square foot every four to six months. Even so, he says, tenants have plenty of options in most markets. “UTC, Carlsbad are examples where space is still plentiful, although not as much as 2001,” says Ginsburg. “Many leases are expiring in 2005, forcing tenants to renew or relocate. I would expect by the fourth quarter the market may then start to become friendlier for landlords than tenants.”

Andrew Ewald of Grubb & Ellis/BRE Commercial says corporate tenants should look at a broker as if he or she was an in-house agent. (photo/lambertphoto.com)

Certain submarkets still favor tenants, says Holland. “The Sorrento Mesa office market is comparatively soft with an availability rate of 21 percent, which is significantly higher than most other office submarkets.

We are transitioning from a tenant market to a landlord market and have been in a state of transition since the beginning of 2004. The availability rate for office space in San Diego County stands at about 15 percent. Once availability rates dip below 10 percent, the supply/demand scale tips in favor of landlords.”

Brokers believe corporate tenants will still be able to squeeze concessions out of landlords. “The days of three years of rent abatement are gone, but a tenant can get rent abatement,” says Ferguson. “Concession/incentive packages in a typical transaction should equal 30 percent to 35 percent of the transaction. These incentives may be in rent abatement, reduced or stepped rent to offset an existing lease, cap on operating expenses or increases, tenant improvements, free parking, moving costs, payment of space planning fees, construction management, early lease terminations, existing lease buyouts, and fixed-price options. What do you want, what do you need as a tenant? If a tenant’s need is logical and important and presented well, a landlord will typically provide it.”

Ferguson says defining what a tenant needs is important. “For instance, a recent client had spent $500,000 on an unanticipated corporate restructure and needed to offset that cost in some way. We negotiated upfront rent abatement that covered that cost and more.”

As the market tightens, tenants will see less in concession packages, says Holland. “In certain soft markets, good-credit tenants can negotiate three to five months of free rent on five- to seven-year leases,” he says. “But this is the exception rather than the rule. In most markets, we are seeing little to no free rent being offered.”

For a five-year lease outside of Del Mar Heights and in the more “soft” markets, four to six months of free rent, 3 percent annual rent increases, tenant improvement allowances in the range of $12 to $20 per square foot and reduced or free parking charges are among the incentives still on the table, according to Ginsburg. “Given the fact that many landlords have been burned with the dot-com bomb, landlords are looking to heavier measures in terms of increased security deposits, letters of credit, pre-paid rent with tenants who are not financially sound,” says Ginsburg. Hughes says resourceful brokers can always find significant incentives for their clients such as additional tenant improvements, renewal rights, signing bonuses, moving allowances, sign rights and free rent.

So how does a corporate tenant choose a resourceful broker? What questions should the tenant ask before hiring a negotiator? “Absolutely first and foremost is, ‘Do you or your firm also represent landlords?’” says Hughes. “This is critical, as many landlord agents try to supplement their earnings by preying on tenants. This is a gigantic conflict of interest. The greatest mistake tenants make is letting dual agent brokers represent them against a landlord. If you were getting sued, would you ask the lawyer suing you to represent you in your defense?”

Scot Ginsburg of The Staubach Co. expects the commercial real estate market in San Diego may start to become friendlier to landlords than tenants by the fourth quarter. (photo/lambertphoto.com)

Hughes says brokers also should be asked how many tenants they represent. “Brokers with many clients have much greater negotiating leverage than those with no other clients.”

Ferguson advises tenants to seek out advocates, not salespeople. “Real estate agents are marketing agents,” he says. “They typically work for a large firm and sell or lease properties for developers and landlords. Nice folks, good salespeople, but who do they really work for? They work for the landlord. In today’s expensive real estate market, you need an advocate, not a salesman. A good tenant advocate is not just a one-time wonder negotiating the original transaction and not seen again for four or six years.”

Holland of CB Richard Ellis suggests that tenants ask brokers whether they track tenant demand. “As a market tightens, a good broker needs to know which companies will be vacating space before the news hits the street,” he says. “Having this information will allow a good broker to develop more leasing options, resulting in greater negotiating leverage for the tenant.”

The tenant should look at a broker as if he or she was an in-house agent, says Ewald of Grubb & Ellis/BRE Commercial. “This will allow companies to better utilize our services,” he says. “Real estate operating costs are the second largest company expense aside from salaries, therefore it makes sense to have quality representation to minimize the costs of real estate.” Ferguson agrees. “Keeping clients in a manageable lease is why the tenants’ advocate needs to be a part of the company senior management team,” he says. “We like to say we are a company’s outside real estate department.”

Most commercial leases run from five to 10 years. Brokers suggest that tenants should engage a broker at least a year before the lease expires. “Larger tenants need more time — smaller tenants less,” says Hughes. “But by having a fiduciary broker on board early, he or she will be able to look for opportunities as well as protect their clients from potential problems.”

Businesses leasing 20,000 square feet or more should start negotiating strategy about 18 months out, says Ginsburg of The Staubach Co. “When a landlord knows the tenant is out of time and cannot move because of the time it takes to build tenant improvements, the tenant has lost all of his leverage and will not produce the best economic results,” he says.

“If you are a tenant who is thinking about renewing your lease six months before your lease expires, you’ll find yourself behind the eight ball,” adds Holland. “The last thing a tenant wants to do is give the landlord the impression that he has a captive audience. The landlord has to firmly believe that the tenant has one foot out the door.”