Competition From Within

Much to their dismay, office building landlords are facing off against a fast-growing and unexpected group of rivals: their very own tenants.

Companies big and small have put millions of square feet of suddenly surplus offices up for sublease as businesses move fast to reduce costs in response to a weakened economy.

The unprecedented wave of low-priced sublease space during the last year has created bargains for tenants but has forced landlords to reduce rents, dimmed the outlook for newly completed development and raised concerns about loan defaults and the industry’s financial health.

In only a year’s time, the amount of sublease space nationwide tripled to about 108 million square feet by the third quarter of 2001, according to real estate firm Grubb & Ellis.

Fourth-quarter results have not been tallied but are projected to show a continued surge in sublease space.

It probably will be a year at the very least before there will be any noticeable improvement, said Sam Zell, chairman of Chicago-based Equity Office Properties Trust, the nation’s largest owner of office space.

“This is the largest collection of sublease space that has ever been available in the U.S. market,” said Zell last week at a Real Estate Conference Group forecast in Century City. “The U.S. real estate market has too much inventory today.”

Much of the sublease space is concentrated in areas--such as San Francisco, Boston and the Westside of Los Angeles--where the once-booming high-technology and dot-com industries have gone into a tailspin.

But the high-tech firms have been joined by “old-economy,” blue-chip corporations that have moved more quickly than in previous recessions to cut their real estate costs.

“They have been quick to downsize and lay off employees,” said Grubb & Ellis’ chief researcher, Robert Bach. “When they do that, they are faster to throw back space on the market and sublease it.”

The rise in sublease space in Southern California has not been as dramatic as in other parts of the country.

Still, during 2001, the amount of sublease space jumped about 30% in Los Angeles and 60% in Orange County, according to Insigna/ESG. Some tenants anxious to unload unwanted offices have undercut their landlord’s asking lease rates by nearly 50% in some cases.

Arden Realty, Southern California’s largest owner of office space, said the growing pool of sublease space has had a minimal effect on its business. However, in areas where there are large blocks of sublease space available, the firm has trimmed its rents on comparable space by about 5%, said Robert C. Peddicord, senior vice president of leasing.

“We are not panicking,” Peddicord said. “We are not dropping rates dramatically but we are more aggressive.”

Landlords continue to collect rent on sublease space and usually pay it no mind since it normally accounts for a small share--often 10% or less--of all space available for rent. However, landlords come under greater pressure to reduce rents or offer other incentives to fill their own vacant space as the pool of bargain-priced sublease space grows in size. In Santa Monica, for example, tenants subleasing offices accounted for more than 40% of all available space in the third quarter of last year.

In one of Santa Monica’s newest and largest office buildings, Water Garden II, Internet consulting firm Sapient Corp. put nearly two-thirds of its space up for sublease at rates nearly half of the $3.50-a-square-foot it reportedly agreed to pay the owner.

“It is competition for the landlords,” said broker David Toomey of Cresa Partners.

Most tenants prefer to lease space directly from landlords and are unwilling to deal with the risks and drawbacks of subleasing. For example, a firm that subleases space could end up on the street if the company it is subleasing from fails to pay the rent or goes out of business. Also, some subleases are available for a relatively short period of time--sometimes only a few months--and are still subject to the approval of the landlord.

Despite such drawbacks, more companies seem willing to deal with the risks given the large amount of cheap sublease space and multitude of options. For example, Century City law firm Alschuler Grossman Stein & Kahan subleased 85,000 square feet in a Santa Monica building from Turner Broadcasting last year, according to broker Seth Dudley at Julien Studley Co. Turner, meanwhile, is said to be looking at sublease space in Burbank.

“Tenants are really focusing on [sublease space] and are actually leasing it in volumes we usually don’t see,” Dudley said.

In addition to low lease rates, bargain-minded firms and cash-strapped entrepreneurs often move into space that has been remodeled, furnished and wired for high-speed communications by the previous tenant.

“That sublease space is an opportunity for some people ... to get quality space that they never could get before,” said Paul Loulis, chief executive of Sublease.com, which lists subleasable office space nationwide.

About a year ago, Matt Coffin, chief executive of LowerMyBills.com, moved his 40-employee Internet firm from North Hollywood to an entire floor in a Westwood high-rise being sublet by a downsizing dot-com. The sublease was only for one year but it featured a monthly lease rate of less than $1 a square foot and allowed the subtenant to keep the furniture. When the lease expired in December, LowerMyBills.com moved to sublease space in Santa Monica on a month-to-month basis.

“Very often [firms with sublease space to rent] are desperate to get anyone in there,” Coffin said. “That’s very much the case now.”

But the availability of so much cut-rate space has spread concerns among investors and lenders about potential loan defaults and other financial problems. The reduction in rental income could result in some property owners having difficulty making loan payments and failing to meet profit and financial targets established by investors.

“Everybody is very nervous about that,” said economist Jack Kyser with the Los Angeles County Economic Development Corp.

In October, bond-rating agency Fitch announced it would focus more attention on the effect of sublease space as it reviews securities backed by mortgages on commercial real estate. “A prospective tenant coming into the market has twice as many choices. As a result, leasing space becomes very difficult” for landlords, said Fitch real estate securities executive Mary O’Rourke.

The inventory of sublease space is expected to continue to grow in Southern California through much of this year as job growth in key industries remains flat or falls, said Esmail Adibi, director of the center for economic research at Chapman University in Orange.

“The demand for office space is basically going to be absent,” he said.