Why 5-Year Office Leases are Golden for Startups
San Francisco continues to be one of the hottest office markets in the nation. As commercial real estate brokers in San Francisco, our phones are always ringing off the hook with startups requesting space for one to two year terms. Their needs are all the same. Startups are looking for a creative, collaborative workspace with an "industrial look" and an open plan. Oh, and they need to move in within the next month, or sooner.
Most of these startups have never secured office space before and have no idea what the process is like, nor realize the costs and timelines facing both the future landlord and themselves as tenants.
There are a few items on the leasing checklist that startups need to consider when looking for new space.
Firstly, they need to think about the landlord and their intentions. All over San Francisco, building owners from conventional Class A office buildings, warehouses, or office conversions are spending money to create these popular industrial spaces that technology firms are seeking. The problem is, whether they build them as "spec suites" (ready for immediate occupancy) or if they are willing to build out these spaces for future tenants, the costs to convert will be extremely expensive for the landlord. On average, a building owner can expect to pay between $60-$80 per square foot in order to remove old ceilings and lighting, and to expose the ceilings and air conditioning ducts.
Second thought to consider is from the tenants' perspective. The startup looking for space will want the popular industrial "look" in order to attract potential employees in an ever-increasing competitive tech market. To give their startup the competitive edge, they will want to have one of the coolest office spaces to win over potential candidates.
Most employees, especially in tech, will be spending late hours creating, promoting, and planning their latest tech gadget or service; anything less than "cool" for a workspace will simply not work. Startups typically desire "open plan" office space in order to maximize the amount of people they can have working productively within one space. As a new company, startups do not know their future other than that first year. According to the Wall Street Journal, three out of four startups fail. Successful companies (have received a large amount of funding or investments) then they will likely grow exponentially, hiring more employees to meet their growth demand and will therefore need more office space. Otherwise, they could potentially be bought out by a larger brand.
At $60-$80 dollars per square foot, the problem then belongs to the landlord, who will need to figure out how they will recoup their costs with such a short-term lease and such uncertain tenants. Additionally, the landlord will need to finance the renovations, either through a bank or through their investment fund. Either way, their financing is tied to a longer-term lease, where they need to amortize their costs over an appropriate time to make the investment make sense.
This is why startups should not make the mistake of thinking so short term. If they were more willing to look at five-year leases, then more options would be available to them as well as more flexibility to create their preferred style of workspace. Startups are probably thinking, "But how does that make sense since we will have no idea where the company will be in one year, let alone five years?"
By law, a tenant can sublease their space. Often times, landlords have the right to recapture a space that is being offered for sublease. Today, rents are on the rise in the Bay Area. Most industry leaders believe that rents could go up another 20% this year alone. Say as a startup, you take a five-year lease. Let's say one year later, you need to expand. You would have four years remaining on your lease. This would give a sublease tenant four years of term, which would still attract a large amount of potential tenants, particularly conventional firms. In turn, the sublease tenant will also have the rights to sublease again, if they need flexibility.
With rents rising, most leases call for profits after expenses (brokerage and attorney fees) to be divided between the tenant and the landlord. Moreover, landlords are now more willing to recapture the property, rather than end up in a situation where the tenant subleases, where the tenant enjoys maximized profits. Either way, the tenant can sign a longer-term lease, which will give them more options and have the landlord more willing to build out their space and create the preferred look and feel that the tenant is looking for to meet their needs now.