This article first appeared in D Magazine’s Commercial Real Estate section.
Contrary to what many read about the commercial office market in national news coverage, Dallas-Fort Worth is trending in the right direction, with companies instituting “return to work” policies and business leaders writing thought pieces and internal memos on the importance of in-person collaboration. Just this past year, DFW led the nation in number of added in-office jobs—adding nearly 60,000 office roles, more than double the amount added by another major metro area in the US during that time-period—and we have seen over a thousand office leases signed. Ninety-six percent of those were new deals.
It comes as a shock, then, to tenants and landlord just how trying and drawn out the process has become to successfully negotiate an office requirement. Even though conditions within the market are improving, the gap between tenant and landlord expectations resulting from the pandemic has created many challenges, disrupting the office market in a way unseen since the 2008–2009 recession.
What Landlords are Experiencing
In the DFW Metroplex, rental rates in well-positioned assets (Class-A buildings in high-performing submarkets) continue to increase despite higher levels of vacancy. This movement can be attributed to the state of our capital markets, the surge in construction pricing, and the successful leasing activity of the newest and most expensive developments such as McKinney & Olive, Weir’s Plaza, 23Springs, and The QUAD.
To combat inflation, the Federal Reserve has increased interest rates by 5 percent since March of 2022. For landlords, these economic headwinds have made borrowing money to finance new office buildings more expensive, and subsequently, rental rates have increased to keep up with the rising cost of debt.
Record-high construction costs, which are forecasted to increase more than 18 percent from 2022 to 2024, have further complicated matters. Many landlords underestimated the rate at which construction costs would increase over the past three years, impacting the overall profitability of their assets and forcing them to rethink their original investment projections.
While it seems counter intuitive that rates continue to increase despite higher levels of vacancy, the law of supply and demand is balanced for new construction. Landlords must increase rental rates to overcome the cost of debt and the increase in construction costs. Tenants are willing to pay these high asking rates to be in a state-of-the-art building with walkability and access to the latest and greatest building amenities. If tenant demand for new construction declined or ceased to exist, new products would stop being developed.
Tenant Rental Rate Expectations
During the COVID crisis, companies in a position to make an office decision enjoyed the benefit of receiving unheard-of deal terms from landlords in exchange for taking a leap of faith and continuing to trust in the “return to normal” in the office sector; however, the ultra-incentivized pandemic pricing set unrealistic long-term expectations for rental rates. Furthermore, tenants now require watermark allowances from the landlord to offset the capital costs of building out office space and, even then, are often responsible for covering the difference between the allowance the landlord provides and the actual cost of construction.
Finding Middle Ground
Now more than ever, it’s imperative that landlords and tenants have the right people in their corners, advocating for them and providing sound advice. One of the most difficult and uncomfortable conversations to have with a client, in any business, is when you must deliver tough news. The ability to not only deliver that message in the proper form, but then proceed to recommend a solution or way forward is what separates the good from the great. The great commercial real estate representatives, on both sides, should be skilled in using facts and market trends to take the subjectivity and emotion out of the negotiation process. Otherwise, we’ll continue to be saddled with lengthy and unproductive negotiations. Simply telling your client what they want to hear, or what you think they want to hear, will only accentuate the growing divide between landlord and tenant expectations.