Chicago Landlords Are Refusing To Pony Up Cash For Tenant Improvements
Like players of credit card roulette at a Michelin-starred restaurant, office landlords are increasingly attempting to duck the bill for tenant improvements, closing their wallets as shaky fundamentals linger on — and on.
Panelists at Bisnow’s Chicago Office Summit squabbled over who should bear the financial burden for costly tenant build-outs, exposing collegial tension between landlords and tenant representatives at the event, hosted at Braveheart by IndusPad.
While some panelists said participating in the amenities arms race is a must to stay competitive, others argued that capital spent on tenant improvements is no longer feasible as market and financing weakness pushes them to the breaking point.
Farbman Group CEO Andy Farbman said he can no longer spend significant capital to build out tenant improvements as a landlord in this environment. He said tenant representatives don’t understand landlords’ limitations and are so focused on their tenants winning that it is causing deals to fall through.
Landlords have to make money to invest in real estate, Farbman said, and it is unrealistic to expect them to put up sizable sums for tenant build-outs given the financial climate.
“Landlords are now starting to sit on their hands and they're saying, ‘Look, I've got to be able to win too,’” he said. “The days of $100 [per SF] work letters? That ... is over.”
R2 Cos. principal Matt Pistorio said he is recommending against spending large amounts on tenant improvements. Instead, he is looking at second-generation spaces where the previous owner spent significant capital on build-outs. He also suggests lower-cost tenant improvements like new paint and carpeting.
These simple fixes can cost just $30 per SF instead of the $100 to $150 per SF landlords historically needed to put up for tenant improvements, Pistorio said.
“We have been getting really good returns and having high success rates leasing these second-generation spaces,” he said. “Tenants just want space soon, they want it immediately. They're not going out and looking for space 12 to 18 months in advance.”
Developers in certain scorching-hot submarkets have been able to steer clear of offering up sizable chunks of financing for tenant improvements. Sterling Bay Executive Vice President Russ Cora said that generally, the company’s Fulton Market tenants are spending more to upgrade their spaces than developers are giving in TIs.
Cora said he is “all for” less money spent on tenant improvements, but it is hard to accomplish when tenants will simply move on to a different landlord willing to provide the financing.
Landlords and tenant representatives need to work together to create win-win scenarios for both parties, said Steve Stratton, international director of the headquarters practice group at JLL and co-leader of the Chicago tenant representation group. However, buildings need a certain level of amenities to draw prospective tenants, and those require financial investment.
“If you don't have capital … there's no way you can add these amenities, which is basically table stakes to even get in the game of attracting tenants,” Stratton said.
A March JLL report underscored the importance of amenities in driving occupancy in urban centers across the country. Buildings with more amenities, which JLL defined as properties with 10 or more tagged amenities and at least one distinct offering like a roof terrace or full-service fitness center, have prospered. Those buildings have absorbed 23.3M SF since the beginning of the pandemic. Other urban Class-A product lost more than 50M SF of occupancy, according to JLL.
Even amid sagging occupancy at properties without top-notch amenities, some of the panelists were cautiously optimistic about the future of Chicago office.
IndusPad CEO Jitender Makkar said there is such variety in the available offices that the differentiating factor often comes down to how creatively owners position their assets. He said 2024 is going to be a great opportunity to get into the market.
“Everybody is beginning to see that there is light at the end of the tunnel,” Makkar said. “I am excited about that.”
Pistorio was slightly more restrained in his expectations. While he said his outlook on the Chicago office market is bullish, instead of the U-shaped economic recovery the country saw following the 2008 financial crisis, he expects a more linear recovery in the wake of the pandemic.
“People that are able to buy real estate at these depressed values … as long as they do the right things and they reinvest in those buildings and are thoughtful on how they spend money, I think those folks will win,” Pistorio said.
Recently released less-than-rosy data on downtown office assets seems to undercut that optimism.
The total vacancy rate in the central business district topped 25% in the first quarter, a high-water mark for the seventh consecutive quarter, according to a Q1 CBRE office report. The figure is up from 22.4% a year ago and significantly higher than the 13.8% downtown vacancy rate in the CBD before the pandemic, Crain’s Chicago Business reported.
The situation is particularly troubling in the River North submarket, where the total vacancy rate is 31.1%, the highest of any of the submarkets tracked in the CBD, according to CBRE. The area also saw 477K SF of negative net absorption, far and away the most of any downtown submarket.
Lower-tier buildings in the CBD will struggle to recover without substantial investment, Stratton said.
“There’s a ‘coming to Jesus’ period in downtown right now,” he said.
