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When it comes to real estate, law firms are increasingly finding there is little margin for error. Real estate remains the largest fixed cost on a firm’s balance sheet. A bad real estate transaction can hurt a firm’s ability to be economically competitive for 10, 15, or even 20 years. It’s a potentially fatal blow, given the laserlike focus by law firms today on profits per partner in their struggle to retain and attract top talent. Further, given the heightened sensitivity by landlords to creditworthiness, there is a disconnect between real estate strategies that used to work and what tactical maneuvers must be employed going forward. Faced with the many financial implications of real estate transactions, law firm leaders must fully consider the impact on a firm’s ability to borrow money and optimize profits. But how? TOO MUCH OR TOO LITTLE? No law firm that I know of has ever been driven out of business by having too little office space. Nor, in all of my years of commuting around this city, have I ever seen lawyers working from tents or kiosks on Pennsylvania Avenue. This attitude is not meant to be cavalier, but it is to remind leaders that needing more office space is a good problem and having (significantly) more space than required is a bad problem. Having too much space can cost a firm millions of dollars. These costs come straight off the bottom line. Conversely, having too little space can be a nightmare for law firm leaders and administrators because less-than-ideal situations must be endured. Still, such situations are temporary and don’t usually have any downside implications in terms of cost. When considering long-term tenancy, nobody likes to plan for the bad things that might happen as well. But failing to do so can cost a firm significantly. The goal is to determine what a law firm’s true space needs are, both now and in the future. While this is impossible to forecast with total accuracy, there are elements of flexibility that should be employed in structuring the transaction after we have done our best guesswork. Some of these elements are obvious and include rights to expand, contract, or terminate leases as well as rights of first offer or refusal. The sublease and assignment rights can be important as well. But other issues are less conspicuous. These include considering a building’s overall size and tenancy, for example. A larger building with more rolling vacancies can provide nonspecific opportunities in the future. What’s key is not to let real estate drive your business expectations or it can become a serious financial burden. Perhaps the biggest mistake made when negotiating the economic terms of a real estate transaction is misunderstanding the value of the office space. Law firms need to get away from the notion that there is a prevailing neighborhood or building type where a firm must be located to succeed. As a matter of fact, if one takes a historical view of the real estate strategies of some of this city’s most esteemed law firms — Covington & Burling; Hogan & Hartson; Arnold & Porter; and Williams & Connolly, for example — quite the opposite is true. Such pioneering firms were willing to buck the status quo by locating in what at the time were up-and-coming neighborhoods, and have reaped huge rewards as a result. So, if a law firm is willing to view office space as a commodity, merely a place from which it can achieve its agenda, it will immediately develop significant leverage in the negotiation process. JUST SAY NO Once a firm has found space that appears to be suitable, the first steps are familiar: get an understanding of the owner’s costs, perform the appropriate sensitivity analysis, and agree to a gross economic deal which allows only a fair return for the landlord. But at this point, too many law firms and their advisers drop the ball. There are so many other elements that will have lasting financial implications throughout the term of the lease, but all too often a tenant accepts the notion that these issues are determined by “the market.” What a load of hogwash. Everything — let me repeat — everything is negotiable. Consider the escalation provision. Why is it that a tenant will accept a fixed annual escalator as a “market provision,” when landlords long ago rejected the notion that a percentage of the Consumer Price Index was an adequate adjustment to rent? Who dictates whether there should be bumps in rent or what those bumps should be? I don’t recall seeing any stone tablets on which these matters are prescribed. Another often misunderstood clause of the lease covers operating expenses and real estate taxes. One must thoroughly define what should equitably be included in a building’s annual expenses and be even more detailed in what should be excluded. This is where I think many tenants allow themselves to be lulled into a false sense of complacency. “Since everyone who has come before me has erred, I shouldn’t be concerned about allowing an owner to include expenses which are not fair,” tenants think. “That’s just how they do things.” Who said that expenses cannot be capped, avoided, or incorporated over time? Who said that the tenant should be the sole bearer of increased tax assessments, particularly if instigated by a sale of the property? Why should you, as a tenant, pay for a management office and a management fee? Why should you pay for garage maintenance when the garage is a for-profit concern? These are only small issues, but dozens of them taken together have real cost implications annually. And, without an audit provision that has real teeth to it, what good is a well-honed expense provision anyway? The definition of market rent will affect the rates that the law firm will pay throughout the term of its lease and any extensions thereof. Make sure to receive the benefit of all tenant concessions that a disinterested party would receive and amortize them out of any specified rental rates. Also, pay particular attention to any additional fees that the landlord charges for construction supervision and subsequent reviews of plans or subtenants. In general, it is far more advantageous to “set the market” rather than follow trends established by others. Don’t allow for an apparently attractive economic transaction to be diluted by the rest of the lease. Negotiate everything from a position of strength by not being wed to a particular property. DESIGNING FOR PROFIT Most law firms today are doing a much better job of designing more efficient space and spending less money constructing it. Still, I believe many are spending too much on design that does not promote or sustain profitability. Personal observation shows that where firms are falling short — and costing themselves serious money — is in the reconciliation between the design efficiency and actual utilization of the premises. In other words, law firms should insist that space is better designed to allow for better space management. Set a budget that allows for a firm to brand itself appropriately, in its own image, not its architects’. Spend prudently and ask whether all the bells and whistles are needed and if they make sense. Negotiate so that a firm’s own money is spent on items that can be written off over the term of the lease, such as carpet. And plan ahead for the balance sheet implications caused by the acceleration of the unamortized improvements at the end of the term. Or better yet, create a structure going into the transaction where the firm is no worse off after taxes on an annual basis, but avoids any consequences of such acceleration. It is imperative so that the firm’s profits per partner continue on the all important upward trend. A SENSE OF SECURITY Security deposits are very interesting and landlords have become much more focused on them over the years. The notion that a firm has been around forever or is a top global firm is no longer a way around some amount of guarantee under most circumstances. That being said, there are several things that a firm should do to position itself for a favorable outcome during this phase of the negotiation. First, a law firm should be forthcoming with its financial information, but should make sure to present it in the most favorable light. The firm should be able to point to a diversity of income generation, including practice groups and individuals. The person responsible for the firm’s overall economic performance should be prepared to meet and discuss its statements in detail and offer reasons for any lackluster performance with specific ways that improvement will be sought. Landlords like tenants who are aware of and focused on economic results. Second, once again, we must remember that we are not the victims of mistakes that others have made. A well-run business should only provide an owner with a reasonable security deposit to cover a portion of the shortfall in the event of a disaster. This should take into account all of the circumstances relevant to a particular law firm. Nobody but Brobeck should be paying for Brobeck. Third, and probably most important, is that law firm leaders must consider the compounding effect of multiple security deposits now that they are commonplace. It used to be that a firm might offer a letter of credit for a few million dollars in its largest offices and nowhere else. Today, a firm might find, to its horror, that adding up all of the letters of credit it has employed to guarantee multiple leases around the world has seriously impinged its borrowing capabilities. This is where the savviest firms will figure out ways to use off-balance-sheet guarantee structures such as lease bonds. It is important to find an adviser who understands and has employed this technique in order to keep premiums cost-competitive and make owners comfortable with the concept. The way that a law firm handles its security deposit(s) can either enhance or be a drag upon its ability to carry forward the strategic plan. Overall, there are innumerable issues in a lease transaction that have economic implications and will impact a law firm’s profitability. As the legal community continues its corporatization, centralized decision making on real estate and other issues will enhance economic results allowing for recruitment of the best legal minds. Smaller players will be affected by the trends established by larger firms and must prepare adequately to do battle in this ever-shrinking world. Aaron Katz is a managing principal of Newmark & Co. Real Estate, resident in Washington, D.C. He has specialized in representing law firms for 19 years and heads Newmark’s Law Firm Advisory Services division. He can be reached at (202) 292-0135 or [email protected].

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