How can law firms manage occupancy costs to protect profitability?
By Kevin Brennan and Steve Barker|March 26, 2007 at 12:00 AM
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Real estate costs are typically a law firm’s most significant operating expense aside from payroll. In addition, a lease has meaningful long-term ramifications, impacting firm image, flexibility to grow or contract, operating efficiency and recruiting capabilities. And because of a law firm’s unique structure, occupancy costs can directly affect each partner’s personal bottom line in the form of per-partner profits. Structuring an office lease is a high-stakes endeavor and the sky-high prices recently paid for Class A or premier San Francisco office buildings have upped the ante considerably. This is particularly true for the city’s law firm tenants, who occupy approximately 15 percent of the total Class A inventory. Accordingly, it’s imperative for law firms to understand the dynamics of the current office market as well as the potential impact on law firm occupancy costs. The critical question: How can law firms insulate themselves against rising real estate expenditures? INVESTORS BUY IN RECORD NUMBERS FOR RECORD PRICES Since 2003, a total of 38 million square feet of Class A property has been sold, representing nearly 75 percent of downtown’s top-tier inventory. At the close of 2003, the average sales price for Class A buildings equaled $232 per square foot. Today, the average stands at $564 per square foot � an increase of 145 percent � and that number is rising. Morgan Stanley’s recent purchase of Blackstone’s (formerly Equity Office Properties) 10-building downtown portfolio for a reported $2.65 billion � or $675 per square foot� is indicative of the ongoing trend. BUT WHO REALLY PAYS? The unprecedented sales prices can impact law firm occupancy costs in two significant ways: First, rental expectations are escalating in lock-step with the jump in purchase prices. Asking rents have climbed dramatically � in some cases by as much as 50 to 80 percent, driven more by the influx of institutional money, primarily pension funds and private REITs, into downtown buildings than by actual tenant demand or office space absorption. In fact, active tenant law firm demand is currently down 60 percent as compared to 2004-2006. Presently, there are 400,000 square feet of law firms active in the marketplace, mirroring 2002 and 2003 levels (demand for all tenants equals about 2.5 million square feet, down 40 percent from a year ago). The declining demand can be attributed, in part, to the fact that many large tenants pre-empted their ’06 and ’07 lease expirations in order to take advantage of the 2004-2005 tenant-favorable marketplace and secure future growth. As the second-largest space user, after financial services, within the Class A property marketplace, law firms seeking to expand within or relocate to recently sold properties could be particularly hard hit. Not to be overlooked is the impact on law firms who simply stay put � those tenants who already occupy space in recently sold buildings. While these firms may be protected from rental rate increases, they are not immune to the tax increases that come with the inflated purchase prices. As properties are assessed at the higher value, the property owner’s tax bill will increase, and that burden will be passed on to the tenant. For example, when the Morgan Stanley deal closes, the assessed value of One Market St. will jump from $300 per square foot to more than $800 per square foot. For the typical large law firm with a 100,000-square-foot existing lease at One Market, the tax increase could be $600,000 a year or $6 per square foot. THE SINE QUA NON These incredibly “bullish” rental expectations along with property tax increases can materially impact attorney occupancy costs, creating severe downward pressure on partner profitability. Historically, law firm take-in rents have averaged just over $33 per square foot per year, contributing to overall occupancy costs ranging from $30,000 to $35,000 per lawyer per annum. However, the new average asking rents for comparable Class A law firm space are $45 to $50 per square foot per year, translating to a total of $50,000 to $55,000 of occupancy costs per lawyer per annum, or a 50 to 80 percent overall increase, exclusive of additional real estate tax increases for in-place tenants This sharp spike makes San Francisco the third-most expensive real estate market for law firms, following New York and Washington, D.C.
Average Occupancy Costs Per Lawyer2007 projectedSan Francisco � $50,000-$55,000D.C. � $55,000-$60,000New York � $55,000-$85,000Source: Studley
THE BEST DEFENSE IS A GOOD OFFENSE Law firms can employ a number of proactive strategies to insulate themselves against rising costs. The suggested strategies correlate to the length of the law firm’s existing lease obligation.
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