In-Depth: How tenants can survive in a friendly market

It is already not a secret that the rapid development of the office real estate market that captured Moscow over the last several years has been dramatically transformed, right before our eyes, into a tenant’s market during the financial crisis. Rates are falling, the percentage of vacant space is growing. At the beginning of next year on the market there will be a huge volume, almost 1.8 million sq.m, of class A and B office space, which it was not wise freeze. On the background of decreasing demand the advantages for tenants are obvious: for the first time in many years (perhaps, for the first time in the Russian market) they not only have a choice, but developers have also become more flexible, reducing rates to fill empty areas.

To lose in such a situation, at first sight, is difficult. But there’s no need to run ahead. From the point of view of tenants the market has really become much more attractive. But it has also become more complex. In the new financial conditions that are unusual for the Russian market, there are new risks. For both developers and tenants it is extremely important to study the conditions of the market.

Transformation of the market

To assess the opportunities of a new space, it is necessary from the start to understand that the market has really changed. In the last 2-3 years we have observed rapid growth in construction caused by the fact that the real estate market in Russia was catastrophically under-saturated. Growth of business and growth of demand for new premises greatly increased the ability of developers to bring new areas to the market. Rates grew steadily, becoming almost the highest in the world (this summer for example, in the center of Moscow rental transactions were worth more than $2,000 per sq.m a year).

A fall in liquidity in the world financial markets came to Russia when the real estate market was at its peak. Companies began cutting costs and personnel and plans regarding the volume of space required in 2009 were reconsidered. Meanwhile the volume of space planned for the following year was guided by the needs of the market as of the beginning of 2008 and, this naturally, did not take into account the falling demand we observe today. However for many developers that have already started construction, it is more favourable to complete the projects than freeze work at a building site. In addition, many companies began to return the stock of un-demanded areas to the market.

Development of events

In the short-term period we will see the following picture. In the first half of 2009, the level of vacant space may reach 20% or more. Here we’re talking about probably 2 million sq.m of office space being empty from a total of 10 million sq.m. Among them will be high-quality areas which, it is not excluded will be offered under very attractive conditions.

The medium term prospects are slightly different. First of all, the market is stall falling very quickly and it will continue to fall. Under our assumptions, the market will reach its bottom in approximately the middle of 2009. Low rates will remain, as there will be a large volume of area on the market, and demand will remain low throughout the year. Eventually the market will start to be restored approximately six months after the start of economic growth. If we assume that economic growth will begin in 2010, then growth in demand for office space may coincide with the low supply of the new areas. Such a script assumes an immediate growth in real estate prices and rental rates.

It may turn out to be more favourable to operate with tenants in the short-term period and not postpone the decision till the end of the crisis.

A change in tactics

Feeling more comfortable in the market, tenants have begun to use all possible measures to benefit from the falling rates that began in the autumn.

Tenants that remain active in the market can be divided into three groups: those who are going to conclude transactions; those who have concluded preliminary agreements; and those who wish to reconsider existing rental contracts.

The first group are not in a hurry to conclude transactions in the present crisis conditions. Many tenants who were looking for new premises, have begun to postpone any deals until 2009 in order to wait for more attractive offers from proprietors. At the start of the year they hope to receive more favourable conditions of rent or purchase. It is an obvious strategy - in fact in 2009, especially by the second quarter, deals that proprietors will be forced to make will differ considerably from what we saw in the market in 2008.

The second group of tenants includes those who signed preliminary agreements not so long ago. The buildings they have chosen have been completed, and the tenants that concluded contracts at the beginning of 2008 or the end of 2007, should be able to move in in the near future. The question is how closely will the rates they have signed for at the peak of the market correspond to today's prices. Hence, some tenants are coming back to proprietors and are starting to discuss the commercial conditions again. Others are reducing the areas on which they have concluded preliminary contracts. And those that have not managed to return surplus areas to the proprietor, plan to subrent such areas.

The third group of tenants, which have contracts in operation are trying to reconsider their conditions. Recollecting 1998, it is possible to say that when there is a significant fall in the market proprietors are inclined to reconsider the rates of operating contracts even though directly these contracts do not allow for changes to the conditions or to break them. However proprietors should agree. It can’t be that a square meter, which on average in the market costs, for example, $700 in a year, costs $1,500 in a concrete building of the same quality. This is too strong a disbalanace that tenants will find ways to exit such contracts by making a complaint about the services of the building or its functions.

Don’t miss your chance

2009 will become the year of great opportunities for tenants and buyers as competition between proprietors will increase. But this does not mean that the market will be simple. There will be a lot of choice, proprietors will negotiate and make offers to tenants. To choose the best premises a correctly structured strategy and study of the future realization of this strategy is required. When choosing a premises it is necessary to look at new areas of risk which previously very few people thought about.

So what tactics are necessary to not simply survive but to take advantage of the existing opportunities?

The most important is to understand what a company will need in the future and it can cut costs.

Optimization of expenditures on real estate is the second-largest cost for the majority of corporations and has become one of the most urgent administrative problems. To reduce costs and increase the financial, organizational, and administrative efficiency of real estate in conditions of high market volatility we can recommend a number of strategies.

Operative reassessment of the requirements of real estate.

It is important to use up to date instruments that allow you to consider in a short period not only various possible changes in the number of staff of the company and the types of workplaces, but also existing variants of flexible use of space in specific buildings and premises.

Complex re-structuring of current rental agreements.

This includes not only a dcrease in rate, but also an improvement of the whole package of conditions for tenants such as the inclusion of additional services, minimization of losses if the you leave the contract early, the conditions offered to the company to prolong contracts (the definition of the effective market rate and tendencies for each building).

Decentralization and consolidation.

With competent financial planning and by looking for suitable variants, company-tenants can gain from decentralization or partial consolidation (for example, auxiliary offices). When planning decentralization and the movement of structural divisions, it is important to consider all possible financial, and non-financial (connected with personnel, conditions of work/service of a building) risks in any possible new premises.

To free tied-up capital.

This strategy all over the world has proven to be successful during times of crisis (1997-1998, 2000-2001) and has shown the advantages of opportunities that corporations can extract from their portfolios (sale with simultaneous rent, changing the target use of a premises, sale with a complex structure of payments, etc).

Rationalization of use of space.

In the Russian market, unassigned desks for employees, losses caused by the lay-out of an office premises, and undeveloped corporate standards and requirements for real estate are characteristic. Many companies have significant potential to reduce operational costs, reduce lost space, get rid of any surplus.

Having chosen a well thought strategy to optimize costs, it is possible to enter a market and start negotiations with proprietors. Tenants who plan to conclude transactions in 2009, will appear to be in an advantageous position – however it is necessary for them to pay attention to the quality of the project and the financial conditions of the developer to exclude the risk of the project going bankrupt. For such tenants, an advantage of the market will be the availability of plenty of ready projects. In 2009 of a building will already exist and on them documents will be already received. It will lower risk of the transactions connected with preliminary contracts, and will make the market more transparent.

For those tenants that are prisoners of their contracts, a wide weaponry of examination and experience for negotiations with the proprietor is required. Revision of the rental rate is a difficult business and at first sight contradicts practice. However both parties are interested in compromise: proprietors want to keep tenants, and tenants want to reduce expenses. We currently often work with similar cases whereby the tenant comes back to the proprietor and asks to reconsider the conditions of rent. For successful revision we recommend to pay attention to three aspects of the negotiating process:

- the tenant should understand precisely thevolume of space it needs, as other requirements to the premises have changed.

- before starting to work with the proprietor with whom there is a contract, it is necessary to look at what else is on the market, what the rates are and under what conditions. It is necessary to understand the price of comparable premises.

- we always begin the process of negotiations by studying the contract in detail with lawyers to understand what opportunities there are to leave a contract and what penalty charges there will be. The market may seem so favourable to tenants that it is possible to consider the possibility of breaking the contract with paying penalties but still saving a significant amount of money.

Many tenants consider subrenting as a way out. We think this should only be considered as a last resort as the market will be oversaturated: by the second half of 2009 more than 0.5 million sq.m will be subrented.

It seems as though even if you have concluded contracts at the top of the market, there is no need to despair. In conditions of economic recession the market offers great opportunities for tenants in the short-term. The main thing is to take advantage of these opportunities. Having obtained profitable and good quality premises at the right time, tenants will have a new level of competitiveness when the market starts a new wave of development.