High Improvement Costs Make It Difficult for Landlords to Deal

Although vacancy rates and rentals have started to stabilize and tenants are coming back to the marketplace, landlords are faced with a new problem that may make it difficult for them to commit to many office deals this year: Tenant improvement costs have skyrocketed over the last 18 months. From carpeting to steel, costs for the simplest jobs are making even “down and dirty” deals hard to make.

In San Francisco today, average class A office rents are $28.00–$32.00 per square foot (PSF), class B office rents are $20.00–$26.00 PSF, and class C rents are $17.00–$20.00 PSF, all on a fully serviced basis. Carpeting has jumped from $2.00 PSF to $2.75 PSF for a class A quality-grade installation. Paint has jumped from $1.00–$1.50 PSF to $2.00–$2.50 PSF. A full class B construction today from shell exceeds $50.00 under the ceiling and a whopping $80.00 a foot under the ceiling in a class A building. These figures translate to an increase in the cost of an average paint and carpet transaction involving additional electrical work and cleanup from $5.00 PSF to $10.00 PSF.

These increased costs have affected the ability of class A landlords to respond to offers. If a landlord secures a tenant willing to pay $32.00 PSF rent, the operating expenses to run a class A building are $12.00–$16.00 PSF. This leaves $14.00–$20.00 to cover other costs, mortgage, and profit. If a landlord considers building from shell, $80.00 build-out amortized over 5 years without considering carrying costs would cost $16.00 PSF, not including brokerage fees, legal fees, and the like. At $32.00 per foot, minus $14.00 to cover expenses and minus $16.00 to cover a build-out plus another $3.00 to cover brokerage and legal fees, the building will lose $1.00 per year to make this deal.

Even if a tenant is willing to reuse existing improvements, the removal of a wall or two could trigger upgrades to meet current codes, which in turn could lead to expenditures to meet requirements of the Americans with Disabilities Act (ADA) and life safety upgrades.

Costs such as carpeting and steel will not go down anytime soon. Carpeting costs have skyrocketed because manufacturers have consolidated to a few players, causing less competition and raising prices. Steel shortages worldwide have become severe due to increases in costs of steel. Last week, construction costs on the new Bay Bridge were reported to be drastically over budget on a project that has just begun—mostly due to steel price increases. Even places such as the Lake Merced Golf Course have suffered—rising steel prices and the inability to obtain the product have forced a delay in the construction of a new clubhouse.

Brokers all over town are complaining that landlords are not responding quickly to offers. Brokers and their clients are dumbfounded when a landlord does not respond quickly; they see this as reluctance to spend money on tenant improvements.

But the problem is much deeper than that for landlords. Often landlords  seek additional financing to cover improvements, but because rental rates are so much lower than they were when most buildings were purchased or refinanced, funding sources are reluctant to lend more money. Even equity buyers have difficulty funding tenant improvements because the cost will lower their returns. Landlords must find new alternatives to meet tenants’ demands, or tenants must be willing to reuse existing improvements to make leasing deals happen.