Office Markets Feel Pull From Law Firm Changes
Sublease space pressures rents, transaction velocity in S.F. and L.A.
By Kari Hamanaka
California Real Estate Journal
May 4, 2009
Jay Sternberg can quickly list the names of law firms that have either vacated or occupied office space in the last year in San Francisco’s central business district.
“A lot of them are evaluating what’s going on right now,” said Sternberg, a senior vice president in Colliers International’s occupier services group in San Francisco. “We obviously saw Heller Ehrman [LLP] and Thelen Reid [& Priest LLP] leave, which did have quite a bit of impact on our market. We’re also seeing other law firms put space on the market.”
In the last six months, deals of more than 15,000 square feet included Covington & Burling LLP’s move from 601 California to 1 Front Street. Hogan and Hartson LLP subleased 22,134 square feet at Four Embarcadero, while Phillips, Spallas & Angstadt LLP subleased 15,396 square feet at Three Embarcadero Center. Meanwhile, firms such as DLA Piper are trying to sublease space, competing with already existing office landlords. And those deals only are representative of activity in San Francisco.
At the core of these changes occurring within the legal industry is the question of whether firms’ business models, which usually includes a sizeable amount of income going to office rent, are sustainable and how much more of an impact that will have on office markets.
“Pretty much across the industry, you’re seeing a lot of firms looking at how can we reduce costs,” Sternberg said. “A lot of layoffs have freed up space, which becomes sublease space.”
According to an April 17 transaction update from Colliers, Class A rents in San Francisco’s Financial District declined to an average of $35.19, while Class B rents fell to $23.50.
While first-quarter 2009 numbers have not yet been finalized, Class A rents are expected to drop 8 percent to 10 percent, Sternberg said. Between the third and fourth quarters, Class A rents already had taken a 20 percent nosedive.
“The larger firms that are active right now are gravitating toward subleases most likely due to economic incentives, downsizing, disposition of space and cost containment,” Sternberg said. “Our issue right now isn’t availability of space; it’s the demand side of the equation.”
According to fourth-quarter 2008 data from Jones Lang LaSalle, sublease office space in San Francisco totaled 999,521 square feet at the end of last year. Sublease space in the Los Angeles metropolitan area was one of the highest out of all areas included in the report with 2.4 million square feet available at the end of 2008.
“The sublease market is in far worse shape than the market for direct space, and that is, of course, because the space is being offered by tenants,” said Dan Mihalovich, president of Mihalovich Partners, a tenant representation firm that also is exclusively partnered with the Bar Association of San Francisco to provide members with leasing services.
According to Mihalovich, in the last full week of March, 600,000 square feet of sublease space entered the San Francisco market.
“There’s a tremendous amount of quaking in the legal industry,” Mihalovich said. “To some opportunistic firms that means the potential to do some cherrypicking either to acquire small groups or the potential to acquire an entire local firm.”
That sort of movement is certainly nothing new. In fact, Mihalovich said that activity has slowed. Instead, he is now seeing some firms reflect on transaction prices of the past.
“I think a lot of lawyers and law firms are looking in their rearview mirrors and seeing a lot of deals that have gone sour. Of course, in San Francisco, particularly, the market is trying to recover from the loss of Heller Ehrman and Thelen.”
But in Los Angeles it is somewhat of a different story—at least for some.
Peter Zeughauser, a law firm consultant with the Zeughauser Group, said he is seeing an increase of law firms requesting his help in finding Los Angeles office space.
Zeughauser said the interest is a mix of new firms to the market and several firms that already exist and want to grow.
Growth was the case when Seyfarth Shaw LLP leased 55,000 square feet in Brookfield Properties’ Bank of America Plaza in downtown Los Angeles. The firm already has an office in Century City.
But the deal showed that even with the departure of Thelen Reid and Heller Ehrman from the Bank of America building, which emptied a sizeable chunk of space onto the market, other law firms have moved in to scoop up the vacant space.
Last month, Kirkland & Ellis LLP signed a deal to occupy 90,000 square feet of space in the Bank of America building. The firm, which occupies space at 777 S. Figueroa St. in downtown Los Angeles, also has offices in Palo Alto and San Francisco.
“If you want to have an international footprint, you have to be strong in the United States,” Zeughauser said. “The key markets in the United States, in this particular order, or close to this order, are New York, Washington and California.”
When looking at the state, Zeughauser said firms looking at Southern California see Los Angeles as the most attractive market to be in.
For Blank Rome LLP, which was looking to establish itself in Southern California, the answer to where the firm’s newest branch of five partners would be located is at 1925 Century Park East in Century City.
“California is one of the most dynamic markets in the country,” said Carl M. Buchholz, Blank Rome managing partner and chief executive officer, in a statement following the office’s early March opening. “Our Los Angeles office will provide the initial launch for our West Coast growth strategy, as well as a natural synergy with our growing office in Hong Kong, as we continue to build our national and international platform.”
At the end of March, Greenberg Glusker Fields Claman & Machtinger LLP signed a 15-year lease renewal on 61,806 square feet of space at 1900 Avenue of the Stars. Consideration for the lease was $61.6 million.
The long-term lease was welcome as most deals done today are on shorter lease terms, but Gary Weiss, principal at Madison Partners, said the longer term is not uncommon for law firms.
“Usually on deals that are three floors or more, usually those are at least 15 years,” Weiss said. “Primarily, big deals like that don’t want to go to the marketplace every five, 10 years because it’s a lot of work to do if you’re doing shorter lease terms.”
Weiss and Clay Hammerstein, of CB Richard Ellis, represented the law firm on the renewal for its headquarter offices.
As for whether more firms are gravitating to Century City or downtown Los Angeles, Zeughauser said it is a toss up and that most of his clients were having difficulty deciding which submarket to locate offices in.
Weiss added that it depends on the type of practice the firm specializes in, and for Greenberg, which provides services for many entertainment companies, being on the Westside makes sense.
“It was a very good deal from the marketplace, given that the economy’s been slow and law firms have had a lot of layoffs and cuts,” Weiss said of the transaction. “And to Greenberg’s credit, they’ve made a commitment to the market. I think because they’re so diverse, their business is doing well. They’re not one-dimensional.”
Class A or Bust
Even with the layoffs and the talk of mergers and trimming office space, in many cases the expense of the type of office product many large firms command runs almost counter to the economy.
“It’s absolutely not important,” Zeughauser said of the economy’s impact on many firms’ desire for Class A space. “Law firms also invest in a lot of tenant improvements. Space is typically expensive, and they want to be in nice spaces.”
With the clients the Zeughauser Group works with, Zeughauser said having the nice office space to welcome clients into makes sense.
“Most of these firms have Fortune 250 companies as a significant part of their client base. They’re charging $700 to $1,000 dollars per hour for partner time and consider it important and part of the plan to be in the Class A office building.”
But the per-square-foot prices on lease terms and acquisitions of three or four years ago no longer seem justifiable when per-square-foot costs for sublease space in San Francisco is now entering the teens.
“San Francisco in particular has seen probably half of its buildings trade hands in the last three to four years at acquisition rates that are now underwater,” Mihalovich said. “When those buildings were trading at those rates then, those numbers made absolutely no sense to me. What is it about the direction of the economy that seems so obvious during the past 18 to 24 months that these law firms did not see, or the brokers who were representing them did not see, that they negotiated leases well into $60 per square foot per year?”
Mihalovich said it is a number of factors that justified prices that are now unheard of in today’s market. These factors, Mihalovich said, include firms’ use of in-house headquarter resources that may not be located in the market a firm may be moving into and the use of brokerage firms that represent tenants and landlords.
However, the layoffs and mergers occurring within the industry are now lending themselves to industry discussions of fixed-fee work and more stringent limitations on uncapped hourlies, which could bear an impact on firms’ office decisions.
Mihalovich said it will become more difficult for firms to justify spending $150 to $250 per square foot on construction given cost cutting elsewhere throughout the economy.
“At the core of a lot of these poor decisions is this herd mentality,” Mihalovich said. “It’s that mentality or notion that if you’re going to maintain your competitive edge as a law firm and retain and hire lateral partners and new associates, your space must be at least as attractive as your competitors.”
With the bottom not expected to hit just yet for office or any asset class, tenants, including law firms, have the upper hand with choice, increasing concessions and lower rents. But as industry cuts continue to be the norm, strategizing about the right location at the right price may weigh more heavily on any firm—not just those in law.
“Generally speaking, I don’t think we’ve seen the bottom yet,” Sternberg said of the office market. “There’s opportunity for savvier tenants to take advantage of current dynamics. Ultimately, they could be in a position to reduce costs if they operate the appropriate way and take a strategic view as it relates to the market.”
©2009 Daily Journal Corporation.