When Office Demand Becomes Elastic
Historically, demand for office space has been relatively inelastic because businesses viewed it as a necessity. If a company needed 20,000sf to run its business, it generally leased that space whether the rent was $30/sf or $35/sf. That philosophy may be changing because, with the acceptance of remote working, companies will have more flexibility in determining the amount of space they truly need. While demand for essential space will remain relatively inelastic, a growing portion of every company’s space requirement will become more discretionary and, therefore, dependent on the rent.
Inelasticity and Elasticity of Demand
Demand for a good or service is said to be “elastic” if a change in price causes people to demand disproportionately more or less of that item. Demand for a good or service is said to be “inelastic” if a change in price causes people to make relatively no change in how much they demand of that good or service. Demand elasticity or inelasticity is measured on a relative scale as demand for different goods and services react differently to different movements in price. The more essential a good or service is, the more inelastic demand will be because people have no choice but to consume that item. Thus, items like gasoline, utilities and food staples have relatively inelastic demand. Elastic goods and services, on the other hand, are much more common and tend to be more discretionary like luxury items. Every manufacturer and service provider must have a keen understanding of the elasticity or inelasticity of demand for their product or service so that, when they increase or decrease prices, the result will not negatively impact overall revenues (by disproportionately reducing demand or failing to increase demand, as the case may be).
Office Space Demand
While it is true that businesses may consume less office space in very high rental markets like New York City, Tokyo or London than they might in lower cost markets, within a given market, companies tend to lease what their space programming dictates. Office space has been a necessary cost of doing business. Going forward, however, the definition of what is truly “necessary” will change.
Assume that XYZ Company was paying $800,000/yr. in rent for 20,000sf of office space (i.e., $40/sf in gross rent) and that every employee had a dedicated seat. If rents go up to $50/sf for this space, the company would be faced with a potential 20% increase in total occupancy costs if it continues with the same space program (i.e., $50/sf X 20,000sf = $1MM). However, with the broader acceptance of remote working resulting from the pandemic, companies will now have more discretion in how much space they need. If the CEO of XYZ Company mandated that there be no increase in real estate spending going forward, the company could offset the rent increase by adopting a hoteling model (i.e., plan for fewer seats than the actual number of employees) and thereby reduce its demand by 20% (16,000sf X $50/sf= $800,000). While XYZ Company may have a relatively inelastic demand for the “essential” 16,000sf of space, the remaining 4,000sf of space is more of a luxury and, therefore, whether it ultimately elects to lease this space will be dependent on the actual rent.
Many people are predicting that businesses will stop leasing space or at least take less space because of remote working. However, in most cases, it’s really going to be matter of price. If landlords want to hold out for higher rents, tenants will decide to forego some of the discretionary space that they would otherwise have elected to carry. If, however, rents come down sufficiently, tenants may decide the value justifies the additional consumption. Again, going forward, for every business, space will be broken down into essential, “inelastic” space and nonessential, “elastic” space. The “elastic” space will change the office market.
How This Will Affect Lease Negotiations
What will all of this mean for lease negotiations? In the past, the lease negotiation was primarily about rent and tenant concessions. Going forward, however, negotiations may add the new element of square footage as tenants will be able to more easily manipulate their program to accommodate their budgets. Companies will instruct their design professionals to create different test fit plans: one with the ideal space configuration assuming rent is not an object, and a second plan that assumes they can lease only the amount of space that accommodates their real estate budget. Tenants will then need to weigh the relative pros and cons of the ideal space plan with higher costs against the workable space plan and lower costs. Landlords (and their lenders) may also have to make a choice: do they want the deal that affords them a higher rent but with more vacancy or do they want the lower rent and less vacancy?
The flexibility to manipulate its square footage will increase a tenant’s bargaining leverage at the negotiating table because it will enable it to fit its requirement into more buildings in the market and to create multiple options for each building. More buildings and options in play means more landlord competition and that always works in the tenant’s favor.
The acceptance of remote working will provide businesses with more flexibility regarding the amount of space they lease. Going forward, many businesses will bifurcate their space requirement into essential or “inelastic space” and discretionary or “elastic” space. The acknowledgement of the elastic component of their demand will add a new dynamic to space planning and lease negotiations, and ultimately create downward pressure on rents.
Copyright © 2020, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.
CBIZ Gibraltar Real Estate Services is a national, conflict-free tenant advisory team providing lease negotiation and workplace solutions for a range of companies. CBIZ Gibraltar Real Estate Services is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).