Understanding Occupancy Cost Growth

occupancy cost, CRE, commercial real estate By global standards, office space in the United States is relatively affordable. One survey placed America's most expensive market -- Midtown Manhattan -- at number 11, behind Moscow, London, Paris and an assortment of Asian cities. The next most expensive market -- downtown San Francisco -- was number 15.

However, there is more to the occupancy cost growth story than just the absolute ranking. America's world-class markets might not be the world's most expensive, but that could change relatively soon. Occupancy costs are growing faster in some American markets than in any of the others around the world.

As we come out of the recession, office completions remain well below historic peak levels. Many markets, including Atlanta, Chicago and Seattle are all seeing vacancy rates drop. As occupancy tightens, landlords are free to increase rents at a faster rate than that which would be justified by inflation alone. As an example, in one quarter, rents went up 3.7 percent in San Francisco and 3.5 percent in Houston.

The underlying causes of these occupancy cost escalations go deeper than just a shortage of development, though. The American economy remains extremely strong in certain sectors and real estate that serves those sectors is where the largest cost increases can be found. Markets like Houston have high rates of increased cost because they are driven by the expanding energy industry. Other high-growth markets are driven by such areas of business as high-technology and aerospace.

Another large trend is driving occupancy cost increases in certain high-desirability markets -- the flight towards quality. Coming out of the recession, companies across the globe have decided to cluster their operations where other companies do. That way, the decision making process becomes safer. However, this also concentrates demand in a limited number of markets, further exacerbating the occupancy cost increase challenge.

Managing Increased Occupancy Cost Metrics

Just because some markets are having rapid cost increases doesn't necessarily have to mean that your company has to budget for rapidly growing rents, CAMs and other real estate expenses. Here are three strategies that may help to insulate you:

Go where others don't. Even if you are a high-tech company, you don't have to be in San Francisco. Whether you choose to take advantage of lower Manhattan's "Silicon Alley" or the highly educated work forces located in mid-sized low-cost Midwestern cities, you have options that go beyond the obvious and usual suspects.
Sign long-term leases. Locking in a rent for the long term can protect you from occupancy cost growth. Given that the development community is still relatively slow to add new office stock to the economy, the current environment of high cost increase rates is likely to remain for at least the near term. Long-term leases position you to ride out the current market and let you wait for new space to be developed and to alleviate the shortages.
Tie increases to the CPI. If you have to sign an agreement with increases, try to tie them to inflation metrics like the Consumer Price Index. Given that inflation is running at a much lower rate than occupancy cost increases, tying to CPI could leave you looking at 3 percent annual cost growth instead of 3 percent per quarter.