Every business decision, or personal decision for that matter, comes down to costs versus benefits. We all make this calculation, wittingly or not, hundreds of times a day. Usually, the decision is relatively straightforward. A coffee’s bold flavors and caffeine buzz is more of a benefit than its two-dollar cost. The problem is, defining costs and benefits becomes increasingly difficult over longer time horizons. The reason: risk.
What might cost relatively little now might see its price skyrocket as situations change. The two-dollar coffee purchase might no longer be appealing if it spills on your white shirt before you get a chance to drink it. Taking all future risks into consideration before making a choice is a complex undertaking, but becomes more necessary the more important the decision becomes.
An office lease can be one of the most expensive line items on a company’s P&L. It can also legally bind a company into an expensive rental agreement for ten years, a relatively long period in the fast-paced business world.
In the past, the size of an office space was dictated by the company itself. Generally, prospective tenants will forecast their growth needs and hire a broker to find the best-suited and most fairly priced space. While there is nothing wrong with this approach, it is prone to a be overly optimistic. People inside the organization tend to view their future growth as a certainty. Now, with the help of advanced computer modeling, CBRE brokers are able to weigh in on their client’s needs. The initiative aims to bring all the situational factors into the decision-making process and more expertly plan for uncertainty.
The first step in this process is realizing how uncertain the future is. “Instead of designing a solution for the ‘most likely’ outcome we focus on the range of things that can happen and define the bounds of that uncertainty,” said Christelle Bron, senior managing director of CBRE’s integrated transaction solutions practice. “Our analytics runs through tens of thousands of scenarios where the company is growing and contracting. Then, we test all possible lease solutions against those scenarios and determine which one performs the best.”
Brokers and their clients know that flexibility is valuable, but these tests can precisely define its costs and benefits. “The objective is to save money. We try to advise to get less space and build in some flexibility upward and downward,” Bron added. By putting risk into quantifiable metrics, CBRE’s predictive analytics gives its clients a clearer understanding of the costs and benefits.
She equated this to the insurance industry. Most of us have a health insurance policy because we have determined that the monthly cost is worth the benefit of compensation in case of injury or illness. Bron said that, much like insurance calculations, the predictive lease analysis favors loss prevention when things go wrong and cost reduction when things are going well. She used an analogy to point out how much can be at stake, “In 2008, financial service companies in New York City carried vacancies of around 25-35% for as long as 5 years. There was nothing in the lease that allowed them out and the market wasn’t strong enough to find sublessor.”
“In 2008, financial service companies in New York City carried vacancies of around 25-35% for as long as 5 years. There was nothing in the lease that allowed them out and the market wasn’t strong enough to find sublessor.”
Flexible space comes at a premium. Co-working spaces absorb vacancy risk and require larger margins for their increased exposure. But, paying a premium for a few extra desks at a co-working site when a company is expanding (and presumably flush with capital) is less of a burden than being stuck with unneeded space when times are tough.
I naively proposed another solution. Why don’t companies just push for shorter lease terms? Landlords have various reason for not wanting this including increased vacancy risk and financing concerns. The tenants also have reasons to desire longer leases. The Generally Accepted Accounting Principle that companies use for amortizing their office expenses only lets companies depreciate office costs for the length of the lease. As companies have become more willing to put big money into creating productive spaces, office buildout has become increasingly expensive. Having to amortize all those expenses over a shorter period of time is financially burdensome for a business unit and weigh-in heavily in the decision of making longer term commitments.
The insights that CBRE has uncovered could very well change the nature of the entire office leasing landscape. If the tenants decide to take smaller leases and rely more heavily on co-working spaces when extra flexibility is needed we might start seeing a shift in the way office buildings are laid out. The money that goes towards the flexibility premium is a net loss for a building owner without any co-working options. We might start seeing more office buildings with a few designated floors for their tenants’ flexible space needs.
Also, brokers now have an additional tool to assist clients in making this important decision. Here we see a great example where technology and innovation are helping the brokers add to their value proposition. The remaining hurdle is explaining to the customer how this new technique can be beneficial to their decision making process and hopefully their bottom line.
The advances in computing and data science have only begun to impact commercial real estate. Being able to use large data sets and calculate outcomes of nearly infinite scenarios will help us better predict the future. This should lead to greater efficiency when utilizing resources. When the resource in question is space, CBRE’s algorithms predict that less is more, even if it means having to pay extra for flexibility when needed.