Spec Office Suites In A Modern Market: Viable Business Model or Band-aid Solution?

The office market is cyclical. Vacancy rates fluctuate and can vary significantly between markets.?

Traditionally, when vacancy rates are low, building owners offer traditional leases with extended terms, high rents, short free-rent periods, and tenant improvement allowances that don't do much to reduce the cost their tenants need to invest in improving their spaces.?

But in more challenging lease environments, many building owners take on the burden of improving that space to attract long-term tenants—in most cases, fitting out space before securing a tenant.?

These fully built-out units became popularized as "spec suites." Short for Speculative Suites.

In the aftermath of prolonged pandemic lockdowns, many companies have adopted collaboration technology, changing how they use the workspace. Hybrid, distributed work and work-from-anywhere initiatives are being rolled out at most office space occupiers, from fortune 500 companies to SMBs.?

This trend begs the question of whether spec suites are still a viable and valuable option—or whether building owners are better served to explore other, more innovative opportunities.?

In this article, we'll unpack today's companies' needs and explore whether building owners should do more than offer spec suites to attract and retain tenants.?

Why Tenants Are Vacating Their Long-Term Leases?

In many major markets across North America, building owners with less than AAA office buildings (and even some with AAA buildings) have been experiencing a mass exodus from their locations.?

The catalyst for these increased vacancy rates is a perfect storm of

? High inflation rates

? Rising construction costs

? The increased cost of capital?

? Decreased product utilization?

All these factors create significant headwinds for building owners looking to secure traditional long-term leases.?

What Companies Want From Their Offices In A Post-Pandemic World

When you dive into the data, market signals indicate that decision-makers in companies across North America want:

? Built space that doesn't draw on the company's capital

? Flexible lease commitments

? Quick transaction timelines to meet real-time needs

? Onsite staff to help them run the office efficiently, allowing them to focus on their core business

? A hospitality partner with proven solutions attracts teams back to the office, solving for productivity gains, relationship strengthening, and improved health/wellbeing.

It's no wonder building owners have been moving towards spec suites. On the surface, they look like an innovative solution to meet some of these changing customer demands.

So, these owners are signing leases on fully furnished spec suites in a challenging market. Problem solved, right? Well, as they say, the devil is in the details.??

The Viability of Spec Suites as a Long-Term Strategy for Building Owners?

There are three big questions to ask when looking to spec suites as a solution in today's office leasing environment.?Do they serve the tenants, building owners or the market??Let’s unpack these three questions in more detail.??

Question 1. Are spec suites viable long-term strategies to meet the needs of a post-pandemic tenant??

Historically, spec suites were deployed to attract long-term tenants as they removed the cost, time and risk associated with fitting out office space.??

But there's a disconnect at work: today, the tenants attracted to spec suites are not interested in signing long-term leases.?

Instead, they want flexibility—that's why they're choosing a spec suite—and building owners are currently complying with one or two-year terms; in fact, many of the spec suite programs in the market today have the name "flex" in the title.??

A recent survey of enterprise customers showcased at CoreNet's Chicago conference indicates that over the next five years:

? On the low end, 25% of respondents would convert between 20% and 30% of their traditional leased portfolio to flex space

? On the high end, 7.5% of respondents would convert more than 50% of their portfolio to flex

So, the notion that a tenancy with long-term sight lines will be attracted to a short-term, generic space to "try before you buy" is an improbable outcome.

Question 2. Do these deals pass the underwriting "sniff test?"

Equipped with a high-level understanding of the what, why, and how of spec suites, it's essential to dive a bit deeper into the mechanics of this offering and compare those to traditional leasing.

Here's how they differ:?

? Traditional lease structure: In a conventional lease scenario, a building owner will provide a tenant with a TIA that they amortize over the lease term and add to the rent charged.?

? Spec suite structure: With a spec suite, a building owner will spend between two to four times the market TIA to fit out and, sometimes, furnish the space. In response to tenant demand, building owners offer these spaces on "flexible" terms, as short as one to two years.???

When considering the answers to these questions, logic dictates that these spaces should attract a significant premium.?

But in a soft leasing market, the challenge is that spec suites compete directly against "cheap" subleases.?

The spec suite strategy is familiar, and it's easy to replicate. So, we're already seeing more building owners jumping in, flooding the market with spec suites, slightly improving on the current inventory, and dropping prices to attract customers.?

Ultimately, spec suites are easily copied and commoditized, and building owners should consider the risks and costs of selling and operating this business model.??

Yes, a spec suite will get leased (for a short term). And, on the surface, this may look like success. But buying customers with an unsustainable pricing model is like picking up pennies in front of a freight train.????

The challenge is that spec suites cost significantly more to build, lease and operate than a traditional triple net 10-year lease. Additional costs include:

? Higher commission rates to attract brokers as they don't get paid enough on short-term deals (in Canada, we are seeing rates as high as $5.00 per square foot being paid to move these spec suites on one-year terms)

? Repair and maintenance costs to bring the suite back to leasable standard at the end of the term

? Higher staffing costs to manage build-outs, operations, and short-term leasing cycles

? Leasing downtime to clean up the suite and find new tenants every one to two years

? Additional capital in the event the space becomes obsolete over the investment horizon

? Increased financing costs

When considering the answers to these questions, logic dictates that these spaces should attract a significant premium.?

But in a soft leasing market, the challenge is that spec suites compete directly against "cheap" subleases.?

The spec suite strategy is familiar, and it's easy to replicate. So, we're already seeing more building owners jumping in, flooding the market with spec suites, slightly improving on the current inventory, and dropping prices to attract customers.?

Ultimately, spec suites are easily copied and commoditized, and building owners should consider the risks and costs of selling and operating this business model.??

Yes, a spec suite will get leased (for a short term). And, on the surface, this may look like success. But buying customers with an unsustainable pricing model is like picking up pennies in front of a freight train.??

Question 3. What the Rise of Spec Suites Means for the Office Leasing Industry in the Long Term ??

From a pricing perspective, spec suites are nearly indistinguishable from a "cheap" sublease; therefore, there's a price ceiling that doesn't allow the building owner to achieve a reasonable return on the upfront cost to build-out and manage the space.??

In addition, most customers attracted to spec suites are driven by price. All things being equal, they would choose a serviced option. These customers tend to be less sticky as they will move to the next new space at the end of their short term, especially if the alternatives are offered at a lower price.?

Traditional spec suites also suffer from a product mix challenge. In most cases, they're not complemented by alternative suites that will meet the tenant's needs as they grow or contract. This factor lowers the probability of renewal at the end of the short-term lease.??

As spec suites flood the market, building owners will experience longer downtimes between leases, higher costs to re-lease the space, and further price compression.

So, what does this all mean???

Inundating the market with furnished spec suites on short terms at rental rates which do not factor upfront or ongoing costs, contributes to a race to the bottom on pricing.?

It creates an expectation from the tenants, which is financially unsustainable.??

This business strategy will ultimately drive down asset values as lenders and investors realize that "effective net rents" are a fraction of the face rates being reported.??

If not spec suites, what should building owners do to attract and retain tenants over the long term?

The facts are clear: spec suites are a band-aid solution to a bigger problem. And some savvy, progressive building owners are zooming out the camera to look for more financially sustainable solutions.?

Those building owners are looking at what their customers want and building out a full-stack solution to attract and meet the needs of the broadest range of tenants, which includes:

? Activation of building amenities with service initiatives?

? Offering event and conference spaces, flexible office space offerings, and flexible and serviced self-contained units (priced appropriately)?

? And yes. Long-term leases optimized by the amenities referenced above

This approach creates a robust product offering driven by a serviced ecosystem to attract and retain customers and tenants on a sustained basis. We refer to this as a "full stack " solution.

How are building owners implementing a Full Stack solution in their buildings??

Building out a full-stack solution that aligns with the demands of modern businesses is a massive undertaking.

Many progressive building owners are partnering with flexible workspace operators who understand what it takes to meet the needs of a much more diverse and sophisticated customer base with high expectations for service and quality.?

The structures of building owner-operator partnerships are varied as the needs of both parties can be unique.?

But with that being said, in most cases, the expectation is that the building owner will:?

? Achieve "market rent."?

? Garner a return on the TIA above a standard lease?

? Participate in profit

? Gain insights into the needs of their customer

? Realize predictable and sustained income over the long term.

Each building and situation can be different, but the point is that flexible workspace operators understand how to run a profitable operation after paying (or "truing up" to) a market rent.?

In many cases, there is an opportunity for building owners to outsize their returns by leveraging the expertise of an operator with a track record of success and profitable operations.??

As we witness the accelerated impacts of remote work in the wake of the pandemic and the mismatch of supply and demand within the office sectors, it's never been so important to think about flexible office space as a lease-up and retention strategy for assets.

And it's equally important to consider the cost of inaction—the opportunity cost of owning a building which is under-amenitized, under-serviced, and under-priced.

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Choosing a path forward

With all these factors considered, building owners have a few choices

1. Continue to get that "high" from leasing spec suites, kick the financial can down the road, and hope customer preference turns back toward long-term leasing.?

2. Build the capabilities required to construct and service a robust mix of serviced office offerings (possible but challenging).

3. Partner with best-in-class flex operators and start looking at the assets holistically to iterate on the 'full stack' building concept and a network of on-demand workspaces across their broader portfolio.

The first option is like choosing not to go to the dentist. It might be fine in the short term, but eventually, it catches up with you.

The second option is like Michael Jordan's choice to play professional baseball. Unfortunately, being an exceptional building owner doesn't necessarily translate to being an excellent serviced office provider. They are two very different business models involving additional infrastructure, stakeholders, and performance metrics.???

And the third option is like choosing a surgeon to fix a long-term injury. It's a big decision; you should research and ensure you're getting the best person to do the work. Ultimately aligning with a professional operator with a track record, infrastructure, and core focus on serviced office offerings will likely provide a significant competitive advantage over a DIY solution.??

Which option would you choose?

Co-authored by: Dave Cairns & Kane Willmott