Cautious Optimism Tempered by Increasing Tenant Improvement Costs
Office investors remain optimistic about the market, but a recent RCM sentiment report shows that tenant improvement costs are raising concerns, especially in markets with lower rents.
In identifying the greatest challenges facing the office market, nearly two thirds of participants (62.2 percent) in the Office Investor Sentiment Report by Real Capital Markets (RCM) identified the increasing cost of tenant improvements as the most significant operational concern they have in the market. The only other concern identified by more than 50 percent of the participants was the ongoing trend of tenants taking less space, selected by just over half (52.2 percent).
Those primary concerns are justified, based on reports that tenant improvement costs generally are escalating faster than rental rates. According to a report earlier this year by JLL, tenant improvement costs are increasing at an annualized rate of approximately 13 percent. And, according to a recent CBRE report, rents in the top markets across the world are growing, but only at a nominal rate.
As part of RCM’s Office Sentiment Report (insert link), Steve Pumper of Transwestern, noted that the cost of tenant improvements over the last two years has “skyrocketed” – from $60-80 per square foot 10 years ago to closer to $110 per square foot today. Even more modest improvements have jumped from $40 per square foot to $75 per square foot.
The primary forces behind this shift include:
- Skyrocketing labor costs account for nearly half of TI costs. This is due in large part to a shortage of qualified labor. With so much development, and tenant improvements, taking place, there is a smaller pool to draw from—regardless whether the city is Chicago, Los Angeles, Austin, Atlanta or Denver. Supply and demand forces are driving project costs up and extending the timeline for completed assignments.
- Material costs too are impacted by supply and demand. Prices for certain materials are being driven up further by the uncertainty of tariffs and trade wars. While increases in TI costs may be offset by more open and collaborative space plans, it may not always be enough to overcome the increases in material costs.
- The cost paid for the benefits of technology. We live in a rapidly-evolving world of technological advances. These advances often result in increased requirements for tenant spaces and systems, which may also come with a hefty price tag.
Investors are focused on tenant improvement costs due to the correlation between TI costs and rents, and the disparity in which rents are increasing to help offset those costs. That disparity is perhaps most noticeable in secondary and tertiary markets where rent growth simply cannot keep pace with TI costs.
One interesting misnomer is the idea that the difference in TI costs in secondary and tertiary markets versus primary markets will be similar to the difference seen in rental rates. Though there are some differences, the costs of labor, materials and technology, buoyed by constant demand, are fairly consistent across the U.S. The shortage of labor is widespread. The demand for materials, and the impact/uncertainty of tariffs and trade labor shortages knows no boundaries. Furthermore, the technological requirements of tenants and users are only increasing.
In an environment that isn’t likely to change in the near term, investors are scrutinizing these costs more than ever, and being very critical of them when underwriting potential acquisitions. According to Paul Noland with L&B Realty, there are markets where investors may never recoup the capital allocated/spent on commissions and TIs.
At this stage in the cycle, it appears to be one of the costs of doing business.