High-Tech Companies Absorbing Space, but Will It Be Short Term?

Fast-growing technology companies looking for big blocks of space to rent are rewriting the commercial real estate leasing rules in Southern California--literally.

So-called dot-com companies are looking for office and industrial space in huge chunks, often several hundred thousand feet at a time, in one of the most sustained flurries of big leases in Southern California since the heady days of the late 1980s.

But the technology-space race raises thorny issues for building owners and their high-tech tenants alike.

On one hand, landlords enthusiastically welcome such high demand from businesses. But they’re also nervous about the stability of dot-com tenants, many of whom face uncertain financial futures despite having barrels of venture capital or cash from public offerings on hand.

Landlords like to be assured that tenants are going to be around for the typical five- or 10-year lease because building owners bear heavy upfront costs for broker commissions and customizing space according to tenants’ needs--known as “tenant improvements”--which the landlords expect to recoup over the term of the lease.

Technology companies, meanwhile, often need to expand quickly into larger quarters, so they want assurances that the landlord will be able to provide the space or will release them from long-term obligations.

The upshot of the dot-com phenomenon is that leases today include provisions rarely invoked in the past or, in some cases, all-new clauses designed to accommodate technology tenants while providing safeguards for landlords.

“The dot-com companies are like other tenants in that they want to lock in a five- or 10-year lease, but they also want cancellation options, plus the right to expand,” said John Parker, a partner at Aliso Viejo-based Parker Partners, the developer and manager of a new 70-acre office campus called Summit in Aliso Viejo, which was designed with high-growth, high-tech companies in mind.

In exchange for taking the greater risk of leasing to start-up companies and allowing the tenants greater flexibility in their leases, Parker said, landlords often require tenants to post letters of credit or lease bonds, or to make other special financial arrangements.

High-tech companies fill much of the 177,000-square-foot first phase of Parker’s 1.7-million-square-foot Summit project, which will eventually include 17 buildings of three to six stories, said Aaron Weiner, another Parker partner.

Weiner said the first phase at Summit, completed last year, is 100% leased. Costa Mesa-based QLogic Corp. has agreed to lease all 210,000 square feet in one of the two other phases now under construction, and Buy.com has signed up for 82,000 of the 320,000 square feet in the other portion of the project that’s underway.

Weiner noted that Buy.com took 53,000 square feet in July but has since expanded. Another company, NowDocs.com, is in 1,700 square feet at Phase I of Summit but is expanding into 7,500 square feet of the project’s second phase, he said.

“These tenants come to us with plenty of capital, but the question is, what are their long-term prospects?” Weiner said.

Landlords are asking technology tenants for letters of credit rather than the more traditional cash security deposits because letters of credit aren’t tied up in court if a tenant goes bankrupt, explained real estate attorney Paul Rutter of Gilchrist & Rutter in Santa Monica.

Rutter said leases generally provide that the letter of credit will reimburse the landlord for broker commissions and tenant improvement expenses, plus interest and a penalty, if the tenant leaves before the end of the lease. The letters of credit are designed to decline in value over the term of the lease because it’s assumed that, as long as the tenant stays in the space and is paying rent, the landlord is gradually recovering commissions and tenant-improvement costs.

In past business booms, the question of tenants’ financial stability had been less of an issue because the big lessees have been what the industry calls “good credit tenants”--companies with solid balance sheets and earnings histories.

“If these technology companies succeed, they will become credit tenants in the future, but for now, it’s hard for landlords to know how to underwrite them,” Rutter said.

Burgeoning technology companies have created a growth industry for companies selling lease bonds, according to Dennis Ellman, partner in charge of the real estate practice for Greenburg, Glusker Fields Claman & Machtinger in Los Angeles. A lease bond provides a landlord with essentially the same safeguards as a letter of credit, except that the tenant buys the bond from a bonding company as opposed to posting collateral with a bank for a letter of credit, Ellman explained.

Ellman said the current quest of online retailer EToys for bigger quarters illustrates the mushrooming demand for office space by Internet companies.

Ellman represented the owners of the new, 192,000-square-foot Arboretum Gateway project in Santa Monica, a joint venture of New York’s Apollo Real Estate Advisors and Pacifica Holding Co. of Denver, during months of negotiations until Universal Music recently signed a lease for the entire building.

Several times during negotiations, Ellman said, EToys offered to lease the building if Arboretum Gateway and Universal couldn’t strike a deal. EToys is looking for more than 300,000 square feet of space, according to Matthew Miller, a Cresa Partners broker who represents the Santa Monica-based company.

Online retailers and other dot-com firms have supplanted the entertainment industry as the leading source of growth in the Westside office markets, according to Vince Pellerito, a broker with Cushman Realty Corp. Technology companies now account for about 80% of the space in leases he negotiates for new tenants coming into Westside markets.

“Entertainment has slowed down, but the dot-com companies, the companies that serve them, and other types of technology companies have made up for it,” Pellerito said. Other technology firms clamoring for space on the Westside include software developers, World Wide Web site developers, and companies providing content for Web sites, he said.

“Credit-worthiness is the No. 1 concern of landlords with these companies, but the landlords are being more open-minded than they might have been in the past,” Pellerito said. “Five years ago, if potential tenants didn’t have a balance sheet, landlords would laugh at them.”

An emerging trend, Pellerito said, is for some landlords to share the risks and rewards with Internet firms by offering to accept an equity share in the tenant’s business in lieu of rent or in lieu of a letter of credit or a lease bond.

One reason that building owners can insist on stern safeguards from the dot-com tenants is that the steadfast Southern California and national economies continue to boost demand for office and industrial space, a situation that favors landlords over tenants, industry sources say.

In short, conditions allow landlords in many markets to be choosy about their tenants.

San Francisco-based Krausz Cos. turned down a lease proposal from an online company that wanted to rent 20,000 square feet in a Phoenix office building owned by Krausz because “I wasn’t convinced the [prospective] tenant’s business plan was viable,” said Jay Krigsman, a Santa Ana-based vice president for Krausz.

The dot-com firms constitute one of a number of categories of technology companies responsible for dramatic changes in the world of office-space leasing.

Telecommunications companies have single-handedly revived a number of downtown Los Angeles office buildings that had languished vacant or nearly empty for years.

Such companies, which rent office space to fill it with switching equipment, now occupy all but about 7,000 of the 241,000 square feet of space at 800 Hope St., said Rob Beguelin, a partner in building owner 1-800-Hope.

Beguelin said some Internet-related businesses are now taking space in downtown buildings too, fueling hopes that downtown L.A. might someday prove as popular with dot-com tenants as it has with telecommunication companies.

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Here Come the ‘Dot-Coms’

Internet and telecommunications companies accounted for more office leasing in downtown Los Angeles during the third quarter than any other industry category.

Internet / telecommunications: 112,400 square feet, 39.3%

Miscellaneous: 52,400, 18.3

Law firms: 40,040, 14.2

Financial services companies: 24,000, 8.4

Insurance companies: 21,200, 7,4

Real estate companies: 20,400, 7.1

Not-for-profit firms: 15,200, 5.3

Note: Figures are for leases of 10,000 square feet or more, which accounted for 286,000 of the total 400,000 square feet of downtown L.A. office leasing during the third quarter. The remaining 114,000 square feet was in leases of less than 10,000 square feet, which were not categorized according to industry.

Source: Grubb & Ellis