Landlords, property managers: Beware of the ‘flip factor’

Open-plan spaces can be converted by landlords into conventional office space and back again in as few as five years. Photo by Ron Johnson Photography.
Tia Jenkins

Tia Jenkins Principal/architect, Kieding, Denver

Many property managers are discovering that closing up an open-office floor plan after a tenant vacates the property can be challenging, especially if the original build-out was for a more traditional company. Open-plan characteristics can vary widely, but most consist of 12-foot ceilings (or higher); exposed ductwork; perimeter windows, if available; very low or no walls; and concrete slab or other hard-surface flooring. Throw in sprinkler realignment, suspended lighting, and a general aesthetic cleanup of excess wiring, old paint, dust and dirt, and the open plan bears virtually no resemblance to the standard office grid, which still is favored by the vast majority of today’s tenants.

If an open-plan tenant moves into a new building, the landlord has the significant benefit of building out that space for the first time. Once that tenant’s lease is up, the manager essentially has two choices: leave the space as is and market its existing assets to a similar open-plan tenant, or flip it back to its original condition and market it as standard office space. The latter obviously requires “closing up” that space.

That’s the typical approach in a new building. It’s another story altogether if the landlord leases space to an open-plan tenant in an existing building. In that case, the landlord must rip out what usually are perfectly fine finish materials to satisfy open-plan requirements, and potentially build the space back out as a standard office five years later when the tenant’s lease runs out. Older buildings pose even more challenges to this method, especially when managers are not exactly sure what lies above grid or when accurate documentation may be lacking.

Confusing? It certainly can be. Why would a landlord even consider such an extreme demolition-to-build-out cycle after such a short lease term? And who pays for it all? The answer is in the market. In fact, it’s always in the market.

Managers need to fill their buildings. Period. In order to accomplish this, they must be prepared to compete, which means appealing not only to the majority of tenant types, but also to those who represent a trend or, certainly, a paradigm shift in which the American office market still finds itself. That is not to say that the open-plan office is a new movement. It’s not. In fact, open-plan offices have been around for decades, evolving and adapting to technology and cultural demands. But the fairly recent rise in millennial office workers is largely responsible for the sharp incline in open-plan offices.

Consequently, managers are prepared to take more risks when handing out tenant improvement dollars for these types of build-outs. It may serve this type of tenant to opt for a longer lease term, which is what the manager would obviously prefer, but that doesn’t always happen. So managers have to be prepared for the possibility of flipping a standard office suite into an open-plan layout and back again within a five-year span.

This is very good news to the construction industry, at least for those companies specializing in tenant finish. Indeed, tenant improvement projects nationwide have jumped a significant 14.2 percent since the second quarter of 2013, according to a feature last year in World Property Journal. The article noted that “this is especially prevalent in office markets that are saturated with new construction and renovation.” That pretty well sums up metro Denver as managers continue to pay a higher tenant improvement dollar for customized open-plan space. And it’s not cheap.

It costs approximately $20 per square foot to convert a 10,000-sf office suite with standard grid into what most of us would term an open-plan space. Call it “industrial” or an “urban loft” or something else, but the construction component includes removing all of the ceiling grid, lights, the heating, ventilating and air conditioning unit and whatever else may happen to show up that wasn’t planned. Mechanical trunk lines must be removed, sprinklers must be turned upward, and all lighting must be suspended. Sometimes the floor is stripped down to concrete, which must be leveled, repaired and sealed. There are engineering and architectural soft costs all along the process, and sometimes those fees can be significant.

Returning that same suite back to its pre-open-plan layout costs another $10 per sf in construction alone. While it seems like a waste of time, money and materials to flip tenant spaces back and forth within a fairly tight time frame, managers are accustomed to doing it. It’s the cost of doing business and a risk that must be measured case by case. And every detail must be spelled out clearly to all parties in a marketplace as competitive as Denver. While that might seem like ridiculously oversimplified advice, it is not.

It is not uncommon for even the sharpest property manager to miss something unseemly above grid, for example. It happens, especially when deals are done at breakneck speeds. One open-plan tenant found itself with a sweeping lead shield in the plenum to protect occupants from x-rays performed in the medical office above. Another had to deal with hot-water heaters nestled in the ceiling corner for a tenant’s kitchen on the second floor.

Some landlords include a clause in the lease that calls for the tenant to return the space to building standard condition upon departure to account for the “flip factor” associated with open-plan conversions.

The point is, the property managers can negotiate virtually anything into the lease or the work letter. So can the tenant. Managers already are paying top dollar for open-plan tenants. In this market, they should take extra care in protecting their assets, especially when such rapid change is the new normal.

Featured in the CREJ’s Property Management Quarterly January 6, 2016, issue.

Edited by the Colorado Real Estate Journal staff.