BBJ Table of Experts: The Future of Commercial Real Estate Featuring Kevin Keane

The Baltimore Business Journal recently hosted a panel discussion with a team of experts to discuss effective strategies for small businesses. The expert panel included: John Hermann, vice president of asset management/leasing, Corporate Office Properties Trust; Krysta Herring, director of asset management/leasing, Corporate Office Properties Trust; Kevin Keane, senior vice president of office leasing, David S. Brown; and Matthew Mullen, senior vice president/chief lending officer, Chesapeake Bank of Maryland.

Their discussion has been edited for length and clarity. You can read more of this discussion inside the print edition of the Baltimore Business Journal.

How would you describe the current state of commercial real estate in Greater Baltimore both from overall investment to leasing?

Kevin: When you talk about the “commercial real estate market in Greater Baltimore”, you are talking about numerous different asset classes and numerous sub-markets throughout Greater Baltimore. Overall, most commercial assets have benefitted from the unprecedented general economic expansion of the last decade. Within our office leasing portfolio, this year is significantly ahead of last year in terms of the number of leases being signed and the total value of those leases. We are seeing rental rate increases and our occupancy is level.

Rental rates have been growing slowly. Even though we are doing more deals with more square footage leased in the transactions, our occupancy is staying mostly flat because some of the larger corporate tenants are continuing to “right size” and “densify” when their lease terms renew.

John: In the big picture, we have a very strong economy in this region. Similar to the broader U.S. economy, Maryland unemployment has been below 4% for the past 12 consecutive months and many companies continue to hire. Interest rates are low and this helps the value of commercial real estate. There is a lot of inexpensive capital and many investors are interested in owning real estate. Overall, we are enjoying a good economy.

Krysta: If I could add to that, as a company, COPT had a record second quarter in leasing volume – approximately 1.6 million square feet.

It was a strong quarter for us on almost every metric. A large segment of the tenancy in our portfolio is government contractors. Among that community, there is a lot more confidence in the future business outlook regarding government spending. It feels like the spickets are back on and it is impacting the need for office space. There is a bullish attitude among tenants as they renew their leases. They are keeping space and proactively securing it in anticipation of near-term contract procurement.

Matthew: The ground up cost of construction is very expensive. If you can have existing space, chances are you can renovate those spaces and keep you costs lower. Those lower costs could make the difference in how aggressive you can price your space and ultimately effect demand.

Matthew, what is the appetite for financing commercial real estate deals?

Matthew: This year with interest rates going lower, there has been a greater appetite for financing. The competition from bank to bank, from large bank to community bank, life insurance companies and anyone that offers financing is extremely competitive. We are all looking to finance strong projects with low leverage and high levels of occupancy. If your project fits that criteria you will have a lot of banks to chose from.

Are there projects that are easier or more desirable to finance?

Matthew: For the last couple years, the multi-family or the apartment sector was a very hot area. There was not as much supply and there was a great amount of demand. The banks were doing a lot of multi-family financing. This has slowed some but is still very competitive for banks to provide that type of financing. With the low interest rate environment we are in today, we are seeing much tighter yields. But for us, we are better to fund a strong project with low risk and low yield, than a higher risk project with higher yields. The risk isn’t worth it. Regardless for the borrower, there is certainly a lot of buying power and competition for their business from the various lending institutions. It would be fair to say this is a “borrower’s” market.

What are the differences between traditional consumer/residential financing and commercial real estate financing?

Matthew: There are a lot of options. In general, when we look at commercial type transactions, we are looking at that project. What is occupancy level look like? What is the rent roll comprised of? How long are those leases in place? If it is an acquisition, we are looking to see that there is someone that has put money in this project and have skin in the game. For the most part, it is all about substantiating the ability to repay. It is different than residential where you go out and can get 100% financing. Those types of products do not normally happen on the commercial side.

It is also important to note that Banks live with these commercial loans forever. Your mortgages get sold in the secondary market. It is important to note that with commercial loans they are kept on the balance sheet for the length of the term of the promissory note. This is different from residential mortgages which are typically sold on the secondary market. The impact keeping those loans is that we have to regularly review those commercial loans for the risk. Its simply not just the risk of the transaction at origination but any forward looking risk that could occur.

How has what tenants look for in an office space changed over the past 2-3 years?

Krysta: Two to three years ago, the CFO was still in the driver’s seat when it came to decision making. There was an emphasis on controlling cost and controlling cost per employee. Now more than ever, it is the HR department. There are different metrics involved in evaluating office alternatives: What is the human experience when we get to the office? What are the amenities in the building? Is the overall experience accretive to the work-life of my employees? Some of it is intangible.

Kevin: There has been a shift toward a more employee-centric culture. For landlords who want to recruit and retain tenants who, in turn want to recruit and retain employees, you have got to add amenities. You need to find out what they want. There is more of a focus on work-life balance now. We never talked much about the “tenant experience” until the last few years. Now it is a focus.

Krysta: And the amenities race has evolved rapidly. It started with the fitness center in the basement. Check. Conference center in the toughest space to lease. Check. Now it is about creating a spa-like fitness center with towel service and spin rooms in the best space in the building. Rooftop conference centers and landscaped terraces with views. It is totally different, more human, and not a check-the-box process.

And now we’re taking it a step further. We’re focused on what happens in our amenity spaces. COPT has a full-time Community Manager on our team focusing on programing these spaces. We host pop-up happy hours, sushi making classes, yoga, wellness fairs, “Friendsgiving” events, you name it. At any point during the week our tenants can engage in something that is happening in these shared spaces and make a connection not just to the building but to the community. That is the whole package.

The open office spaces have been getting some pushback lately. What impact is this having on the way you design your spaces?

Kevin: Open versus private workspace has been back and forth over the years. Low cubicles with concrete floors and open ceilings were very cool and collaborative, but some of the noise issues, employee privacy issues and HIPAA issues were not fully anticipated. We have seen it swing back to a bit more traditional, but they still want open collaborative space. It is still very open, but we are seeing more huddle rooms. Overall, open workspace is still very prevalent, but it is evolving.

John: We build spaces for a wide variety of tenants across many industries. There is no one size fits all, but there are trends towards more cross-functional and less formal spaces for many tenants. We are designing and building both open space plans and office-intensive ones. We are seeing more multifunction design, which allows for space to be used for a boardroom, a war room and/or a game room.

We talked about right-sizing, but what other trends are you seeing in commercial office leasing overall?

Kevin: The emphasis in office leasing is increasingly more focused on design rather than saving the last twenty-five or fifty cents per square foot in rental rate. Employers are more concerned with how they are going to recruit and retain talented employees.

It is a balance. What some of the government contractors are putting into their spaces, we never would have seen five years ago. Landlords may provide generous tenant improvement allowances, but tenants are often spending multiples of that to make sure their workspace is appealing to the employees they are recruiting.

Matthew: I think rents have moved up. The increased costs that are included in some of the new amenities and designs would most likely be included in increased rents. Obviously there is a limit to those increases but it seems like today it is more important to take care of your employees and clients than worry about every last penny.

John: Design aesthetic has changed, such as the dark wood paneling has gone away and is replaced with bright colors or metallic. Leather furniture is out, fabrics and patterns are in. 2×4 ceiling tiles and grids are becoming less prevalent. You see a lot more clouds and floating ceilings.

Matthew, is the design of the space a good investment?

Matthew: Some of it can be. In terms of investments, the value of a property is generally a function of the income it is producing. You may have higher cost associated with it, but it is going to demand higher rents. Higher rents would most likely provide additional value and better investment. There is a limit for what the market will allow. The other portion to this is how quickly a property may lease up. Those extra amenities and designs may lease the property more quickly or have a higher occupancy rate which in turn provides a better investment.

How has coworking impacted office leasing?

Krysta: For decades there has been demand for small/individual office suites and short-term, flexible leases. Right now, highly-designed, highly-amenitized coworking models are capturing that demand. I do not see a lot of competition between that model and traditional office leases. They are very complimentary. We have even built a coworking, hybrid concept in our portfolio (“CIRQL”) that has been a great feeder for more traditional office suites. Tenants can occupy quickly with small teams, sign short-term leases, grow, then graduate to larger suites while making longer lease term commitments. It is an overall complement to our core business.

Matthew: The problem that I see with banks and this concept is the short-term nature of those leases. For example, let’s say some of that space is on a 1 year lease. Banks and Lenders will tell you that we normally match the structure of the loan to how the loan will be repaid. Structuring a loan for longer than one year if the property has a bunch of one year leases will be a challenge. In terms of financing that will be something that we will need some time and historical data to get more comfortable with the concept.

John: Coworking’s impact on the market has been positive up to this point. Although COPT’s portfolio has minimal exposure to coworking, the sector has absorbed a lot of space and helped to reduce vacancy in many markets. For the most part, we are not competing for the same tenants, so they are a positive influence on commercial real estate for now.

It certainly has been a boom for entrepreneurship. It really has been a boom for that five-person company that wants to have their own space.

Kevin: Absolutely. I think it has also pushed landlords. The amenity-rich environments that we are now creating are, at some level, a response to some of the coworking tenant experiences. It has pushed how we look at our tenant engagement.

We have never had a tenant engagement platform, now we are using social media and technology to make sure we are more in touch with all of our tenants.

Going back to the importance of amenities, John, what is your company’s philosophy when it comes to providing tenant amenities?

John: We have chosen to supply our buildings with a mix of amenities because they always lead to more robust tenant interest and enhance the tenant experience. This leads to higher rental rates, quicker lease up and better tenant retention. The underwriting is made easier, if you have enough critical mass and a sufficient amount of space over which to spread the costs. Often times, the lost rentable square footage can be recouped with a minimally higher building core factor. The viewpoint has changed over the last several years and now owners are looking for more ways to differentiate their properties and asking themselves, how nice can we make the amenity suite?

Kevin: Physical amenities and services are being added or upgraded at most office buildings, but it is still a relationship business. At David S. Brown, we are a family owned and operated company and we are members of the community. We know all our tenants and we strive to enhance those relationships by listening to them and providing the services and amenities they desire.

Matthew: How much can the amenities overcome a location? Can the amenities push somebody to change their ideal location?

Kevin: Office location is generally driven by existing employees or access to new employees. For several years there was a trend toward an urban focus, but millennials’ demographics are shifting. They are now having kids and many are moving to the suburbs to raise their families, so suburban office is starting to see a resurgence in demand.

What excites you the most about the future of Baltimore’s commercial real estate developments?

Matthew: It is interesting how the retail side has shifted to the industrial warehouse style of space. We are seeing some real shifts of these e-commerce type places where they need industrial space. I think it’s going to be really interesting to see how that landscape changes from your traditional retail to retail e-commerce, and where do those businesses go? What kind of space do they really need to be successful?

With the continued rise in e-commerce, big box stores continue to downsize and/or move away from malls. What does the future hold for shopping malls?

Kevin: Some examples are Owings Mills, which was de-malled and now is a strip shop area. The malls are most often in the best locations in the metro area. It could be the crown jewels. Interstates dump into malls, there is access to transportation and high-density residential areas surround malls. A mixed use, active environment, office, retail, hospitality, residential, all support each other. High density maximizes most of the value of that site. Security Square Mall is ripe for that.

In Bethesda and Chevy Chase, there are other malls that are doing great. The Towson mall is also thriving. I have read everything from Amazon’s last mile, taking space in malls and empty boxes. We have churches taking boxes.

Krysta: It seems like the trend is to go more outward and less inward. It’s moving toward blowing up the “box” and converting the space to an indoor/outdoor mixed-use destination.

John: I think about the malls we perceive to be successful and what they are today versus what they were 15-20 years ago. Shopping malls have turned inside-out with great outdoor spaces for food and beverage tenants or live entertainment. Many now have residential and office components as well as entertainment and fitness tenants such as theaters, bowling alleys and rock-climbing walls or yoga studios. Before you used to have to get in your car to go to the mall, now they are communities where people can live, work and play.

The cybersecurity industry continues to grow in this region. In your experience what are cyber tenants looking for from a landlord?

Krysta: Generally speaking, they are looking for a path to grow. The small to mid-sized cyber companies tend to value local scale, meaning they could initially lease a small suite, and work with their landlord to map a path to expand over time. They want to work with a trusted partner that can be nimble as their needs change.

Cybersecurity is such a competitive industry in terms of talent – there is a tremendous shortage, particularly for cleared talent. This puts a lot of pressure on these companies to offer competitive compensation packages and benefits to their employees as well as the perks that foster a fulfilling work-life. The workplace culture and cool-factor or “vibe” of the office space is so important – this of course includes access to amenities. Many of the companies focusing on government cyber, which are prolific in this region, are also cost-sensitive. So the challenge for landlords is meeting the criteria above at rental rate that enables these companies to compete for contracts at a competitive price point.

How big of a factor is parking? It is certainly a concern downtown. What are tenants looking for with regard to parking?

Kevin: Our office portfolio is predominately in the suburbs where ample free parking is typically a given. We see a growing importance of public transportation that supports a decreasing need for parking spaces, but that is countered by the trend toward more densely occupied offices.

John: It is all trade-offs. If a tenant or their employee must pay for parking, they want it to be safe, well lit, affordable and convenient. In an urban environment, parking is a real cost that impacts the employers or their employees. But I do not think it is as big a deal as you might think for people who are inclined to live or work downtown. Particularly among the younger workforce because many of them want to live in the city.

Kevin: When I show office space at Metro Centre in Owings Mills, I frequently share a photo I took with my mobile phone. One day I went up on the subway platform to take pictures of the project and two subway cars arrived about 10 minutes apart. From each subway car, a twenty-something guy, a millennial, stepped off the train in professional work clothes carrying a bicycle. They carried their bikes off the platform, out onto our project and rode off to work. These are the millennial workers living downtown and taking public transportation to work in the suburbs. We are seeing this more and more. Public transportation is increasingly important.

We talked about there being various sectors of commercial real estate. Matthew talk to us about which areas of CRE are the hottest.

Matthew: I think the industrial/warehouse space will be a big one now. Prior to the expansion of e-commerce, the warehouse/industrial space was used for just those types of businesses. Now retail businesses require an online platform to be successful. Those companies will require more and more warehouse space and potentially less traditional retail space. We received a lot of requests for multifamily, especially in the Greater Baltimore market and there is still a big demand. Right now, even though it is changing, millennials still like the idea of having leased space instead of having to purchase their own house. The multifamily sector has been hot for some time.

So industrial has been on this upward trajectory for a while now. How long is this hot trend going to last?

Matthew: I think it will continue to trend upwards. The e-commerce businesses will need this type of space. The issue will be how does this type of space work hand in hand with retail space. Traditionally warehouse/industrial space has not been in areas where retail would be located. Traditionally those spaces are leased at a much lower price per square foot. Where retail goes along side the industrial/warehouse trajectory will be something to watch.

While there is certainly a lot of new development, Baltimore has a lot of old office buildings.

John: That’s true, but many old office buildings have been removed from the inventory due to office-to-residential conversions over the last five or six years. This has strengthened office fundamentals in Baltimore, where we own three of the most recognizable office towers in the city’s skyline, all of which perform very well as office properties. In our Baltimore portfolio, we are focusing on renovations that build on our amenity base with the goal of activating our building lobbies and attracting tenants.

For example, at 250 West Pratt Street, we bought this highly leased asset in 2015, but it was built in the mid-1980s and it was due for a renovation, which we anchored around street-level retail opportunities.

The project was led by our very talented design and construction group. Outside of the building, we completely renovated the plaza in front of the property and created a friendly, pedestrian area that is more conducive to retail. We removed all the ground level dark reflective glass and replaced it with clear store front glass. We landed a deal with Starbucks and they opened a 2,500 square foot store in March of this year.

We completely renovated the lobby space, added a conference center and a fitness center overlooking Camden Yards. We are sourcing another restaurant opportunity for the ground floor. We have a beautiful restaurant shell with an opportunity for outdoor seating.

It is all about activating the lobby, creating a space where the tenants and their employees want to hang out. We built a beautiful 60-foot-wide video screen that has very artistic, local curated content.

Overall, a six million dollar investment was made in that project. We completed it earlier this year and certainly the level of activity is much more robust than it had been before we made our investment.

Kevin: We are seeing the same thing in the suburban office market. We are adding amenity spaces to common areas, community spaces in lobbies and both indoor and outdoor seating. The one repurpose project we did recently is 405 West Redwood downtown. We stripped the building down and replaced all the mechanical systems. It was an office building, but with the current market demands, we converted it to residential. Being right next to the University of Maryland Medical campus and because of all the student traffic, it is better suited as a rental apartment building.