Strategically Manage Occupancy Costs to Increase Law Firm Profitability

During the past decade, there has been a significant change in the way major real estate assets are owned. The recession of the early 1990s led to foreclosures by major lenders, who then sold much of their portfolios in bulk to well-capitalized, publicly traded real estate investment trusts. The most important consideration to these new owners is the stability of cash flow, and because replacing a tenant is often much more costly than retaining it, owners will frequently allow tenants to restructure their leases. By analyzing the public documents a REIT is required to file, a tenant can determine the weight that it carries within the REIT's portfolio and whether the owner can afford to incur the additional costs created by a vacancy.

Space Equals Leverage

The more office space a tenant occupies, the greater leverage it has. In the typical market, the average tenant occupies only 5000 to 10,000 square feet. To replace a law firm that occupies 80,000 square feet (about four average-size floors), the landlord will endure a substantial re-leasing period, during which it will not receive any rent. The landlord will probably have to foot a considerable bill for improvement costs for new tenants and cover the cost of converting the law firm space to multi-tenant premises. The re-leasing period could easily span 4 years 'and therefore depress the building's profitability.

A restructuring takes effect anywhere from 2 to 8 years in advance of a lease's scheduled expiration date and usually involves some combination of reduced rental rate; a landlord-funded improvement allowance; relinquishment of excess space; and reduction of credit enhancements, such as personal liability provisions or letters of credit, which provide the landlord with greater security in the event of a default. The savings can be as much as 30% ' even when market rents are rising.

Playing hardball with the landlord is not the only way to squeeze the most out of your occupancy costs. Scrutinizing the use of your current office space, to make sure it is as efficient as possible, can pay off too. The space needs of law firms have changed dramatically in the past 10 to 15 years. Many firms occupy 900 square feet or more per attorney when 700 would do just fine. The question for office administrators and managing partners is how to improve efficiency while maintaining an environment that sends the right message both to clients and employees.

A good first step is to evaluate the configuration of your office and determine whether it supports the firm's way of operating and is flexible enough to support changes. Here are some questions to ask: Should the firm limit higher levels of finish, such as mahogany walls and marble floors, to specific areas? Is the library properly sized? Has the ratio of secretarial stations to attorney offices decreased? Are the quantity and size of conference rooms in line with demand?

Pay attention to what the competition spends on occupancy. The large accounting and consulting firms favor the same top-quality downtown properties, at similar rates per square foot, that large law firms do. However, they spend less than law firms by “hoteling”: assigning two or more consultants to one office or cubicle and having them spend more time at clients' offices. Thus the accounting firms' space needs per professional are one-third to one-fifth the space needs of law firms, which occupy 700 to 1000 square feet per attorney and 275 to 325 square feet per staff person. This is not to say that law firms can or should adopt identical practices. Nevertheless, competition being what it is, this disparity has major bottom-line implications.

Efficient use of space does not always mean simply getting more people into less space. The challenge is to create efficiency without sacrificing performance. Possible solutions include eliminating multiple reception areas, moving conference and administrative functions to a lower (and often less expensive) floor, using upgraded fire stairwells to link contiguous floors of a firm, reducing the number of office sizes (though not necessarily the sizes of the offices) from three to two or even one, and using grouped secretarial stations. Many of these tactics not only reduce real estate costs, but also reduce staff expense.

Make Use of the Core

In many cases, the greatest efficiencies can be derived by relocating to a building with few columns and large rectangular floors. The configuration of these buildings allows for greater efficiency than that afforded by the angled buildings that went up in the 1980s. The rectangular configuration creates more core space for uses that may not require windows, such as certain offices, some conference rooms and the library. A thoughtfully designed space that makes use of the core will contribute much more to efficiency than will shrinking offices, which does not really reduce overall square footage per lawyer.

Consider the example of a firm that houses 200 lawyers in 200,000 square feet. A renewal might be offered at $50 per square foot, while the rate at a new building might be $53 per square foot. On a per-square-foot basis alone, a move would not make financial sense. But the new building's design and the firm's re-evaluation of its needs could reduce its space needs to 150,000 square feet. That translates into an annual savings of $950,000 ' more than $10 million over the course of a 10-year lease, once rent escalations are calculated. If the firm grows and requires more space during the term of the lease at the new building, the amount of savings increases more because less space will be needed to accommodate each additional attorney and associated support staffer.

Take the Lead

In many markets, large blocks of space in efficiently designed buildings are not available. In this circumstance, a build-to-suit arrangement may make sense. The law firm presents itself as the lead tenant to a developer that is seeking to begin a building but, because of the current financing environment, cannot proceed until anywhere from 30% to 70% of a proposed building is leased. Because of this creative approach, the developer is more likely to consider the law firm's needs as the building is being designed, ensuring that the firm's needs are addressed in the most efficient way. In addition to increasing the number of buildings that can be considered, this strategy can also reduce rental rates because an entrepreneurial developer will typically accept a lower return on investment (9% or 10%) than an institution, such as a pension fund or insurance company that may require 13% to 15%. That disparity can result in a savings of as much as $10 per square foot per year in rent.

By implementing these financial strategies, a new building can be less costly than staying put. If major renovations are required, a move could actually be less problematic than a renewal. Furthermore, because a tenant's goal is often to create several acceptable choices, this strategy not only makes the new building a viable option, but serves as added leverage in negotiating a renewal with the current landlord.

Sounds great, you say, but why would any developer in his right mind create inventory in a market that already has substantial vacancy? The answer is that developers make money developing new buildings. If they can secure a credit-worthy law firm as the lead tenant, there is a very good chance that such a building can come to fruition ' regardless of the challenges other owners are facing. For example, King & Spalding's commitment to lease two-thirds of a planned 30-story building in Atlanta led to the construction of a building that will be completed in early 2006 despite the fact that the vacancy rates in Atlanta's Peachtree corridor hover at 20%.

Regardless of how efficiently a firm uses its space or how low its rental rate may be, its lease should act like an accordion, allowing the firm to shrink or expand as its business plan and fortunes change. The legal industry has been experiencing tremendous volatility for several years, and all indications are that mergers and technological change ' the major factors affecting design changes ' will continue. It is critical for major law firms to secure flexibility throughout their lease terms.

If a landlord has vacant space, it will be more than happy to lease it to a current tenant. However, a firm's growth needs may not coincide with a vacancy in the building, so it is crucial to negotiate multiple expansion rights as part of a lease.

During the early stages of the planning process, the firm should project its annual personnel growth and accompanying space needs and negotiate to secure options for space. (These are guarantees from the landlord that specific floors will be available at agreed-upon dates ' ideally, on pre-negotiated terms.) Because growth does not always follow a predetermined schedule, the lease should include additional rights of first offer and first refusal, as well as the right to relocate other tenants elsewhere in the building. These rights not only allow for the firm to accommodate growth, they reduce costs, because the firm can add additional space only as it adds lawyers.

Too Much Space

While the financial health of a law firm generally is not threatened because of an inability to expand ' there will always be space somewhere for a good tenant ' the same cannot be said about firms with too much space.

Although lawyers are in the business of helping their clients avoid unnecessary risks, the absence of contraction rights in most law firm leases creates a major exposure to increased occupancy costs and the concomitant issues brought about by stresses on profits per partner. Excess space can be precipitated by a catastrophic event, such as the loss of a major client or the defection of top-producing lawyers, but it can also occur over time as a result of new technology, which allows the firm to reduce the size of its library or the number of secretaries.

The economic cost of excess space can be staggering. Suppose that a law firm's annual rent on a 75,000-square-foot space is $45 per square foot, or $3.375 million for a 100-attorney office. If the firm is on the wrong side of a merger and loses 25 attorneys, the effective annual cost of housing its lawyers rises from $33,750 per lawyer to $45,000. This vacant space costs the firm $843,750 per year ' and it could remain vacant indefinitely, particularly in a soft market. A contraction right gives the firm a guaranteed exit from such a situation, and if it is properly structured, it will not cost the law firm anything until it is exercised.

A landlord may claim that contraction rights are not consistent with the usual practice in a given market. Even if this is true, it is irrelevant. Law firms are now competing regionally and nationally, and the costs of carrying vacant space can easily erode or destroy profitability. Even if contraction rights are never exercised, they provide peace of mind. Educating a landlord about the needs of the firm and positioning this requirement carefully in the negotiation process can ensure that important rights are secured.

Law firms find themselves in an increasingly competitive economic environment. Their approach to handling their real estate requirements can enhance their profitability, even in a slow legal market. A real estate solution that respects the firm's culture while positioning it to benefit from the trends in the real estate industry will help ensure a productive and wealthy partnership for years to come.

Aside from payroll, real estate costs are a large law firm's most significant expense. Even under the best circumstances, such expenditures ' sometimes called occupancy costs ' consume 8% to 10% of the typical large firm's annual revenue. These costs are not confined to rent; many firms finance millions of dollars worth of expenses associated with the construction of their space.

The real estate market in most cities is described as weak, soft or just plain bad. Such adjectives describe a market in which rents are low and concessions are high. Though this is no doubt a bad situation for landlords, times are very good for tenants who have an opportunity to enhance profitability, remove unfavorable lease language and improve the quality and efficiency of their offices. This environment will not last forever – markets ebb and flow; at the beginning of the decade, most markets were quite tight and large blocks of space were especially difficult to come by. Regardless of market conditions, law firms that expect to maintain or even reduce their occupancy costs will need to adopt creative strategies. By paying special attention to financing, efficiency and flexibility, a firm can develop a real estate strategy that supports rapid changes in its business plan, while positioning itself to compete effectively.

Here is the first rule for strategically managing occupancy costs: If you occupy a large amount of space, never underestimate your value. You have heard the old saying about the three factors that determine the value of real estate: location, location, location. That is not entirely accurate. A building's value is also set by its large tenants.

During the past decade, there has been a significant change in the way major real estate assets are owned. The recession of the early 1990s led to foreclosures by major lenders, who then sold much of their portfolios in bulk to well-capitalized, publicly traded real estate investment trusts. The most important consideration to these new owners is the stability of cash flow, and because replacing a tenant is often much more costly than retaining it, owners will frequently allow tenants to restructure their leases. By analyzing the public documents a REIT is required to file, a tenant can determine the weight that it carries within the REIT's portfolio and whether the owner can afford to incur the additional costs created by a vacancy.

Space Equals Leverage

The more office space a tenant occupies, the greater leverage it has. In the typical market, the average tenant occupies only 5000 to 10,000 square feet. To replace a law firm that occupies 80,000 square feet (about four average-size floors), the landlord will endure a substantial re-leasing period, during which it will not receive any rent. The landlord will probably have to foot a considerable bill for improvement costs for new tenants and cover the cost of converting the law firm space to multi-tenant premises. The re-leasing period could easily span 4 years 'and therefore depress the building's profitability.

A restructuring takes effect anywhere from 2 to 8 years in advance of a lease's scheduled expiration date and usually involves some combination of reduced rental rate; a landlord-funded improvement allowance; relinquishment of excess space; and reduction of credit enhancements, such as personal liability provisions or letters of credit, which provide the landlord with greater security in the event of a default. The savings can be as much as 30% ' even when market rents are rising.

Playing hardball with the landlord is not the only way to squeeze the most out of your occupancy costs. Scrutinizing the use of your current office space, to make sure it is as efficient as possible, can pay off too. The space needs of law firms have changed dramatically in the past 10 to 15 years. Many firms occupy 900 square feet or more per attorney when 700 would do just fine. The question for office administrators and managing partners is how to improve efficiency while maintaining an environment that sends the right message both to clients and employees.

A good first step is to evaluate the configuration of your office and determine whether it supports the firm's way of operating and is flexible enough to support changes. Here are some questions to ask: Should the firm limit higher levels of finish, such as mahogany walls and marble floors, to specific areas? Is the library properly sized? Has the ratio of secretarial stations to attorney offices decreased? Are the quantity and size of conference rooms in line with demand?

Pay attention to what the competition spends on occupancy. The large accounting and consulting firms favor the same top-quality downtown properties, at similar rates per square foot, that large law firms do. However, they spend less than law firms by “hoteling”: assigning two or more consultants to one office or cubicle and having them spend more time at clients' offices. Thus the accounting firms' space needs per professional are one-third to one-fifth the space needs of law firms, which occupy 700 to 1000 square feet per attorney and 275 to 325 square feet per staff person. This is not to say that law firms can or should adopt identical practices. Nevertheless, competition being what it is, this disparity has major bottom-line implications.

Efficient use of space does not always mean simply getting more people into less space. The challenge is to create efficiency without sacrificing performance. Possible solutions include eliminating multiple reception areas, moving conference and administrative functions to a lower (and often less expensive) floor, using upgraded fire stairwells to link contiguous floors of a firm, reducing the number of office sizes (though not necessarily the sizes of the offices) from three to two or even one, and using grouped secretarial stations. Many of these tactics not only reduce real estate costs, but also reduce staff expense.

Make Use of the Core

In many cases, the greatest efficiencies can be derived by relocating to a building with few columns and large rectangular floors. The configuration of these buildings allows for greater efficiency than that afforded by the angled buildings that went up in the 1980s. The rectangular configuration creates more core space for uses that may not require windows, such as certain offices, some conference rooms and the library. A thoughtfully designed space that makes use of the core will contribute much more to efficiency than will shrinking offices, which does not really reduce overall square footage per lawyer.

Consider the example of a firm that houses 200 lawyers in 200,000 square feet. A renewal might be offered at $50 per square foot, while the rate at a new building might be $53 per square foot. On a per-square-foot basis alone, a move would not make financial sense. But the new building's design and the firm's re-evaluation of its needs could reduce its space needs to 150,000 square feet. That translates into an annual savings of $950,000 ' more than $10 million over the course of a 10-year lease, once rent escalations are calculated. If the firm grows and requires more space during the term of the lease at the new building, the amount of savings increases more because less space will be needed to accommodate each additional attorney and associated support staffer.

Take the Lead

In many markets, large blocks of space in efficiently designed buildings are not available. In this circumstance, a build-to-suit arrangement may make sense. The law firm presents itself as the lead tenant to a developer that is seeking to begin a building but, because of the current financing environment, cannot proceed until anywhere from 30% to 70% of a proposed building is leased. Because of this creative approach, the developer is more likely to consider the law firm's needs as the building is being designed, ensuring that the firm's needs are addressed in the most efficient way. In addition to increasing the number of buildings that can be considered, this strategy can also reduce rental rates because an entrepreneurial developer will typically accept a lower return on investment (9% or 10%) than an institution, such as a pension fund or insurance company that may require 13% to 15%. That disparity can result in a savings of as much as $10 per square foot per year in rent.

By implementing these financial strategies, a new building can be less costly than staying put. If major renovations are required, a move could actually be less problematic than a renewal. Furthermore, because a tenant's goal is often to create several acceptable choices, this strategy not only makes the new building a viable option, but serves as added leverage in negotiating a renewal with the current landlord.

Sounds great, you say, but why would any developer in his right mind create inventory in a market that already has substantial vacancy? The answer is that developers make money developing new buildings. If they can secure a credit-worthy law firm as the lead tenant, there is a very good chance that such a building can come to fruition ' regardless of the challenges other owners are facing. For example, King & Spalding's commitment to lease two-thirds of a planned 30-story building in Atlanta led to the construction of a building that will be completed in early 2006 despite the fact that the vacancy rates in Atlanta's Peachtree corridor hover at 20%.

Regardless of how efficiently a firm uses its space or how low its rental rate may be, its lease should act like an accordion, allowing the firm to shrink or expand as its business plan and fortunes change. The legal industry has been experiencing tremendous volatility for several years, and all indications are that mergers and technological change ' the major factors affecting design changes ' will continue. It is critical for major law firms to secure flexibility throughout their lease terms.

If a landlord has vacant space, it will be more than happy to lease it to a current tenant. However, a firm's growth needs may not coincide with a vacancy in the building, so it is crucial to negotiate multiple expansion rights as part of a lease.

During the early stages of the planning process, the firm should project its annual personnel growth and accompanying space needs and negotiate to secure options for space. (These are guarantees from the landlord that specific floors will be available at agreed-upon dates ' ideally, on pre-negotiated terms.) Because growth does not always follow a predetermined schedule, the lease should include additional rights of first offer and first refusal, as well as the right to relocate other tenants elsewhere in the building. These rights not only allow for the firm to accommodate growth, they reduce costs, because the firm can add additional space only as it adds lawyers.

Too Much Space

While the financial health of a law firm generally is not threatened because of an inability to expand ' there will always be space somewhere for a good tenant ' the same cannot be said about firms with too much space.

Although lawyers are in the business of helping their clients avoid unnecessary risks, the absence of contraction rights in most law firm leases creates a major exposure to increased occupancy costs and the concomitant issues brought about by stresses on profits per partner. Excess space can be precipitated by a catastrophic event, such as the loss of a major client or the defection of top-producing lawyers, but it can also occur over time as a result of new technology, which allows the firm to reduce the size of its library or the number of secretaries.

The economic cost of excess space can be staggering. Suppose that a law firm's annual rent on a 75,000-square-foot space is $45 per square foot, or $3.375 million for a 100-attorney office. If the firm is on the wrong side of a merger and loses 25 attorneys, the effective annual cost of housing its lawyers rises from $33,750 per lawyer to $45,000. This vacant space costs the firm $843,750 per year ' and it could remain vacant indefinitely, particularly in a soft market. A contraction right gives the firm a guaranteed exit from such a situation, and if it is properly structured, it will not cost the law firm anything until it is exercised.

A landlord may claim that contraction rights are not consistent with the usual practice in a given market. Even if this is true, it is irrelevant. Law firms are now competing regionally and nationally, and the costs of carrying vacant space can easily erode or destroy profitability. Even if contraction rights are never exercised, they provide peace of mind. Educating a landlord about the needs of the firm and positioning this requirement carefully in the negotiation process can ensure that important rights are secured.

Law firms find themselves in an increasingly competitive economic environment. Their approach to handling their real estate requirements can enhance their profitability, even in a slow legal market. A real estate solution that respects the firm's culture while positioning it to benefit from the trends in the real estate industry will help ensure a productive and wealthy partnership for years to come.