Property: Spaced out

The credit crunch has had a serious effect on the City law firm property market. When will the strain begin to show?

Property: Spaced out Property is the legal world’s second-largest expense after people. It is hardly surprising, then, that in a climate where nigh on 1,000 members of legal staff have been laid off, firms are looking to trim their property holdings.

As revealed by The Lawyer last week (13 October), a number of City firms are locked into long leases on properties that are excess to ­requirements, with the dire state of the real estate market meaning there is little hope of them offloading the properties in the near future.

Among those with space on the market is magic circle firm Freshfields Bruckhaus Deringer, which is looking to sublet 19,000sq ft in a Bouverie Street building with a lease running until 2014. Fellow magic circler Allen & Overy (A&O) also has space to offload – 20,000sq ft in Canary Wharf – while US firms Kirkland & Ellis and WilmerHale are each looking to sublet around 7,000sq ft in their City premises.

With vacancy rates across the City (around 4 per cent this time last year) rising to 6 per cent, and expected to hit at least 10 per cent by the end of next year, rents on most buildings are tanking.

In the summer the most expensive buildings in the City – think ­newbuild towers, think Reed Smith in the Broadgate Tower or Kirkland in the Gherkin – could achieve rents of around £60 per sq ft. On the City’s large stock of less flamboyant ­buildings rents were in the region of £55 per sq ft, while run-of-the-mill buildings on the Square Mile’s periphery, such as Beaufort House, which Reed Smith will vacate next year, were fetching in the region of £40-£45 per sq ft.

That all adds up to a lot of money when the amount of square footage firms generally sign up to is taken into consideration. But, given that last summer the price tag on the City’s most expensive property was £70 per sq ft, and that rents, which have stagnated in the last month, are expected to decrease by a further 10 per cent by the end of next year, the outlook for subletters is anything but positive.

Lower rents should actually stimulate the market, but with money so tight that few, if any, businesses are considering a move, even if firms are lucky enough to find tenants for their buildings, the chances of them breaking even on sublet rents are slim.

Richard Norton, a director at ­property giant Jones Lang LaSalle, points out that any firm looking to offload property at the moment will face an incredibly difficult market.

“It’s pretty grim,” says Norton. “There’s uncertainty in the market and when that happens people don’t know where things are and so can’t make decisions. It’s a spiral that dents confidence, and that puts real estate into a backwater.

“At this point there’s not much activity going on because people are sitting on their hands.”

For firms with space to let this is a worry. In the current economic climate, when reining in expenditure will become an ever-more fundamental part of firms’ strategies, shelling out millions on empty ­buildings is far from desirable.

Reed Smith will move into the Broadgate Tower at the beginning of next year on a 15.5-year lease that will see it pay around £9m a year for 155,000sq ft of prime real estate. While the firm undertook a pre-let on the building,

meaning it will have negotiated a rent-free period of at least a year with the property’s owner British Land, it will also have to foot the bill for the 86,000sq ft it ­currently rents at Beaufort House. (The firm has found a tenant for its other building, Minerva House on London’s South Bank, a 39,000sq ft space with a lease running until 2016.)

While the firm disputes the ­figures, informed market sources claim that Reed Smith is paying between £40 and £45 per sq ft on Beaufort House, meaning it will have to pay an ­annual rent in the region of £3m on a lease that runs until 2014.

Considering that the firm’s average profit per equity partner figure topped $1m (£570,000) in the 2007 financial year, £3m is arguably a manageable sum to write off. But given that ­vacancy rates will continue to rise for at least the next 12 months, there is no guarantee that the firm will be able to sublet Beaufort House in the ­foreseeable future.

If the firm is still paying £3m on an empty building when its rent holiday on the Broadgate Tower ends, that sum will start to look much less manageable, particularly as the financial environment for all firms is almost certain to worsen over that timeframe.

That said, Tim Foster, the Reed Smith partner in charge of the firm’s relocation, claims the firm is in a good position financially and is happy that its plan for offloading Beaufort House is sound.

“Reed Smith is confident it is ­performing better than most major law firms in this climate and it remains possible we’ll achieve our net income plan for 2008,” says ­Foster. “We’re comfortable with the realistic assumptions we’ve made about disposing of our space in ­Beaufort House.”

Reed Smith refused to confirm whether it budgeted for not being able to sublet its existing buildings, but Addleshaw Goddard managing partner Mark Jones reckons it would be incredibly foolish not to.

Addleshaws, which moves into a 200,000sq ft building on Milton Gate next year, currently pays rent on 80,000sq ft in Aldersgate Street and 45,000sq ft in Noble Street.

Although new tenants are lined up for both, Jones says that if the deals fall through, which is certainly ­possible given the state of the market, the firm will not take a significant hit.

“The Aldersgate Street building has a lease until 2020 and we ­wouldn’t have signed up to the move unless we had someone to take that over,” says Jones. “Accountancy firm Moore Stephens is moving in there.

“The landlord on Noble Street is Ernst & Young and we negotiated a break clause with them for every year starting in 2010. While we’re ­currently negotiating to assign Noble Street, if it falls through we’ll be able to break the lease.

“The only budget we ever did was on the basis that we wouldn’t sublet. The current rent on Aldersgate Street is £3m, while Noble Street is £1.4m. Last year’s profit was £64m. I’m not saying I want to keep paying that, but if I do have to, so be it.”

For other firms on the move, ­careful negotiations could prove key if they are to navigate the tough times ahead unscathed.

Mayer Brown, which will become a neighbour of Reed Smith’s when it moves into the British Land-­developed 201 Bishopsgate, will not be saddled with paying rent on its old premises after striking a deal that will see British Land take over its ­Pilgrim Street base when it is ­vacated.

“Mayer Brown’s deal with British Land taking back 11 Pilgrim Street looks to be a better and better ­decision,” says Norton at Jones Lang LaSalle.

And given that, like Reed Smith, Mayer Brown undertook a prelet on its new building, the firm will enjoy approximately a year of rent-free ­living when it moves.

With vacancies soaring and rents plummeting, now would appear to be the perfect time for a firm looking to find new premises to strike a canny deal.

US firms Arnold & Porter and McDermott Will & Emery, which have lease expiries coming up on their current buildings, are in the market for around 30,000sq ft and 60,000 sq ft respectively.

The obvious thing would be for them to negotiate with the likes of Reed Smith or Addleshaws to take over their excess space, but as Norton points out, the property demands of US firms are very different to those of their UK counterparts.

“UK firms tend to have uniform-sized offices within their buildings that have two people in each,” he says. “US firms have traditionally had ­different-sized offices for different levels of lawyers, and that’s made them less flexible.”

This means that, if they were to take over a UK firm’s office, they would have to fork out for a refit, which can cost anything from £60 to £130 per sq ft. Firms would have to pay to fit out an office anyway, but if it is done as part of an overall ­development the expenses can be minimised.

Besides, with IT normally being written off over three years, while furniture is written off over seven, the prospect of landing balance sheets with those, arguably minimal, costs for the next several years will be unappealing.

US firms are also incredibly choosy when it comes to a building’s ­externals and will look for the ­building that best fits with the image they are trying to project, rather than taking on something that is both available and reasonably priced.

Another factor that could be ­making US firms think twice about taking on new office space is that they generally tend to take control of more space than they actually need and release the excess onto the market for up to seven years while they grow into it.

It is well known across the City that Orrick Herrington & Sutcliffe, which currently occupies a 30,000sq ft building, has planned a move to an 80,000sq ft premises on Cheapside, but so far the firm has yet to make the move official.

“We haven’t signed anything with anybody,” The Lawyer was informed by Orrick chairman and CEO Ralph Baxter.

Given that Bryan Cave, Kirkland, Shearman & Sterling and WilmerHale are all finding it difficult to shift their extra space, Baxter’s reticence could prove wise.

In reality, though, it all boils down to money and the current lack of cold, hard cash.

“The hardest thing,” says Norton, “is that, even if the opportunity to move is there, funding the costs of the move and the fit is impossible.”