It may pay to renegotiate your lease because of weak office space demand.

Advisor Michael Boone is happy that his Seattle-area advisory firm is a renter these days. Office-building "vacancies are 25% plus, and lease rates are back to 1997 levels due to the dotcom bubble," says Boone, president of M.W. Boone and Associates of Bellevue, Wash., which recently moved into new offices. "We're paying less per month than at the previous place, and we've got more square footage, more windows, and we're on the 14th floor of a Class A high-rise with a view of Mt. Rainier."

Conditions vary from city to city, of course, and even within pockets of the same locale, but in many areas today, commercial real estate is in the dumps. Weakness translates into favorable terms for tenants- including planners and their small-business clients who lease-but it isn't exactly nirvana for landlords (real estate investors). Therefore, to render complete advice in light of today's commercial real estate marketplace, as well as to benefit their own shops, advisors need to understand the opportunities for tenants plus the asset class's investment outlook.

The latter starts with the notion that the sector tends to lag the economy-last seen limping. "Vacancy rates are stabilizing, but demand for office space is extremely weak, and we don't expect that demand to pick up until 2004, 2005," says Darren Rabenou, of JP Morgan Fleming Asset Management, subadvisor to American Century Real Estate Fund. Tepid demand means that landlords-sellers of office space-lack pricing power. "They won't be able to raise rents for quite some time, and they have to give concessions" to tenants, Rabenou says.

Local governments' fiscal problems may cause further woe. According to Jerome Berkman, an attorney who specializes in commercial real estate, New York City is now ratcheting up property taxes several notches to meet budget gaps. "That's a substantial burden to building owners and tenants, and if you add to that highly escalating fuel oil prices, you have a very depressing effect on commercial buildings," says Berkman, a partner at Day, Berry & Howard, in Stamford, Conn.

Still, there are bright spots. Pension funds have become active buyers in the market, buoying prices. And in a low interest rate, low inflation environment, investors are accepting low cap rates (or internal rates of return) on commercial property investments, likewise propping up values. Moreover, it is actually a seller's market for quality property today. Office buildings with creditworthy tenants under long-term lease are selling at a premium.

Rabenou observes that there has been a significant slowdown in new building. Contrast that with the early 1990s, he says, when commercial construction continued as demand waned, widening the disconnect from supply. The current downturn, therefore, should not prove to be as dire as the commercial real estate bear market of the 1990s, he contends. (As an interesting aside, Rabenou notes, the current residential marketplace is "probably weaker" than the commercial. "They're still building apartments and homes," he says.)

With some cities faring better than others, geographical diversity in commercial real estate investments is more important than ever, advisors agree. Certainly you want to avoid overexposing real estate allocations to floundering markets. Long-term returns on real estate investment trusts that own commercial properties are 6% to 8% in dividends-a level that many are currently paying-plus 2% to 4% in growth, netting total return of 8% to 12%. But the fundamentals don't bode well for appreciation, even though the sector as a whole is not expensive. "Right now we're probably on the lower end of that (total return range)," says Rabenou. To improve the odds that a REIT's dividend stream will continue, look for a strong balance sheet and good properties that can be sold.

It's worth noting that if President Bush's proposed elimination of double taxation becomes law, the impact would likely be negative for REITs. Under present rules, a REIT that distributes all its income to shareholders does not incur income tax, says Mark Luscombe, an analyst at CCH Inc., the Riverwoods, Ill., business-information provider. REIT earnings are therefore not taxed twice and thus would not benefit from the proposed change-but dividend-paying corporate stocks would benefit, rendering REITs less attractive to investors on a relative basis.

Opportunities For Businesses

Entrepreneurs seeking to buy a building for their company probably won't find many bargains because of the robust market for quality space. "But they may do very well in selling a building that has fairly long-term leases and tenants with good credit," says Berkman. For clients who are weary of owning their business's property, the sale-and-leaseback technique is extremely attractive now. You may be able to sell at a nice price and get a long-term lease on the space at today's reasonable rents.

Commercial tenants can gain valuable concessions that are unimaginable in landlord-dominated markets, says Fort Worth, Texas, certified financial planner David H. Diesslin. "You can negotiate for the right of first refusal on adjacent space, with terms and conditions similar to those you currently have. You can get renewal options. You can even negotiate on such terms of the lease as insurance and indemnifications," he says. Best of all, the business owner may be able to wiggle out of personally guaranteeing his company's lease. "That can be significant to peace of mind," says Diesslin, owner of Diesslin & Associates Inc.

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