The Race for Office Space

Thinking about starting up an Internet company?

Better clean out your garage.

It's almost easier these days to secure venture capital than to find office space - and some landlords are learning to scrutinize business plans as well as previous rental referrals.

One tenant broker tells her clients that they need to approach the job of finding office space "as seriously as pitching venture capitalists." Another cites the 2.5 percent vacancy rate in San Francisco, the lowest in a decade.

"I would love to be an owner of space in San Francisco right now," says Darin Bosch, VP at Richard Ellis.

Not many CEOs are happy about the stiff competition they face when it comes to renting a place. "It's a nuthouse down here on the peninsula," complains Frank Huerta, CEO of Recourse Technologies, an Internet security startup that found space in Palo Alto after a long search.

While looking for office space, Huerta came across two landlords who asked to see his company's business plan.

"I refused to do that. I told them they could talk to our bank or our investors, but our plans are sensitive," says Huerta. "In the Valley, people talk."

By refusing to share his business plan with landlords, Huerta may have missed out on prime real estate, but his company was lucky enough to find a good spot without jumping through too many hoops. Still, he recognizes that his experience is the exception.

The Bay Area isn't alone. Boston, Seattle and Washington also seem to be short on space. New York is still the country's most expensive town.

"Silicon Alley owners are sitting in the catbird seat," said Paul Mas, as senior managing director of brokerage firm Colliers ABR. Mas specializes in finding space for Internet companies such as USWeb/CKS and TheStreet.com. "The Internet boom has led to what I call 'bumper-car real estate.'" There wasn't a shortage of commercial real estate in the early '90s, but when Internet startups started getting big venture bucks, the market changed. Once owners realized that they could pick and choose tenants, they implemented more rigorous screening processes.

"In my 30 years in the business, I never interviewed tenants until now," says landlord Mike Kelly, a partner at Levin Menzies & Kelly, a commercial real estate outfit that recently rented its last available office in San Francisco.

"Just this week I had meetings with three dot-com companies competing for the same spot."

"Every day, one dot-com - if not seven - calls us," says Erwin Cohen of ATC Management, which leased space to Oxygen Media in the Chelsea Market. "But I immediately had faith in Geraldine Laybourne. We have to depend on our intuition."

Landlords might trust their instincts, but not until they have thoroughly investigated prospective tenants first. Landlords are so sophisticated that they ask to see business plans. Then they inquire about a company's backers, the size and stages of funding, its burn rate and exit strategy.

"We recently rented to Pets.com, which is in a crowded market. We looked at their financials - Hummer Winblad and Amazon.com are investors, so I think they're a good bet," says Kelly. "But sometimes I find myself second-guessing venture capitalists."

Some tenants try to protect proprietary intellectual capital by asking landlords to sign nondisclosure agreements, but few see any option other than opening up their books for a landlord's perusal.

Not only has the competition for precious office space caused tenants to divulge corporate spreadsheets, it's led to other dramatic changes in the real estate game as well. Landlords are investing in more brick-and-timber, warehouse-type spaces for "creative" atmospheres to please tenants. However, since landlords call the shots, they can demand a lot.

In order to secure space, tenants are expected to sign leases within a week of receiving an offer. Startups must also prepare letters of credit, which make landlords more comfortable about renting to companies without credit histories.

For startups, the letter of credit typically includes a year's rent, as well as the costs of tenant improvements and legal fees. Some landlords even ask for the entire lease amount up front.

Trading stock in lieu of rent and giving warrants to landlords aren't common practices, but they aren't unheard of either. In exchange for taking on the risk of unknown tenants, some landlords want to share in potential winnings.

"We believe we are partners and should participate in these small companies' success," explains Dave Hood of Rosenberg Hood Ventures, which leases space in San Francisco's SoMa (South of Market) district. Hood says equity was included in LookSmart's lease terms.

After looking for over a year, Organic signed a lease on the historic Baker Hamilton building at 601 Townsend. E-Trade, Just in Time Solutions and USWeb/CKS all bid on the space. Organic CEO Jonathan Nelson admits that finding space in San Francisco is tough and he doesn't underestimate the importance of "courting the landlord" in this "mad market."

But rumor has it that Organic used equity to win over building owner Ronaldo Cianciarulo. Nelson denies equity was involved in the deal. "It's simply not true," says Nelson. "But landlords are getting sophisticated and asking for equity."

Nelson may not have paid in stock, but he did find that real estate prices themselves are much higher than when the company rented SoMa space five years ago. "Companies looking for space in San Francisco are in for sticker shock," he says. Organic will pay roughly 10 times its current lease after its move.

"Just a few years ago, $50 a square foot was the limit for most people psychologically," says Cracknell. "Now it's rare to see a building in the 40s in the Bay Area. Space has simply evaporated."

The duration of lease contracts is longer, too. Bosch says it's possible to get a three-year lease in San Francisco, but five years is a more common duration.

In New York, 10-year and 15-year leases are the norm, says Mas.

So why don't companies just move to more affordable space? Because they want to attract the twentysomething and thirtysomething brainpower concentrated in urban hot spots. This has led to a tenant trend Bosch calls "defensive leasing," or renting more space than you need to ensure room for future growth.

Observers don't see the frenzy slowing down. Bosch thinks the bubble will eventually burst. Until it does, tenants would be wise to grab space quickly.

Although many people are bullish on the Internet, landlords would rather play it safe with new-media upstarts.

"It's human nature to favor known commodities," notes Ian Stuart, a partner at Colliers ABR, who says the vacancy rate in Silicon Valley has dipped below 4 percent. "If you were the Presidio Trust, who would [you want] to negotiate leases with - George Lucas or CNET?"

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