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Tuesday, January 24, 2017

Is commercial real estate healthy for startups?

By Jesse Fragale (Toronto)

A few months ago, the Rotman School of Business in Toronto, in partnership with the Urban Land Institute, hosted an event entitled Is Toronto’s Real Estate Environment Healthy For Entrepreneurs? On the panel was an array of experienced individuals, including the CEO of a growing fin-tech company, the director of operations of a popular incubator and the head of a major office REIT. The event was packed – an indication of how relevant the question has become.

As a commercial real estate (CRE) broker in Toronto who specializes in office leasing, I am well aware of the challenges that startups have in acquiring the right office space in their early years. Conversely, from working with clients on the landlord side, I can appreciate the hesitation to lease space to these types of companies.

The Challenges

1.    1.  Uncertain growth trajectory

Companies that are at the first few rounds of financing in their new venture, or at earlier stages, have an incredibly difficult time estimating a growth pattern with any sort of precision. Their growth is certainly not perfectly linear, and this factor poses a challenge for brokers in finding not only the right space, but the right space for now. Companies at this point in their evolution are just not in a position to make commitments of five years or more without being exposed to some significant financial risk. Abstractly, we can think of these companies’ growth as a curved or exponential line on a graph, and office needs as a line that looks like a staircase – once the company is too big for the space, the firm hits a wall and needs to expand (a new step). We need to place this set of stairs over top of this growth line as precisely as possible.

2   2.  Covenant

When tasked with making a commitment to office space, landlords expect that they will be able to hedge their risk with a solid covenant from the tenant. When market conditions dictate that landlords have more bargaining power, they will be less likely to gamble on new ventures that have more potential to “go sideways.” As a result, startups can find it difficult to secure an office location without having a track record. This track record will typically mean a minimum of a few years of profitable operating history.

     3.  Disconnect from the commercial real estate community 

I believe that this point is the most controversial of the three challenges, but I believe it is real and should not be overlooked. The majority of these companies are being run by millennials and hiring millennials. Although the CRE industry is becoming more and more innovative, we are still behind in our engagement with millennials today – there is a lack of presence and engagement on social media platforms that they use every day (Snapchat, Instagram, YouTube, etc.)

What’s a startup to do?

Subleases, shared office, collaboration, oh my

Five- and 10-year deals are just not going to be an option for many startup companies. Potentially discounted subleases can lower upfront capital expenditures and shorten time commitments to make these companies more nimble. Shared offices and collaborative work environments are other good options, provided the clients are amenable to these arrangements and do not require exclusivity/use clauses (i.e. a clause whereby the landlord agrees not to rent space to another tenant that directly competes with the company that has said exclusivity.)  Shared space has become an attractive option over the past few years as we see more co-working groups on the scene in major cities.

No easy way out

Creativity might not cut it here as landlords – in lieu of an operating history – may ask for letters of credit, personal indemnification or upfront rent to compensate their risk. As a broker, the worst thing you can do in this regard is not have an upfront discussion of these potential requirements right out of the gate. The last thing you want to do after negotiating an offer or letter of intent is not be able to waive financing conditions at the 11th hour because you were ill prepared.

Engage, engage, engage!

Furthermore, startup clients should focus on retaining representation from brokerages that make an effort to communicate and engage with them – brokerages that understand their challenges and offer solutions. Staying relevant and using all the resources you have available to you is crucial. Beyond that, brokerage firms should reach out to incubators, accelerators, business schools and like minded landlords who target startups or other dynamic tenant groups (for example TAMI tenants; technology, advertising, media, information). Engaging and spending time prospecting startups is not without risk. Many of these companies fail before they get their feet off the ground. A proficient broker will evaluate new-venture clients more intensely and take a venture capitalist approach when targeting these companies. Does the business make sense? Are the principals committed? What have they accomplished to date? Ultimately, engagement must be a calculated endeavour and as efficient as possible.

The bottom line

A mentor and founding partner at Avison Young once said to me, “Jesse, think of two rotating gears when working with any company. The large gear is human resources and the little gear is real estate. The large gear costs the company much more than the little gear and looks more important – but if you screw up on the little gear, the large gear will grind to a halt.”

Startups should be focused on their business and not get bogged down in acquiring new office space. Brokers who represent these types of tenants need to ensure that they provide solutions that position clients in an optimal place for future growth and success.

(Jesse Fragale is an office leasing advisor who specializes in tenant representation focusing on startup and tech firms. Based in Avison Young’s Toronto office, he focuses on the Downtown and Midtown markets. Fragale holds a Master of Business Administration (M.B.A.) degree in Finance and Strategy from Wilfrid Laurier’s Lazaridis School of Business.  He holds a Bachelor of Arts degree in economics. He has also completed a joint program on negotiation through Harvard University and the Massachusetts Institute of Technology (MIT).

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