Underwriting May Get Tighter In Wake of Bankruptcy and M&As, But Top Law Firms Remain Among the Most Desired of Office Anchor Tenants
Large law firms have long been among the most prestigious and credit-worthy tenants for some of the highest-quality office trophies in CBDs across America. Nowhere is that truer than in Manhattan, where last weekend’s final collapse and bankruptcy filing by Dewey & LeBoeuf LLP, one of the largest law firms in the world, stunned observers.
But from a commercial real estate perspective, the law firm's collapse has become just the latest example of how shifting legal industry economics are compelling landlords, developers and lenders to re-evaluate and tighten their criteria for signing and financing these highly valued anchor tenants.
Law firms make up the fifth-largest sector of office tenants based on total square footage, occupying about 9% of the leased office base in the first quarter of 2012, according to CoStar Tenant.
Paramount Group, landlord of 1301 Avenue of the Americas, where Dewey & LeBoeuf maintained its global headquarters and leased 474,767 square feet, is listed as the second-largest unsecured creditor in what is likely to be the largest law firm collapse in history. The storied law firm, which employs 1,300 attorneys globally and has been teetering on the brink for weeks, on Sunday announced its intent to seek Chapter 11 bankruptcy protection, citing about $315 million owned to more than 5,000 creditors -- including more than $5 million in rent and property taxes for May.
Several CRE brokers specializing in representing legal tenants told CoStar that the collapse is part of a trend of increasing financial pressure that is forcing the legal industry to re-evaluate their operations, including occupied real estate, their second-largest expense behind payroll. Over-expansion during the boom years and excess debt, plus the need for more revenue streams and wider geographic reach have contributed to a number of high-profile law firm mergers and acquisitions over the last couple of years.
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"Each of the reasons is different, but they all have one common thread, which is that the legal industry is changing and law firm economics are tougher," said Steve Barker, executive vice president and San Francisco office branch manager for tenant representation firm Studley. "Clients have gotten smarter about how they engage legal services and are asking for things like fixed fees and discounted rents."
Landlords Cautious, But Top Firms Retain Cachet
Large, well-operated law firms have hardly lost their luster as attractive anchor tenants for landlords, however, said Barker, who heads Studley’s national law firm practice.
Barker noted that the business failures and consolidations involve just a small fraction of the largest U.S. law firms. But events like the Dewey bankruptcy and the 2008 bankruptcy and liquidation of 120-year-old international firm Heller Ehrman have definitely given pause to landlords.
“Law firms have evolved over the years into a measurable credit risk," said Bob Chodos, a principal in Colliers International’s Chicago office who heads the company's national occupier services group.
"They are still reputable, shiny tenants, but there’s no question that the study and review by landlords of the financials of law firms for the purpose of putting up letters of credit to guarantee or secure the lease is a much tougher process," Barker added.
Ted Rotante, executive vice president in the Colliers office in New York, said he was able to finalize a couple of transactions on behalf of law firm clients even during the pending collapse of Dewey.
"Landlords are sophisticated and know this stuff can happen," said Rotante. "Big law firms are still very coveted and I don’t think that’s going to change substantially. Will landlords look at how long the main partners have been with the firm, and more carefully evaluate the financials of the partnership? Yes. They’re going to start looking at the particular aspects of the Dewey & LeBoeuf model that contributed to its blow up."
On a national basis, the consolidation and debt pressures facing law firms have already resulted in tightened credit requirements.
Where previously a letter of credit from law firms for a few months of rent was sufficient to induce landlords to pay out-of-pocket tenant improvements, lease talks now often include requests by the building owner for full financial audits -- and even opinion letters from the major credit rating agencies -- to evaluate profit-loss statements and identify potential credit problems. Mounting debt can quickly cause a firm to fall apart as partners and top talent lose confidence and head for the exits.
"Each time one of these firms goes out, it means we need to have a much longer conversation with landlords, even with the most profitable top 10 law firms," Barker said.
Partnership Structure Increases Landlord Exposure
Most law firms are structured as limited partnerships, giving landlords and other unsecured creditors little recourse in the event of a bankruptcy. Like commercial real estate and other professional services firms, there’s little of value left after the firm’s talent and business rainmakers defect.
But that hasn’t diminished the prestige and stability of signing well-known law firms as anchors for the newest and best located "super Class A" buildings. Well-operated, disciplined law firms are growing again, sometimes significantly, and remain very attractive to landlords and lenders who finance development projects.
In downtown Chicago, for example, major law firms such as Jenner & Block, Kirkland & Ellis and Baker & McKenzie are expanding into new buildings, Chodos noted.
Larger firms may be managing costs more efficiently and carefully evaluating how much space they need, but they aren’t skimping when it comes to offering high-end and high-tech accommodations to young legal eagles seeking the best work and lifestyle amenities.
Ongoing industry consolidation has also exacted a toll on landlords. In San Francisco, several mergers in the last several months have shrunk six high-end law offices down to three, with no shortage of rumors in the marketplace about more movement, Barker said.
In New York City, where built-out legal space is at a premium, Paramount will probably even be able to push rents for the space at 1301 Sixth Avenue a few blocks from Rockefeller Plaza, Rotante said.
"Every law firm in New York of any size has a broker calling them and talking about the Dewey space," he said. "If a law firm can relocate to a space that has been built out for a law firm and reuse most of it, it’s a significant savings."
Dewey and LeBoeuf also lease 146,521 square feet at 1101 New York Avenue in Washington, D.C., where they have hired Cushman & Wakefield to market the space. Dewey also leases another 68,000 square feet at 125 W. 55th St. in New York City, more than 31,000 square feet in Boston, 22,000 square feet in Chicago and about 20,000 square feet in San Francisco, according to CoStar information.
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