Brad Hargreaves | Building Things

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How Entire Industries Become Unethical

with 54 comments

Every office building in New York City grows by a few percent per year. Each stuffy pre-war tower, art-deco complex and shiny corporate center. They’re all growing, like those Kafkaesque SimTower projects that added a few lone offices to the roof each quarter when the rent came in.

Except they’re not actually growing — just adding more space on paper. All office buildings in New York City add a few percent per year to their official square footage, often in lieu of raising rent. So if you are a startup paying $30 per square foot for 1,000 square feet of office space and need to renew your lease, it is more likely that your landlord will claim that your office has grown — perhaps to 1,050 square feet — than attempt to raise your rent.

This is simply the way the commercial real estate world works, and it’s second nature to people in the business. All buildings grow every year — it’s called “loss factor“. But to someone who isn’t familiar with commercial real estate, the concept is completely absurd and unethical.

What makes it seem particularly wrong? Well, square footage isn’t just some abstract number. It’s a real measurement of area. Burger King can claim that a new line of burgers is “50% tastier” regardless of reality, but they would step over the line if they claimed that these same burgers had 50% less fat unless that were actually true. “Tastiness” is a subjective, abstract concept. “Fat” is not.

Somehow, over the course of the development of the commercial real estate industry, square footage has converted from a concrete unit to an abstract unit in the minds of people in the industry. But to the rest of us, square footage remains a concrete measure of area. When I hear 400 square feet, I think of a room that is 20×20 or 40×10 or perhaps even 4×100. When someone in commercial real estate hears 400 square feet, he or she thinks of a space they can lease for $12,000 per year at $30 per square foot. It doesn’t matter how big the space actually is.

Now that we’re here, I don’t see things getting any better — the Nash equilibrium of the situation is for each player to continue increasing the “size” of their spaces by a few percent per year. If one landlord bucks the trend, they’ll need to correspondingly raise their rent per square foot to stay competitive with other landlords. But if everyone else is smudging the size of their buildings, why should you stop? It just means that anyone who wants office space in New York City has to figure out this bizarre system — or get screwed.

So how does this kind of thing start? First, it’s important to recognize how commercial real estate is leased. A commercial space shares a nasty problem with an airline seat: a product that is not a commodity yet is bought and sold as one. In most searches that brokers perform, they are given a price cap by their clients — say, $35 per square foot. If a space falls above that cap, it simply isn’t shown to the client. Thus, a landlord (like an airline) is heavily incentivized to keep their price as low as possible to get visibility in front of lots of potential tenants. The other shoe can drop once the tenant is in the door. This is all analogous to bag check fees, ticketing fees and the other unpleasantries of 21st century air travel.

Therefore, landlords will try to throw as much as possible into the square footage to lower the all-important “cost per square foot”. Initially, the included items were somewhat reasonable — shared bathrooms, hallways and HVAC. In fact, that’s how loss factor is still explained by most brokers. But then someone decided to include not only hallways, but the elevators. Another landlord responded by including not only the elevators, but the lobby and delivery bay. Pretty soon, it got so complicated that square footage became an utterly abstract, meaningless number in the minds of anyone involved in the industry. The square foot was no longer a concrete measure of area.

I don’t think most people in commercial real estate are unethical. Rather, the industry has adopted unethical practices due to a combination of individually innocuous factors: the characteristics of pricing, selection and demand. The airline industry is also clearly trending in this direction, as is higher education. Once an industry is at the bottom of an ethical slope, it is ripe for disruption by young companies that can sell through an honest, straightforward process.

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Written by Brad Hargreaves

August 28th, 2010 at 9:01 am

  • Bud Caddell

    As I’ve been heavy in complexity studies, I find this as a great example of the common system trap of rule beating, so thanks for sharing. Due to feedback loops, regulations, and competition, creativity has been unleashed in the wrong direction. In the 70u2019s, Vermont adopted a land use law that required a complex approval process for subdivisions the size of 10 acres or less. Now, Vermont is littered with plots of slightly more than 10 acre developments. I wonder, what’s the feedback loop that’s causing the behavior? Is it that landlords are restricted from increasing rents beyond a specified range UNLESS the tenant increases their floor space? Do property taxes fluctuate more drastically than rent is allowed to fluctuate? etc. Would be an interesting exploration.

  • subdee

    Oh yeah, we moved out of our old building after the landlord increased the square footage to more than the OUTSIDE measurement of the building. nnA year later, and the space is still empty…

  • DontBeEMO

    ::Facepalm:: Clearly you have never actually worked on a commercial lease in New York City. rnrnLets start with some basics. For starters, no one looks at lease in price per foot. The COO of a company outlines his/her operational needs to determine how many people they will need to house over the course of a lease. Then, the CFO tells the COO how much they can afford to pay for the whole entire lease per year. If you have 20 employees, and I charge you $200k in rent per year, does it matter if I tell you its a one square foot office or a one million square foot office? Absolutly not. Your two questions are “does it work?” and “can I afford it?”. rnrnSecond, this isnt advertised ANYWHERE as square feet. It is advertised as RENTABLE square feet. The inclusion of that adjective in and of itself means a square foot and a rentable square foot are not the same. rnrnThird, and here is the most important one… about 90% of leases (i.e. the written binding agreement for the transaction) in this city do NOT have a square footage written into them. In fact they expressly say no warranties are made by the landlord as to the size of the space. In the 10% where size is mentioned, the landlord clearly states the square footage, loss factor, and method(s) of measurement. rnrnThe long and short of this is that the transaction is completely transparent to all the parties involved. Its just not transparent to people who have never looked at a commercial lease. Greed and ethics have nothing to do with this.

  • Brad Hargreaves

    A company I founded just closed on 16,000 square feet in Flatiron, so not quite.nnIt’s surprising that you can’t recognize your own doublespeak. How is “Rentable square feet” a fundamentally different term than “square feet”? To people without specific knowledge of commercial real estate, these terms are identical.nnIt is irrelevant that leases do not have a square footage written in. Spaces are priced and presented to potential tenants based on a metric that has little connection to reality.nnTrue, most companies have organizational hierarchies that work within this bizarre structure. But many — such as the startups I work with on a day-to-day basis — don’t. To them, these practices are confusing and unethical.