Jim Hartlieb:
Welcome to the First Business Bank podcast. I'm Jim Hartlieb, president of First Business Bank. And I'm pleased today to have a couple of guests from Madison, Wisconsin with me, Beth Prochaska, from Potter Lawson and Dean Porter from Broadwing advisors. Today, we're going to talk about emerging trends in the commercial real estate office market. And before we jump into our topic, Beth and Deanna, would you mind introducing yourselves and talk a little bit about the roles you play in your company? Beth, why don't we start with you?
Beth Prochaska:
Yeah. Hi. Glad to be here, Jim. Thanks, and hi, Deanna. I'm Beth Prochaska. I'm president and CEO of Potter Lawson. We're an architectural and interior design firm in Madison. We help do designs that give our clients a competitive advantage over their competition, which is really important today when recruitment and retention is so critical for all of us.
Jim Hartlieb:
Thank you, Beth. Deanna?
Deana Porter:
Good morning, Beth and Jim. Thanks for having me today. I am the senior vice president at Broadwing Advisors. We're a commercial real estate advisory firm in Madison, Wisconsin. We specialize in working with end users or tenants in the commercial real estate space.
Jim Hartlieb:
Thanks, Beth and Deana. Why don't we get into the topic a little bit, but before we dive into the details, maybe talk a little bit about the roles you play within your company, and Beth, I'll start with you, in terms of the stage of the whole project.
Beth Prochaska:
Yeah, Jim. So, we begin really early in the process, sometimes before a client even knows what they need. We typically start with programming or planning services. It's a study to identify what they need to operate efficiently. Sometimes, it's when they're growing and they need obviously need space, but it can also be when they're getting smaller, and it could be that their industries changed or they need a completely different space altogether. So, we get involved very early, and then we're involved from the planning through design, construction, and occupancy, soup to nuts.
Jim Hartlieb:
Yeah, very helpful. I think this topic is relevant, then, over the last two years, a lot of changes. So, we'll come back to you, Beth, but that's helpful to set the stage as we move forward. And then, Deanna, how about yourself and your role at Broadwing?
Deana Porter:
Yeah, absolutely. When working with our clients, we tend to, like Beth, start out very early in the process. For us, the earlier the better. We like to focus a lot on the strategy. So, really thinking about our client's business first, before the real estate, because there's a lot of moving parts that take place when making a real estate decisions, whether that's your downsizing or really thinking about how you are going to be working, especially now in a post-pandemic era. We really want to be part of that strategy of helping to decide on what to do with your real estate moving forward.
Jim Hartlieb:
Excellent. Well, thank you for that, setting the stage there. As we look at changes that have already occurred, I think about the banking industry, while this doesn't affect First Business Bank because we don't have a branch network like most banks, the last two years have seen the largest number of net closures in banks in the history of banking. So, there was 2,100 branches that closed in 2020, and that increase to almost 3,000 in 2021 as consumer behavior has shifted. That's just a small niche of the overall real estate market, but it's a definite change for the future. And so I guess moving back to our topic then, is it too soon to tell, Deana, in terms of things that will permanently change about the office space itself? What have you seen so far?
Deana Porter:
Well, I think we all see the change. We all feel the change, especially in the office market. People are working from home. I think I read a statistic just recently that 59% of the workforce is working from home. And if you think about that number, how in your real estate, so as a business, as owner, as a business person, real estate tends to be the second or third highest cost on your P&L. So, this is a big bucket. And your first cost or your highest cost is typically your people. So, those two things really align. And so, you really want to think about moving forward, how to continue the work from home process, but what do you do with your real estate? How are your people working? And more importantly, as a leader, how are you continually to develop your talent and your culture? These are things that are important. And so, changes are happening. I think the work from home model is here to stay. We just haven't seen the full impact yet.
Jim Hartlieb:
Beth, you mentioned your role in the design phase and again, maybe it's too soon to tell, but what have you seen in terms of emerging trends with designing of space, either existing or new projects?
Beth Prochaska:
Yeah. Well, as we all know, trends come and go, and some stick and some don't. I remember vividly, 10 years ago, they told us every office was going to have nap pods, beer taps, and pool tables. I can tell you, we didn't design one space that had a nap pod, but we do have spaces that have beer taps and other amenities, more hospitality field. And we're seeing that trend moving forward, for sure. I think I early on in the pandemic, right away, furniture reps and some other brokers came out and said, "The office is a thing in the past. It's never coming back. Buy furniture so everybody can work at home." That's not been our experience. I think some businesses, work from home works or hybrid works. For instance, in the past, we did call centers where people were shoulder to shoulder, and they've found that's an easy one that can work from home.
Beth Prochaska:
Some technology based companies can work from home, but most of our clients are saying we've been work from home. We need to get at people back in the office. Because when everybody's worked from home, the trend that some of our clients that have been work from home are seeing, now it's staff, because there is a staffing shortage. It's a good time to be an employee. They're saying, "Okay, I'm not coming to the office, so I want an increase in pay, and I want more money to cover my bandwidth, my technology, office furniture. So, companies, our clients, and I'm hearing, they're saying, "Wait a minute. This isn't a savings to have everybody working from home. It actually might end up costing us more." And where's your culture? Where's your liability? Where's your creativity? Where's your collaboration when everybody is remote all the time.
Beth Prochaska:
So, I think it's still a little bit too early to say. We just finished designing a space for someone that they're a hundred percent work from home, but their goal was, "We want to design a space where it's fear of missing out. People want to come, and there's not a assigned desks." There's a quiet zone. If you need to come in and you have to have total-quiet, head-down space. There's a comfort zone. If you want to sit on a chair, but you want to be around people. There's collaboration zones. And then, there's a pretty big hospitality component that the heart and home, like your kitchen is in your home, we're seeing clients design food service facilities and kitchens, even smaller spaces where this can be a bar we can have everybody in for happy hour. So, we're still figuring it out, in all honesty. I think work from home or hybrid is definitely here to stay, but not for everybody.
Jim Hartlieb:
Well, that's an excellent point. And at First Business Bank, we're in the same boat. Our client-facing people are a hundred percent in the bank, but the rest of the bank is very hybrid. And as we think about, "What are the impacts on culture?" That's still evolving. And do we need to enhance the space in some way to attract people back to the office on a more regular basis. Deana, I see your head nodding. Are you seeing some of that in the conversations you're having your clients?
Deana Porter:
Absolutely. We just work. We're working with a health tech company who... They're in tech. They're virtual. They're used to working from home, but they really are missing that connectivity and that creativity. And so, they've downsized, which a lot of companies are doing, but they're also rethinking the space that they have remaining. "How do we make this space a place where people want to come and collaborate and share ideas and maintain that culture and that connectivity you think about. Even in my industry, I'm often collaborating with the owner of the company. We are bouncing ideas off each other on a daily basis. I don't think I could do my job as well as I do without that collaboration. He's a little bit more seasoned than I am, so we're at different experience levels. So I come with a different perspective, and often it's the melding of our two ideas or our two thought processes that best serve our customers and our clients. So, I don't think that we're different than any other company out there.
Jim Hartlieb:
So, let's dive into that just a little bit more. And I'm going to talk more the actual lease with you, Deana. And Beth will talk about supply chain and construction a little bit from the design perspective. If I'm a business owner and I could see there's culture deterioration, and I want people back in, but I've got five more years on my lease, and I don't need all of this space, but I need it better. Deanna, do I have options if I have a long runway on my lease yet, or what would you advise in that situation?
Deana Porter:
Well, I would need to read your lease to really answer that question, but you always have options. You could sublease. You could reposition the space. You could think long term. It's five years. Where you going to be in 10 years? So, it's really about coming up with a strategy for your business and understanding what does the next 10 years look like for you? What does the next five years look like for you? And coming up with a plan that helps support your business. As we work with businesses that are going into new lease, we often hear shorter terms. So they're looking at three year terms or five years with a three-year out because there is uncertainty. So, it's really coming up with a plan ahead of time. Or even if you're stuck in a long-term lease, talk to your real estate advisor. Ask them what can be done to help mitigate some of these costs or, "How can I be creative?"
Deana Porter:
There are a lot of interesting things that are happening now with leases. Landlords are holding firm on prices, but we're seeing things like free rent or delaying the commencement date in leases, just to help maintain the asset value by holding the price strong. And I'm putting my landlord hat on now, but there's ways to mitigate some of this. And like I said, ask questions. Lean on your advisors. Lean on your design team. They're a really great resource to help with some of these issues.
Jim Hartlieb:
Yeah, that's really good. And so don't throw my hands up and say, "I don't have any options. I'm in a long term lease." This is just evidence you need good partners around you.
Deana Porter:
Absolutely.
Jim Hartlieb:
So, that's good insight. So Beth, back to the design side. So I'll use the same example. I'm trying to get people back in the office. I have more years on my lease, but I hear about supply chain issues and cost increases, and my margins are already squeezed. What can I anticipate if I do need to do some build out and remodeling of my space in terms of timing or cost increases. I guess, what have you seen here over the last 12 months?
Beth Prochaska:
Well, it's been a roller coaster ride to say the least. Material and supply chain issues have been a challenge. Overall, we saw about a 20% increase from pre pandemic to 2021. Lumber went sky high, and then it came back down. Steel kept going up and tapering off and going up and tapering off. Appliances are still through the roof, if you can get them. It's about a 300% increase. Lead times are crazy. We do a lot of multifamily right now, and we're telling people when you break ground, order the appliances. And so, if you get them, you're good, but now we're finding some people, they get them, and then they got to pay to store them, but they get them. Because we had one client who didn't want to do that. We advised them to do that. They didn't. The appliances came in. The vendor could get more for them, so they sold them to someone else at a higher price.
Beth Prochaska:
So it's a challenge. Curtain walls up 26%. Roof insulation's up 33%. Backup generators are up 200%, and they have a year lead time. So, it's changed our industry immensely. What it means is usually we used to have to, when we'd start a big project or any project, but you know, steel was our long lead time. So, as soon as we get going, we'd start with the steel. Now, just about everything's a long lead time, and it really has challenged our staff because we'll specify something, and then we'll get that far in construction and it's not available or the price has gone through the roof. So, we'll try and find another substitution that's just as good that we can get. So, it is creating more work on the design side, but we're rolling up our sleeves and making it work for our clients to keep them happy.
Beth Prochaska:
Looking forward to 2022 and beyond, I think we're cautiously optimistic with the view as construction spending is still strong. There's lingering supply chain issues and labor shortage that I think is going to continue to put pressure on projects, but we'll see some persistent cost fluctuations, but I really think historically, if you look at how this has happened in the past, escalation is going to start to plateau off pretty soon. And while it's tempting to say, "Let's just wait a year," we did have a client on a big project that took a big pause in 2020. They are really regretting that now because now they're starting it back up and they're paying a 20 something percent premium and construction cost. Design cost is the same, but construction cost is a lot more. So, if you really need it, my gut is to go. Go now.
Jim Hartlieb:
Yeah. Figure it out.
Beth Prochaska:
Yeah.
Jim Hartlieb:
It's an investment in your people. And as we talked before, in many companies, that's the most important asset is the people. So, Deanna, I guess I'll come back to you on the same topic. As these construction costs have been increased, obviously sometimes the tenant bears that out, sometimes the landlord [inaudible 00:15:07] shared. Have you seen that push lease rates up yet as there's new construction for office space?
Deana Porter:
Yeah, I think the impact of the cost is driving lease rates up. There's only a certain amount of money the landlord's going to invest improving this space. And so, if that is $20 a square foot and the investment is $60 square foot, well, where does that delta come from? And a lot of times it's a combination between amortizing 20 more dollars into that lease rate over five years or whatever, seven years, and then the tenant is coming out of pocket. And there's a lot of thoughts on, "How do we value engineer this? Where can we cut corners? Do we really need the fancy tile, working with your design professionals, your construction professionals. Here's my budget, and how can we get there and still create a really great product?" are conversations that are had all the time. And I am working with a client right now, who they've only waited six months, and their project's almost doubled in costs. So yeah, it's a real issue.
Jim Hartlieb:
It's a real issue, but it's really important. And I think the common theme is being sure you have strong partners because what you're talking about is design construction. Selfishly, the banker might be a part of that, as well. "How much can I afford? You know, what kind of a loan could you approve for me to be able to do these things to get employees back into the office?" if you do need financing. So, having a strong team around you is critical.
Deana Porter:
Sorry. I was going to say those are some of the first questions that we ask. "Who is your banker? Who's your accountant? Who's your attorney? Who's your design professional? Who do you have relationships with?" Because it will take all of these partners to really create a successful project.
Jim Hartlieb:
Yeah, that's great advice. Obviously, tax implications and other things. So, good advice there, Deana. I'm going to shift gears a little bit to ESG, environmental, social, and governance. Sustainability obviously has taken on a lot more bandwidth here over the last few years. How has that shown itself up in your world, Beth, in terms of projects, design, and construction?
Beth Prochaska:
Huge. Biophilic design, and I really don't like that word, so I'm rebranding it as human-centered sustainability. It's essentially incorporating elements of nature throughout a space. I think it's really important. It's been proven to reduce stress, improve focus, boost creativity and overall wellbeing. And with everything that everybody's gone through the last two years, there's a mental health crisis brewing everywhere. There really is. Sustainability is also a big priority, and it's always been a priority for Potter Lawson. We've been doing sustainable design way before it was cool back in the '80s. But after two years of plastic and disposable everything, I think we're going to see a hard swing back to caring about sustainability and being eco-friendly in everything we do, from materials that we choose to the products that people have in the office for day-to-day use.
Beth Prochaska:
Maintaining a healthy planet is just as important as designing a beautiful workplace, which is why we carefully select manufacturers that we work with with [inaudible 00:18:41] materials to be more carbon neutral. It's really important. Aside from sustainable materials, energy efficiency is important, and that's where maximizing access to natural daylight, which is proven with circadian rhythms and all the research with that, but also LED lighting and energy efficiency, all really big trends that aren't going to be going away.
Jim Hartlieb:
Deana, have you seen some of these same characteristics play out in the space that you've been a part of?
Deana Porter:
Yeah. Absolutely. People want to be in the environments that have natural light. When you think about design, you also want to think about your mechanicals. Are you bringing in fresh air? Coronavirus taught us a lot of things about our work environments that we didn't even know about. You'll see now landlords installing pretty high-tech HVA systems to help mitigate the risk of infection. And these are things that tenants are starting to look for and ask about. And so, I think landlords need to be prepared to answer those questions. And when you're working with a client that's looking to build a building or construct their own project, they're going to start asking these questions. "What can I do? What can I install to help keep this environment safe and clean and a place where people want to come and work?"
Beth Prochaska:
Yeah. If I can add to that, right in the very beginning of the pandemic, we found out about the GPS system. It's global plasma system. It's basically really cool tech analogy. It's an ionic system that you install in your HVAC duct work. At the time, they said 99.9% that it kills cold and flu, but we didn't know about COVID-19, but I said, "Pull the trigger. Let's do it because cold and flu isn't going anywhere anyway." So, that's really helped. Since then, they determined that it does in fact kill coronavirus, so we're really happy. I think it makes our staff feel safer, which that's part of the mental health thing, wellbeing of your employees.
Jim Hartlieb:
Absolutely. And none of the things that you mentioned make the project cost less, but we have to weigh the cost of that physical investment versus the cost of maybe losing an employee or an entire group. And so, that's what business owners... Making the tough decision is part to being that business owner. And having good partners around you. So, appreciate your input on that. As we wrap up, maybe just any final thoughts, if you were advising a business owner that is in space or looking at new space, are there any little nuggets of information that maybe aren't as prevalent out in the media that you might advise them to think about? Deanna, I'll start with you.
Deana Porter:
Yeah. I would say, "Get back to basics. Think about your business plan. Think about your people. Really, you almost have to take a step back and rethink and adjust to this new way of working and create your path. It's almost a shift in culture somewhat, but think about doing it well and really understand where you're going as a business and lean on experts. Talk to your bankers. Talk to your CPAs. Talk to your design professional, your real estate professionals. They'll help. That's what we're here for."
Jim Hartlieb:
I think that's excellent. You know, over the last two years, it was hard to plan. You didn't know what was around the corner the next week or month. As we recorded this today, the mask mandate in Madison is finally being completed. So, really good advice to really get back into planning mode. Beth, what would some of your advice be?
Beth Prochaska:
Yeah, I think Deanna's spot on with that. We used to say, "If companies weren't changing and growing, they were going to become part of the pavement." I think now, we don't want to pave the road until we know where we're going. Times are different. I think the key moving forward is be efficient, functional, flexible with an emphasis on comfort and wellness. That's going to be what's takes precedence.
Jim Hartlieb:
Excellent. Well, thank you, Deana and Beth for joining me on the podcast this morning. Thank you to our listeners. Please visit us at firstbusiness.bank and our resource center where you'll have this podcast, as well as many others, to help you as business owners and executives make important decisions in your business and lives. Have a great day, everybody.