Late last year, when the education publishing company Scholastic offered up about 60,000 square feet of sublease space at the top of the Soho office building 568 Broadway, the firm quickly found it wouldn’t be difficult to fill.
Within weeks, a host of tenants were competing for it, including several tech firms, one of the most active sectors of the leasing market in Manhattan right now. Tumblr, foursquare and AppNexus, all well-known names in the industry, moved to the front of the pack.
On the face of it, such a decision would seem easy. Of the three, only AppNexus, a firm that specializes in online advertising and is backed by the software giant Microsoft, is known to be profitable. But in a tech boom in which riches don’t always flow from the most likely sources, the deal for the space took a different turn.
The competition soon boiled down not to AppNexus but to Tumblr and foursquare, two companies that have become top brands in the new internet boom and have raised tens of millions of dollars in venture capital between them, but have yet to find income-producing platforms for their services.
Scholastic eventually cut a deal with foursquare for the space, despite some clear hesitation: convincing the sub-landlord that the company had the future business plan and talent to make good on its commitment was paramount in winning it the deal, according to its broker in the transaction, Sean Black, an executive at Jones Lang LaSalle.
“What do you do when you’re competing against someone just like you?” Mr. Black told The Commercial Observer during a recent conversation. “Well, I knew what the sub-landlord needed, more than anything: security. What are they going to do if they have a subtenant that goes under in a year or two, then they get the space back and there’s less term on the sublease and the office is worth a lot less? They want to know that the tenant they arrange will be there for the life of the lease.”
Still, Scholastic made what some leasing experts claim to be a risky choice, and in doing so highlighted the conundrum facing landlords all over the city—but particularly in Midtown South, the neighborhood that has emerged as the most popular among tech companies. Although these firms are the fastest-growing segment of the city’s economy and are often backed by big slugs of equity hoping to fund the next Facebook, many have thin financials, a short track record and, in the often sophisticated and fickle world of web commerce and social media, difficult-to-evaluate business plans.
“It’s very hard to tell what works,” Lawrence Lenihan, a venture capitalist with the firm FirstMark Capital, said. “Look at Groupon: everyone thought it was the greatest idea. Anyone in the minority who thought it wasn’t, in the end was right. It’s hard to get inside these companies and understand what will make a good investment.”
The siren song of high rents has landlords increasingly staking a bet on a sector many experts have begun to suggest is experiencing a bubble.
“I definitely think there’s going to be a big shakeout,” Mr. Lenihan, whose firm has invested in several well-regarded tech properties such as Pinterest, said. “Ninety percent of these firms are going to go by the wayside. That’s how it works.”
The boom, ushered in by firms like Google and LinkedIn and Facebook, which have all established sizeable beachheads in the city, has also created concerns whether areas like Midtown South are also unduly exposed to a possible repeat of the dot-com bust a little over a decade ago.
“It has to be a bubble,” one veteran Midtown South leasing broker at a major leasing brokerage told The Commercial Observer, requesting anonymity because of concerns his feelings on the market could alienate landlords who are his clients. “I’m starting to hear asking rents on space that used to be $35 or $40 per square foot at $75 asking rates. That’s like buildings on Park Avenue asking not $100 per square foot but $200 a foot. When did that happen last?”
Though several industries drive leasing in Midtown South, and the area increasingly appeals to established tenants like law firms and financial companies, technology businesses clearly have played a key role in lifting occupancy levels and rental rates in the area.
According to data compiled by the real estate services firm Cushman & Wakefield, about 3.1 million square feet was leased in Midtown South in the first nine months of the year, about the same level that was leased during the same period last year, when the tech boom began to gain steam. The figures are well higher than the historical average for the neighborhood in recent years, which typically sees about 2.7 million of leasing through the first three quarters of the year. A third of the activity in 2011 and 2012 has been driven by tech and new-media companies, C&W says. Rents have responded to the uptick in demand and are currently at nearly $50 per square foot on average in the area, $10 a foot higher than where they were a year ago and fast approaching the previous peak of about $55 per square foot in 2008.
“At this rate, we could hit all-time record rates for Midtown South by next year,” Ken McCarthy, an economist for Cushman & Wakefield, told The CO.
The strong market has emboldened landlords to position product to tap into the demand.
TF Cornerstone, a real estate development and investment firm, is renovating 387 Park Avenue South, an over-200,000-square-foot building it owns on 28th Street, to try to net rents in the $60s per square foot. Earlier this year, Imperium Capital, another real estate investment company, acquired 233 Spring Street and 161 Avenue of the Americas, a twin building complex the firm is planning to combine into a higher-end office building that will be about 740,000 square feet in size, making it one of the largest such towers in its area, on the border between Soho and Hudson Square. It too has lofty rental targets.
“We are looking to achieve rents in the $60s per square foot,” Daniel Glaser, a principal of the firm, told The CO, noting that current tenants in the property pay a fraction of that rate, as low as in the $20s per square foot.
For Mr. Glaser, a fundamental shift has occurred in Midtown South that he says prevents his project from being at the mercy of the technology sector.
“It’s now a neighborhood where you see all tenants wanting to have space,” Mr. Glaser said. “We don’t look at this as a risk. You have hedge funds coming to the area to take space. Everyone wants to be in neighborhoods like Soho.”
In fact, several leasing brokers, landlords and technology experts say that the downside risk to the current surge in Midtown South is far more contained than it was in the early 2000s, when dozens of technology firms that had doubled down on space in the preceding years went under and threw large chunks of space back onto the market.
“There are so many ways they could monetize the product,” Brian O’Kelley, the chief executive of AppNexus, which eventually took over 60,000 square feet of space at 28-40 West 23rd Street, said of Tumblr and foursquare. “These aren’t companies that are going to go under. If a firm like Gilt Groupe has lower sales than expected, it has a lot of equity behind it and it will go back and retrench and adjust and adapt. It’s not going to be like the dot-com bust, where all these companies just suddenly drop. Most of it nowadays is viable business models or companies that have a lot of promise.”
Landlords have also been more cautious.
After losing the space at 568 Broadway, Tumblr eventually resigned its lease at its existing location, 35 East 21st Street, and expanded to about 21,000 square feet in the roughly 100,000-square-foot building. The negotiations included direct talks between the building’s landlord, Centaur Properties, and Tumblr’s acclaimed founder David Karp, who, according to sources, gave a captivating presentation on the company’s potential and future.
Still, ownership took steps to protect itself, according to Daniel Levine, a leasing executive at Newmark Grubb Knight Frank, who along with Newmark’s New York-area president, David Falk, represented Centaur in the deal. Mr. Levine was not specific, but said the landlord received a significant security deposit. The expansion space that Tumblr will build out for its offices is also likely to have an installation that would appeal to other users.
“It’s the kind of space that, if we took out to the market, wouldn’t take long to fill,” Mr. Levine said.