Without question, the use of property by legal firms as both a financial and strategic tool has evolved very quickly in the past three years, aided by the recession. It has transformed from a traditional ‘place to do work’ to one with a myriad of agendas.
While the single largest cost of a law practice is people, the second largest cost is property, and this can cost between 5% and 10% of annual revenue for the majority of firms.
The recent, ongoing recession, and the lack of debt funding for developers, has also dramatically reduced the Grade A office supply pipeline of building and space options in capital cities globally – none more so than in London.
The net effect in the current and short-term future is that certainty of space availability will be challenged. Additionally, office rent levels for Grade A space are forecast to increase in most traditional legal markets, as landlord incentives are reduced. This will also impact on forthcoming rent reviews and the expansion and consolidation needs of legal firms planning for the future.
Planning for the future Senior management teams have and should continue to focus on using market intelligence and advice to reduce all property costs by, for example, reducing the amount of property occupied, ensuring rent reviews are defended, and off-shoring or near-shoring.
Reducing the amount of property occupiedIn the five years prior to the recession, there was cross-border growth, affiliations or outright M&A of law firms. In certain circumstances, this has left legal firms with enhanced property liabilities, but historically the impact on opex was minimal compared with revenue growth. Now there is an acute awareness of these liabilities and their impact, and a full-scale effort is being pushed to reduce property costs.
As a result of these mergers, some firms have duplicate offices or non-core or non-strategic offices which no longer provide value to the firm. Given the lack of good quality and well-located space anticipated as a result of subdued development pipelines in most city centres, this is a favourable time to sub-let surplus space to obtain optimal financial relief.
Furthermore, many firms are incorporating open-plan layouts that increase occupancy density, while improving collegiality and focusing on a re-ignited strategic objective of cross-selling services. By decreasing the space per person ratio, firms can reduce costs and can release space back into the market.
Defending rent reviewsEnsuring rent reviews are fiercely defended is another way to reduce property costs. Firms should consider re-negotiating lease terms using strong covenants as part of the rent review process.
With property rates being lodged at 2008 rental levels, it is imperative that all incorrect property rates are appealed and reductions sought in a very assertive manner. Furthermore, there are a number of circumstances (for example, road works, scaffolding) which provide up to 25% rates relief if the relevant authorities are notified. These are easy ‘wins’ for firms.
Off-shoring and near-shoring
Reducing on-shore or HQ-based workplaces will have a significant impact on overheads, including property costs. Through Legal Process Outsourcing (LPO), for example, many firms have outsourced business support functions (for example, HR, finance, IT) to third party administrators, such as Integron or Exigent, and have reaped the benefits.
Some companies are also sub-contracting lower-margin work to reputable, but niche, legal practices in non-capital city locations. This is usually done as a response to specific client needs and tendered contract costs, but can be considered in the context of reducing property costs.
Off-shoring litigation document review and specific research which was previously undertaken by on-shore paralegals or trainees can reduce costs to clients by 20% to 50%. Many legal firms have capitalised on talent pools located in cheaper locations such as India.
Another option for cutting property costs is near-shoring, or relocating all residual non-client-facing functions from high-cost locations. In addition to IT, HR and finance, this could also include business development, marketing and bid support. This approach underscores the use of property as a more productive tool in improving competitive costing for client service, and not simply a place where employees work.
In the UK, we are seeing all professional service firms, not only legal firms, reviewing who truly needs to be in which location, based upon their clients’ needs.
CSR and attracting talent As corporate social responsibility becomes increasingly important, management of prominent firms are placing more emphasis on locating themselves in sustainable buildings and places. Considering that they are often advising clients on green leases and other Carbon Reduction Commitment (CRC) issues, they should be seen to lead by example.
When it comes to attracting top employees, the amenities within spaces were key in the 'good' years. Fitness clubs, crèches, significant and numerous impressive canteens, pools, squash courts and elaborate roof terraces were the norm.
In 2010, however, the priorities have shifted and staff perks are not the only consideration. Now the spaces not only need to be attractive to senior partners and employees, but also appropriate to the client base and expectations, convenient to transport and other amenities (for example, hotels, restaurants), and useful for client purposes. Additionally, consistency of brand and image of buildings has triggered a desire to improve the quality of locations.
Lease accounting implications
It is looking likely that the effects of the revised lease accounting standards proposed by the International Accounting Standards Board (IASB) may go as far as to impose that the total (not annual) liabilities related to leasehold obligations will have to be recognised on company balance sheets as of the financial year 2012/2013.
The IASB (and the Financial Accounting Standards Board) have tentatively settled on a ‘right-of-use model’. This approach requires the lessor to recognise an asset for the economic benefit it will receive over the life of the lease and for the lessee to recognise a liability for the obligation to pay rentals. The lessee will initially measure the right to use an asset at cost, defined as the present value of the lease payments discounted using the lessee’s incremental borrowing rate.
One key aspect of the proposed changes that occupiers need to be aware of is that the pattern of rental expenses will change from straight line to a system similar to finance leases. This means the rental payments will be split between capital and interest. This is likely to frontload the interest element, increasing near-term profit and loss statement charges.
The gross balance sheet will be increased by both the assets and liabilities, which will mainly affect those companies whose use of capital intensive assets, such as real estate, have been financed as operating leases. The effect of the previously higher profit and loss statement charge will not be reflected in earnings before interest, taxes, depreciation and amortization, since both depreciation and interest are excluded, but at net operating profit level.
The impact to the finances of law firms is not crystal clear. However, those legal firms with large leasehold estates will be affected more so. Profit and loss will most likely be impacted more substantially in the early years of the lease by larger cost figures, as the IASB proposal requires that any lease extension options as well as the full lease terms are used as the basis for calculation. Additionally, some firms may be more exposed to additional advisory costs as they will have to value their leases at every balance sheet date, and may not be able – or wish – to do it themselves.
When it comes to preparing for these changes, the topic is still evolving. However, there is a view that prior to 2012/2013, companies can mitigate exposure to longer leases by buying in freeholds (albeit with a trade-off on the balance sheet) or potentially renegotiating with landlords to either bring in flexibility to reduce the length of the lease, or remove flexibility in order to reduce current rental payments.
As each legal firm has a different portfolio structure, there is no simple solution, and a more focused discussion with advisors is recommended.
Tracey Byer is head of occupier services at global real estate adviser DTZ