When Bill Szeto first looked for office space for his startup in Texas two-and-a-half years ago, landlords were a demanding lot.

"They wanted letters of credit, huge deposits, personal guarantees, and they didn't care how much money a startup had in the bank," Szeto says. In addition, the rent was between $22 and $24 a square foot per year, he says.

Things have changed.

When Szeto scouted locations for his new company, Ceterus Networks, landlords only wanted one month's rent in advance. That was it. And the price? "About $6 to $8 a square foot per year," he says. "Really, they were just happy to have a live person come look at the property."

As the recession wears on, telecom companies based in the United States are facing another overcapacity problem -- not only is there too much fiber in the ground, but they've also bought or leased too many square feet of office space.

For brand new companies with some funding, such as Ceterus, this glut means it is possible to secure a great location at a reasonable price. But for those companies that expanded too fast in the bubble and are now looking to scale back, a large real estate lease can be like a noose around the neck.

Indeed, while telecom companies continue to lay off employees and cut costs, some also have to shell out millions to pay for empty cubicles, vacant conference rooms, and unfinished buildings.

Ciena Corp. (Nasdaq: CIEN), for instance, is still dealing with expenses from its restructuring and acquisition of ONI Systems. As of July 31, it said it owed about $50 million for various expenses relating to unused office space, according to Securities and Exchange Commission (SEC) filings.

During Juniper Networks Inc.'s (Nasdaq: JNPR) restructuring, that company was able to cancel leases on space it couldn't use. However, as of June 30, its SEC filings show, it owed about $4 million for "lease termination charges."

Redback Networks Inc. (Nasdaq: RBAK) has been particularly hard hit, both by the economy's slowdown and by its own overestimation of how fast it would grow. In 2002, the company estimates it will pay $6 million more for space it isn't using than for the space it occupies.

Table 1: Redback's Obese Lease

"It becomes a drain on their cash," says David Gross, an analyst at Communications Industry Researchers Inc. (CIR) "In Silicon Valley a couple of years ago, office rental rates spiked so much that [leased, unused space] is more of a financial burden now.

"Back then, every tenant wanted to present themselves to their landlords as companies with all kinds of opportunities for growth. In many cases, they simply took more space than they needed."

In Silicon Valley, entire office buildings are vacant. In fact, some startups used venture capital to renovate buildings, only to go bust. During a recent vist by Light Reading editors, several Valley veterans point to the building that once housed Nexsi Systems, which now stands vacant on Tasman Drive next to the Cisco Systems Inc. (Nasdaq: CSCO) campus (see Nexsi Hits the Exit).

A big reason for the glut is that tech and telecom firms assumed their companies would keep growing. They assumed rents would keep going up, so they leased more space than needed -- or even built new buildings -- as a way of saving in the long run. They also assumed the stock market would continue to soar.

Now they're 0-for-3 and the economy is chucking fastballs at their balance sheets.

How bad is the glut? About 14.6 percent of the office space in the San Francisco Bay Area (including Silicon Valley) was vacant in the first quarter of this year, according to CoStar Group Inc., the commercial real estate research firm.

In the Dallas/Fort Worth area, where dozens of telecom companies are headquartered, there was a 20.9 percent vacancy rate in the first quarter, more than twice the industry norm, CoStar says.

The Boston, Dallas, and San Francisco metropolitan areas combined had about 128 million square feet of developed but vacant office space the first three months of 2002, according to CoStar.

To put all that space in one building, you would have to stack New York's Madison Square Garden on top of itself about 156 times.

Interestingly, there may be even more vacant office space than CoStar's numbers show, considering that some buildings that have been paid for don't show up as vacant. "We believe... a substantial portion of the space that is technically classified as 'not vacant' is, in fact, not being utilized," writes Merrill Lynch & Co. Inc. real estate analyst Steve Sakwa, in a recent research note.

Indeed, the office space glut is the reason sections of Silicon Valley's Highway 101 look more like an empty Hollywood set than a thriving technology hub. [Ed. note: Tasman Drive? Try Tasmania!] It's also the reason the northernmost edge of Texas's Telecom Corridor is lined with one empty industrial complex after another, a single security guard watching over each lot.

Of course, the problem isn't just limited to telecom companies. In a recent conference call, executives at Mission West Properties, a major real estate company, sang the tenants-are-leaving-and-Wall-Street-is-grieving blues.

"In the 30 years that I've been in the business, we've never had a situation like what we've got now," said Mission West CEO Carl Berg. "Everybody out there has 50 to 60 percent more space than they need."

Mission West's vacancy rate stood at about 14.2 percent in the third quarter, which signals that, in Silicon Valley, not much has changed since the beginning of the year. Worse for Mission West -- whose tenants include Cisco, JDS Uniphase Corp. (Nasdaq: JDSU; Toronto: JDU), and Microsoft Corp. (Nasdaq: MSFT) -- is the fact that it only expects to renew about 20 percent of the leases that are expiring next year, and it sees no demand for the available space.

"The residential real estate market isn’t as bad," says Ceterus's Szeto. "I've joked with some that they should just buy an office instead of a big house.

"I mean, if they work for a startup, they'll end up living there anyway."

— Phil Harvey, Senior Editor, Light Reading
www.lightreading.com