Why Institutional Investment Keeps Rents High

When I began my real estate career in San Francisco in the early 1990s, office buildings were mostly owned by private investors using a relatively small selection of institutional capital partners.  The Shorenstein Company, whom I worked for from 1990 – 1995, was a great example.  At that time, they were the largest owner of office buildings in San Francisco, holding 11M sf.  During those days, most owners, including Shorenstein, employed a simple strategy centered on preserving tenants while minimizing cash requirements (funding of tenant improvements, etc.).  In most cases, the first choice was to keep the existing tenant by offering a rental rate which was discounted to market.  If that failed and the tenant moved out, the next step was to undercut the market by lowering the rental rate to steal a tenant away from another building.  The goal was to buy and manage the asset to generate maximum cash flow, which the investors counted on each quarter.  Importantly, the majority of assets were owned by this type of investor.  But by the mid-1990s, the nature of office ownership was beginning a period of significant change which would materially impact rental economics for decades to come.
 
There were 2 main catalysts for this change. First, the resurgence in real estate investment trusts (“REITS”), a form of ownership that was developed in 1960 but which really didn’t gain traction in US office markets until the mid-1990s.  Second, in the 1990s, asset allocation theory began calling for institutions to increase their share of real estate holdings.  These two events resulted in a wholesale shift in the type of ownership structures dominating markets like San Francisco. 
 
Today, office ownership is mostly institutional, with very few owners playing by the “old” playbook of cash flow preservation.  Nearly all the institutional owners subscribe to a similar strategy, one that is geared toward maximizing future asset valuation for a sale.   To perfect this approach, an owner may not want to keep an existing tenant whom is seeking to renew its lease at a discount to market, because despite the cash flow benefits, the associated negative impact on asset valuation is counter to investor objectives (e.g., future profit from sale of the asset).  There are many “buckets” within the category of institutional investor.  Yet the primary focus is always on asset valuation, causing these owners to behave in unison.  Rental rate is no longer the main form of competition.  Instead, owners compete with concessions and amenities.  Things like tenant improvement allowance, free rent and cash allowances to offset rent; and, luxury project amenities like fitness facilities and tenant lounge space.  Lowering the rental rate is a lever of last resort.  This has had the aggregate effect of holding rates higher even as the markets face mounting pressure.