Let's Exchange Financials

The price of San Francisco office space is mostly falling.  Sure, there’s some outlier examples of premier view space where the price is stable, even increasing.  But, on balance, we’re talking about a significantly declining market.  A silver lining for occupiers who’ve otherwise endured a long period of limited supply and record high costs.  Yet while on paper the cost of the market looks better, the effects of the downturn can (and will) render some landlords incapable of effectively running the building.  Because most lease negotiations are set up as a sort of “David and Goliath” battle in which the tenant is David and the landlord Goliath, it’s not necessarily common for tenants to ask too many questions about a landlord’s financial position.  Yet like the tenant, the landlord has many obligations under the lease, the performance of which require its financial health.  Tenants must share their financials and often provide security mechanisms to secure their performance under the lease.  This typically comes in the form of a letter of credit or security deposit.  The landlord version of security for the tenant would be things like a self-help provision and/or an SNDA.  Self-help enables the tenant to solve for issues the landlord is otherwise obligated to solve, but for which it does not have the capital to do so, by paying to have the work done and deducting the cost from Rent.  The SNDA, or subordination non-disturbance agreement, is a legal document that protects the terms of the lease in the event a lender takes over building (e.g., the landlord defaults on the loan).  These are examples of protective mechanisms against a failing landlord. 
 
It’s generally true that larger institutional landlords are better positioned to perform through cycles, maintaining the operational integrity of the asset despite a market downturn.  Quality landlords run the asset with a constant eye on maintenance and performance.  Where possible, they invest to enhance the building’s performance and to ensure the longevity of the equipment and systems.  However, when faced with mounting vacancy and reduced or even negative returns from leasing activity, corners may be cut.  Rarely does this work out in a way that isn’t impactful (negatively) to the occupants.  Maybe it’s the elevators that were slated for mechanical upgrades prior to the downturn, but have now been put on hold.  Or, perhaps it’s the chiller, which in the absence of being replaced or properly repaired is now prone to stalling out when the temperature hits 80 or higher…right when you need it the most.  We’ve seen examples over the years when the “landlord” with whom we are supposed to negotiate has actually lost all its equity and the debt holders are trying to figure out what to do with the asset.  This can be precarious because the party with whom you are negotiating may not actually be able to bind the landlord.  Remarkably, most landlords in this situation won’t volunteer their deficiencies in this regard.  This means a tenant could go all the way down the path toward a transaction, negotiating in good faith with the “landlord”, only to have the terms rejected by the lender (the actual landlord).
 
Now is an excellent time to secure a long term cost advantage for San Francisco office space.  But it’s also a time to be cautious and to know the landlord’s financial position.  It’s a time when negotiations may veer into the realm of the uncomfortable, but with good reason.  After all, a lease is about much more than Rent.  Having the right protections in place to navigate the landscape of a steeply declining market is critical to your success and peace of mind as a tenant.  And make no mistake, we’ve now entered a time in which there will be those who can no longer adequately operate the asset.  Just because the building is a big asset and the landlord a big institution does not mean it’s well positioned.  Right now there are assets in downtown San Francisco (and most major US Metros) that have debt levels which are higher than the market value of the building and for which the leasing potential will yield results that generate a negligible or even negative net return.