Space Disposition Math Exercises in a Declining Market
Who wants to do some fun disposition recovery math?! San Francisco’s office market has been the perfect storm for occupiers looking to dispose of office space. High vacancy and sluggish demand against the backdrop of record high in place rents. While the market is a key variable in determining sublease outcome, it can be a distraction in defining the correct disposition strategy when occupiers focus on current rent values in the market at large. In the declining market, only the values being achieved on comparable sublease offerings serve as a relevant proxy for market, but even then, there is a high degree of fluidity. Why is the sublease offering valued differently than comparable direct space?
Firstly, it’s about the contract. A subtenant is not a direct tenant and does not enjoy the same rights as a direct tenant. For this reason, subleases are often discounted. Why would it matter? Well, for example, if the sublandlord were to default, the subtenant is not guaranteed the ability to stay unless it has a recognition agreement from the landlord, something rarely achieved.
Secondly, the sublease term is often limited. The weighted average remaining lease term for all sublease space in San Francisco is presently about 3 years. This, of course, means the subtenant takes on risk as to what happens when the sublease expires. In this environment, very few landlords will agree to back end terms that reflect where the market is likely to be as they rationalize it’s better to wait and see in the hope the market will recover (landlords are eternal optimists when it comes to future rent). Hence the short term sublease creates the potential for cost increases on the back end, and/or further disruption to the business with a relatively near term move.
Thirdly, the passage of time is a would be sublandlord’s biggest downside. A landlord having a percentage of its asset vacant may choose to hold off on making deals in a given market under the belief it will achieve better outcomes later - - - in other words, the trade of prolonged vacancy for higher future rent is deemed positive. However, sublandlords rarely benefit from this trade. In the context of shorter term subleases, each month of downtime reduces recovery.
The best way to approach a soft market disposition is to identify the total “market” value of the space and work backwards from there. Note, in a declining market, this number will be different than the remaining obligation. By way of example, let’s say you have a 10,000 sf space with 3 years of term remaining. The in place obligation is $100/sf/year, or $1M in annual rent spend, $3M over 3 years. However, the market has declined 30% since the lease was signed, leaving the current direct market value at $70/sf. But that’s the direct value. What’s the going sublease value? Likely as much as 30% less. So let’s say the actual achievable value for the sublease is $49/sf. The total achievable value (a 100% recovery) is $1,470,000 ($49/sf X 10,000 sf X 3 years). Each month is worth $40,833, or about $4/sf. Every month the space is vacant reduces the recovery by 2.7%. Now, since tenants who are seeking office space are nearly always at least 6 months ahead of their desired occupancy (and often more), we know there will be downtime. Further, we can look at the market trend for downtime, which in declining markets is always on the rise. Finally, there is free rent. Free rent is the way sublandlords solve for necessary improvements on the part of the subtenant; and, it’s a common concession in declining markets. Hence it’s important to assume some period of free rent. In the current San Francisco market, the value is typically one month per year of term, net of any TI offset.
Based on these factors, we would underwrite a potential recovery (net of leasing fees) of about $1M, or 33% of the remaining obligation and 68% of the total achievable value. The pricing strategy must be based as much on mitigating downtime as well as achieving “market rent”.
Exactly zero sublandlords like this math. But it’s important to be mindful that brokers, given the nature of their business, may be inclined to accept and/or promote false expectations on the value just to “win” the business. While the near term effect may feel better (we like this team because they’re telling us we’re going to achieve a higher recovery) the impact of starting in a bad place and sitting on the space is magnified as it’s hard to reset, especially against the backdrop of an overall, ongoing market decline.