Market Leverage, Mass Psychology and the San Francisco Office Market
In the context of lease negotiations, counter parties seek to leverage market dynamics to maximize their advantage. For office markets, the primary dynamic being leveraged is that of supply/demand. When supply is scarce and demand is strong, the landlord counter party leverages scarcity to increase rents and reduce concessions. Alternatively, when supply is plentiful and demand is low, tenants leverage their options to lower rent and increase concessions. Basic stuff, right? Perhaps more interesting is the mass psychology that evolves around a marketplace which has experienced a prolonged run of one-sided leverage.
In the decade prior to the onset of the pandemic, available space in San Francisco became increasingly scarce as demand skyrocketed. During this period market participants accepted certain market behavioral characteristics as normal, indeed necessary in order to transact. This mass psychology was initiated and enforced from the landlord’s side of the negotiating table, as it was they who enjoyed the leverage. To a new occupier-side participant, say a company that was new to the market, the mass psychology here seemed insane. To these participants, the uninitiated, it was a struggle to understand how the landlord counter party could be so unreasonable, so inflexible. In other words, despite the dynamic feeling normal to those having historical market context, it was quite abnormal to all others.
That’s what mass psychology does. It makes otherwise extraordinary situations seem normal. This same effect enabled investors to rationalize ever increasing acquisition pricing with the belief that markets would continue to rise. In essence, the more the leverage dynamic tilts one way or the other, the less rational the mass psychology becomes. So it was that we saw more than a decade of market mass psychology that heavily favored investors at the expense of occupiers. Now the narrative is shifting (rapidly). Market leverage, but for isolated and limited instances, is squarely in favor the occupier. What’s interesting is how hard it can be for the counter party who previously enjoyed favorable leverage to recognize and accept a shifting landscape. Today landlords will react with incredulity when they’re met with aggressive proposals from the occupier counter party; this notwithstanding more than a decade of a “take it or leave it” negotiating posture. It’s interesting to observe. Don’t get me wrong, I understand the implications, I understand why one party or the other might find elements of a negotiation challenging. But like it or not, the foundations of a new mass psychology are being established across global markets, certainly here in San Francisco. Included among the things all participants will soon find “normal”:
Long RFPs in which landlords are graded on the extent to which they address all factors
Occupier flexibility that exceeds the limits of traditional lease underwriting (e.g., capital spend vs. lease term)
Long periods of downtime
Large amounts of vacancy
Scrutiny of landlord debt and equity
Self-help provisions
Prop 13 tax protection
Most Favored Nation clauses
Termination, contraction and growth rights
Progressively decreasing lease values (the inverse use of lease comp data from when rents were climbing – meaning tenant advisors look to achieve X% lower than the most recent comparable values as opposed to landlords seeking to achieve increasingly higher values)
In some cases, negative NERs (e.g., money losing leases)
Creative problem solving
Excessive capital contribution including turnkey scenarios
There will be market leading deals that drive the markets to new lows, much as there were such transactions that defined the new highs during the boom times. The most desirable occupiers, those having the best credit and leasing the largest spaces, will exercise outsized leverage. It’s difficult to negotiate from a position of disadvantage. But successful owners will embrace this new reality, accept their market position, embrace the mass psychology and do what they must to get deals done. In fact, those who resist less, will enjoy more