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.
How Remote Work is Changing Small Town Residential Markets
For many years my family has been coming to Vermont for summer vacation. We love the change of scenery from our urban life in San Francisco. Every morning at about 5 am the birds begin singing outside our windows, serving as a natural alarm clock. As they gently nudge you awake with their beautiful songs, the sun begins to rise. Our place is located in a town called Quechee, VT, home to a long running hot air balloon festival. It’s pretty common to hear the gentle hiss of a balloon passing overhead early in the morning. When this happens, it’s such a beautiful sight that we usually jump out of bed and run to the deck to watch. It’s a peaceful experience.
As I dropped my kids off at summer camp this morning, my ears were automatically drawn to a different sound, that of parents chatting about how much they love working remotely and living in Vermont. It got me thinking about this small town and how much it’s changed in the past few years. The proximity of small New England towns like ours to big cities like Boston and New York is a big draw for would be remote workers. We bought our modest condo here in 2012. Having grown up in the area and having family in the residential real estate business, I knew the market had been flat for many years. In fact, residential pricing throughout the region was not historically prone to significant swings in value. But that all changed in 2020. We rent our condo most of year. Historically, renters would stay for a few nights or maybe a week at a time. Suddenly, in 2020, we had renters seeking multi-month occupancies. This continued through 2021. Additionally, we began to get unsolicited offers to purchase the condo. And these offers were 4X what we paid for it.
Visiting with my sister-in-law, a residential agent in the region, I learned that the same phenomenon we’d become accustomed to in San Francisco, homes selling over asking price in a period of hours with multiple bidders, was in fact playing out here. After 2 years of this trend, supply is extremely limited. The presence of wealthy buyers coming from the big cities to the south, coupled with investors (including institutions) buying up single family homes as rentals, has put extreme pressure on many of the would be local buyers who live and work in the region. Their incomes no longer support the cost of buying a home.
The ongoing disruption in how and where we work is having far reaching impact on many aspects of society. Sometimes it’s hard to see the bigger picture. Cities like San Francisco, for example, where office going population is still <40% (and much less on many days of the week), are experiencing business failures as merchants who formerly served this population struggle for survival. In addition, city government is bracing for significant reductions in tax revenue as corporations reduce their office footprint, reducing the value of office buildings and the taxes they pay. Not surprisingly, the office economy is a huge engine for most major cities. At the same time, small towns are struggling with an opposite problem; an influx of urban wealth, rapidly changing the socio-economic landscape. Those choosing to live in a city like San Francisco mostly do so knowing it will be expensive. They come there to participate in an economy that at least provides the possibility of earning sufficient income to make it affordable. But for the working class families that have made small towns throughout the US home for generations, this changing dynamic is not wanted. But it’s happening. The implications of remote work will continue to have far reaching impacts on society, disrupting not just big cities, but also small towns throughout the US.
TenantSee Weekly: The Questions
We’re having the same important conversation with nearly all our clients. It stems from 2 basic questions; 1) What if we don’t have an office, and 2) Can we structure the lease so that if the market declines over the coming years, the rent for our space will similarly decline?
TenantSee Weekly: Who Stole My Narrative
Historically, the narrative within the commercial office markets in big cities has been controlled by institutions. Institutions who own the buildings and institutions who “own” the employees. The markets fluctuated between “tight” or “soft” and leverage shifted back and forth from landlord to tenant. These 2 market participants, landlord and tenant, supply and demand, called the shots. Sure, there were other variables, the economy, other market influences and influencers. But the narrative was defined within a fairly narrow range.
TenantSee Weekly: Why You Need to Spend More on Design
Architecture, interior design and furniture design each impact how we feel. If you’re someone who is not particularly aware of this connection, take a moment over the coming days to note your feelings upon entering different buildings, different spaces. Notice the volume. Contemplate the impact of day light and other light sources. Consider the way the rooms are designed, the flow. What about the furnishings? Is it comfortable? Does it look interesting? Is there artwork? If so, how does it affect you? Does the space inspire you? Does it make you feel content? Does it make you anxious? Does it make you feel gloomy?
TenantSee Weekly: When Workplace Isn't a Place
Technology used to compliment space. It was an adjunct to the physical office. However, today’s workplace is really not a place at all; rather, it’s a hub of technology resources that travel with the employee wherever she may go, which may or may not include a corporate office. Tech has jumped ahead of space as the more important element in defining the total workplace.
TenantSee Weekly: Got Leverage?
With the exception of premium view space, which is leasing at rates above pre-pandemic highs, many office owners in San Francisco are heading into a prolonged period when competition for tenants will be intense. There are several reasons, but let’s start with a few stats:
TenantSee Weekly: Lease Security: How Landlords Underwrite Risk
Ever wonder how landlords underwrite the financial risk of your lease transaction? Or, why many landlords prefer a letter of credit instead of a cash security deposit? The security deposit was originally conceived as a mechanism to help the landlord cover ancillary costs that come up during the term and/or upon lease expiration. Typically equal to 1 or 2 months of rent, it did not cover much. Then, somewhere along the way, an enterprising landlord with leverage got clever and decided to negotiate for more value in order to better cover what really happens when a tenant defaults.
TenantSee Weekly: Essential Math
Office markets are big boats. They don’t turn quickly. There’s always a delay between negative macro-economic events and declines in rental economics. After all, it’s not as if landlords see the negative event and decide it’s time to lower rents. No, they resist. As long as possible. This creates a gap between where everyone knows the market is heading and where it is otherwise defined by comparable lease data. We’ve written in the past about how eventually a declining market reaches a point of broad capitulation when landlords are more unified at the bottom – this is when nearly all tenants benefit from the down market simply by showing up. The challenge facing occupiers whom are negotiating at the front end of the downturn is how to capture the full benefit of a decline that has yet to fully mature.
Market Outlook QTR1 2022 - Tenant Perspective
This San Francisco office market report is provided compliments of Samantha S. Low and Greg Fogg, co-creators of TenantSee. TenantSee is a tenant real estate product combining a team of subject-matter experts with powerful technology to make tenant real estates smarter, faster, and better. Our report is intended to provide you, the tenant, with meaningful insights, not raw data. To learn more about TenantSee, please visit www.lowfogg.com
TenantSee Weekly: Following the Money: A Tenant Advisor's Compensation
Ever wonder how and/or how much a tenant advisor is paid? It’s an obscure compensation model. In the interest of transparency, we thought it might be useful to provide a more detailed view.
Tenant advisors (in most cases) are not paid a salary. Their compensation is usually 100% commission-based. This is among the reasons why the industry lacks diversity, both racial and socio-economic…it’s nearly impossible for someone without a measure of financial support to get started. The path to compensation begins with being retained by a client. Yet being selected to advise a client is not easy. It is typically the culmination of a long period of marketing, knowledge sharing and relationship building. Developing a meaningful relationship may take several years (and probably should). Hence a lot of the activities in which a tenant advisor is engaged are non-compensatory…they’re speculative.
TenantSee Weekly: Culture and the Modern Workplace
Culture: noun: the customs, arts, social institutions, and achievements of a particular nation, people, or other social group.
We all want to be part of something great. We want our workplace culture to be worthy of its “Best Places to Work” status. But in many cases, the corporate “cultural persona” does not fully reflect the cultural reality.
Why? Firstly, leadership. Leaders tend to focus on the desired culture as opposed to the existing culture. It’s easier (and more uplifting) to identify the cultural characteristics you want, as opposed to sifting through the complexities of the culture you have. But when the aspirational culture fails to align with the existing culture, it results in an authenticity problem. However, you can’t fully blame leaders. Most companies lack the right incentives for leadership to invest in the hard work and difficult decisions necessary to bridge the gap between existing and aspirational culture. For example, achieving cultural alignment might necessitate terminating individuals who are financially productive but culturally cancerous. There could be entire groups within the company who behave in a manner that is inconsistent with the aspirational culture.
TenantSee Weekly: Stupid is Easy (and expensive)
In tenant-favorable market environments, landlords often provide more concessions to compete for tenants. Concessions come in many forms, the most obvious being, landlord funding for tenant improvements, free rent, reduced rent and more flexible lease terms. But understanding the value of the concession is not always easy, especially relating to tenant improvements, one of the biggest economic variables in leasing.
TenantSee Weekly: Equity and the Hybrid Workplace
Workplace equity is a big, important topic. The pandemic has helped advance a better discussion about how to create workplaces that are more inclusive, that support the specific and differing needs of the employee base. It’s not so much that we’ve learned our offices don’t serve all equally well, we already knew this. Instead, companies have been forced to address this reality head on because the concept of the office has been turned on its head. The act of creating equity when everyone was remote has (hopefully) built some institutional “muscle memory” that will serve us well as we embark on what’s next.
TenantSee Weekly: Where Else Can You Go?
One of the more interesting outcomes from the pandemic has been the advent of a new competitive factor for landlords to contemplate when negotiating with existing tenants; namely, the possibility of no office, either as a permanent or temporary solution. When a company is willing to let the lease expire without having secured an alternative office solution, it takes one of the landlord’s most effective “levers” out of play. As we’ve written about in prior posts, landlords are very good at using time to their advantage. Historically the closer the tenant gets to lease expiration without having fully negotiated new deal terms, the more leverage the landlord has to command better terms.
TenantSee Weekly: 3 Reasons Why Demand for San Francisco Office Space May Remain Low
https://comms.cushwakedigital.com/rv/ff008d36d8e9840641c54f537249ac4791145879
TenantSee Weekly: Underwriting Tax Increases (Before You Lease)
Over the past decade, may office buildings in San Francisco have been sold, some multiple times. For tenants, these sales translate to material increases in the cost of the lease. Why? Primarily because of taxes.
California has Prop 13, which limits annual increases in real estate taxes to 2%, excepting at the time of a sale or financing of the asset, at which point the tax base is adjusted to market, often causing a big spike in taxes. It’s in these latter scenarios, a sale or financing, when tenants are exposed to potentially large cost increases. This is true because the tax attributable to a sale or financing is passed on to the tenant.
For every $100/sf in increased asset value, the rent increases by $1.50/sf. So if a company leases space in a building that has a tax base value of $400/sf and the building subsequently sells for $800/sf, there is a $6.00/sf/year increase in the lease cost. For a 10,000 sf lease, the added annual cost is $60,000.
TenantSee Weekly: Sucking More, Not Less: A Modern History of the Office Lease Document
Ever wonder why the office lease is 60+ pages of single spaced madness? The answer is simple. The “selling” of protection from crafty attorneys and incident-driven drafting. With the former, lawyers craft language and sell it to institutional clients as creative mechanisms for protecting landlord value. Over the years, I’ve seen “gotcha language” buried deep in all sorts of poetic BS. Firms have incentive to create these documents because protection sells. In the latter, incident-driven drafting is what happens when a tenant and landlord have a dispute and the landlord says, “…let’s draft language so that never happens again.” As you can imagine, throughout the decades, there have been many disputes and issues between landlords and tenants, greatly adding to the heft of your lease document.
TenantSee Weekly: Intent, Policy, and Behavior
It’s not uncommon to see discrepancies between corporate policy, the intent of the policy and the actual behavior of the leaders who are charged with implementing the policy. Jan Johnson and Jeff Leitner have studied this phenomenon in their work on the power of unwritten rules in shaping human behavior. I was thinking about their work as I recently participated in a panel discussion titled, “The New Geography of Work”, hosted by the Northern California Chapter of CoreNet. The discussion was fascinating, mostly thanks to the contributions of our moderator, Robert Teed of Integri Group, and the smart panel members, Kate Lister of Global Workplace, Chandler Bonnie of Dropbox and Irene Thomas Johnson of JLL.
TenantSee Weekly: The Space Between
Choppy markets lack data that point to a trendline which all participants understand and accept. The San Francisco office market is now in the choppy phase of a broad decline that has yet to fully materialize. The data is lacking both in terms of sustained tenant demand and completed transactions.
During this phase, completed transactions often seem too high or too low; whereas, once the market trend is clear, pricing becomes more unified. Resistance is a real factor. Landlords do not want to lower rent and increase concessions. But the market trend is, ultimately, fed by the supply/demand dynamic. It cares not what an investor paid for the asset, just as the impact of higher rent on the tenant’s bottom line is not a factor in determining how much rent a landlord can charge in a tight market. In the end, everyone has to play in the same sandbox.
