TenantSee Weekly: Timing the Downturn
Since the pandemic, the cost to lease San Francisco office space, but for the most premium segment of the market, has steadily declined. The pace of decline is beginning to accelerate as more landlords capitulate to unprecedented vacancy and reduced demand, just as more companies are (finally) taking a longer-range approach to workplace. For occupiers, this provides a welcome respite from the relentless effects of a decades-long dynamic in which the office market was both too tight and too expensive.
TenantSee Weekly: The Lingering Fog of a Bull Market
The Lingering Fog of a Bull Market.
Advisors on the right side of a bull market end up looking good, no matter what they do. This was certainly the case for landlord advisors in the San Francisco office market for the ~10 years leading up to the pandemic, a time when you could win for losing, as the deal you failed to make was often (quickly) replaced by a new deal at better rental economics due to rapidly appreciating rents. Today, both landlord advisors and the investors they advise are, in some cases, suffering from the lingering effects of the bull market.
TenantSee Weekly: The Artificial Floor
Currently, there’s a lot of downward pressure on rental rates in the San Francisco office market. This is caused by a massive uptick in available space (4% to over 30+%), the proliferation of subleases in which the sublandlord is motivated to mitigate cost, not achieve target NOI, and the presence of owners having a materially lower cost basis, either through a long-term hold strategy, or a recent acquisition at steeply discounted pricing, both of whom can compete at much lower rental economics. Indeed, the economics being offered by these parties stands in stark contrast to those offered by landlords who bought or refinanced in the years running up to the pandemic. This latter category, by the way, encompasses a large swath of the market. These investors are struggling against a confluence of factors, including rising interest rates, maturing debt, rising insurance costs, decreased demand, lack of capital, and valuation outcomes that put equity and debt underwater.
TenantSee Weekly: Meet WALT
WALT, or weighted average lease term, is an essential metric in the valuation of office buildings as it forecasts the stability of future cash flow. WALT was less important back when office markets like San Francisco were seeing aggressive year over year rent growth. Back then vacancy was worth more than leased space, the theory being a buyer could take advantage of vacant space to capture higher rent (necessary to justify inflated pricing which baked in aggressive rent growth assumptions). However, in the broader historical context of valuation, the idea that vacancy is worth more than occupancy is antithetical to defining value. Indeed, the more prevalent (and logical) approach to value hinges on the quality and duration of the net operating income. Of course, this approach is less sexy as it disables a seller’s capacity to “sell the dream”. The buyer is buying stability and yield, both of which are measurable going in.
TenantSee Weekly: What Could Go Right?
Mass psychology is literally contagious (that’s how it becomes “mass”). This is especially true in times of change, when a significant event has precipitated such change (e.g., the pandemic). These events can be positive or negative. In our current state, the catalyst was negative, and, in many ways, has resulted in a decidedly negative outlook. When things turn negative, there will always be market casualties (just as a rising tide lifts all boats in the positive context). For example, the impact to investors in the domestic office sector has been mostly negative. As change unfolds, it can have knock-on impacts that weren’t necessarily anticipated. For example, the demise of urban downtowns due to shifts in daily worker population. Collective sentiment tends to aggregate around a view and stay there until some brave souls dare to take the contrarian view. As these contrarians see success, it spurs others to jump on board and the collective sentiment begins to shift, once again, in the other direction.
TenantSee Weekly: How to Protect From Landlord Default?
Office building owners are facing the most challenging environment of the past 50 years due to substantial reductions in demand for space. The shift in demand is not cyclical; it’s a systemic shift caused by changes in how work is done in the information economy. In other words, investors can’t count on a swift reversion to the norm. This dynamic is playing out globally. There are geographic differences, but the fundamental trend is the same. The impact on office investors has been swift and brutal, leaving many in a precarious financial position.
TenantSee Weekly: The Disconnected Worker
I read an article recently about layoffs in the tech sector. In it, one worker shared her story of being laid off by 3 companies in less than a year. The first was a startup where she had worked for several years. She questioned why she had been selected – it clearly felt personal. The next 2 employments were each of short duration, the last being merely a month long. In the end, she was left questioning whether she wanted to continue working in tech. The tech sector, especially the startup segment of the tech sector, has never been a great place to seek job security because of its inherent volatility. Yet it has long been a place in which employers seek to espouse winning and attractive cultures that are all about “the people”. This got me thinking about job security in the post-pandemic workplace. Has employment in the information economy become more unstable because there is less connection between employer and employee? Is the relationship between employer and employee becoming more transactional?
TenantSee Weekly: Sublease, Terminate, or Restructure
Subleasing is the most common approach occupiers take in mitigating the cost of underutilized space. Yet in San Francisco, it has become increasingly difficult to sublease office space. With recoveries ranging from 0 to 25%, companies must consider the full spectrum of options. Remember, too, sublease recoveries can be expensive to execute (fees and concessions); and, in subleasing, the occupier takes on a variety of risks that can prove costly (e.g., subtenant default).
TenantSee Weekly: Knowledge, Leverage, and Opaque Markets
An office lease is a unique financial transaction. While supply data is widely available, the values associated with completed leases are not so readily available, nor is the financial position of the landlord and its partners. In effect, despite the preponderance of available data in residential markets (e.g., Zillow, etc.), office markets remain opaque. The educated occupier can certainly access more information today than in decades past. But it’s not enough to merely know available spaces. Achieving a complete understanding of the markets can only be accomplished by partnering with a firm which is engaged in the market in a variety of very specific contexts. You need an intimate understanding of landlord motivations, capital structures, and even the intricate dynamics of tenants within a building. Yet many real estate service firms don’t have this information because they lack the practice groups.
TenantSee Weekly: I Digress...
A little AI distraction to cheer your day (and relieve us of yet another discussion about workplace). Ever wandered through the streets and felt like you've stepped into the future? With their undeniable presence here in San Francisco, the driverless car is quickly becoming the most prominent representation of AI in our daily lives. If you spend any time in San Francisco neighborhoods, you can’t miss them. The other day, as I chatted with a neighbor, I counted 6 autonomous vehicles casually cruise by our front door within a span of 10 minutes. Intriguing, right? And today, in a twist of irony, I was held up by one. Blocked by a double-parked UPS truck, the driverless car hesitated, unsure about navigating into the lane of oncoming traffic. Of course, all the drivers in the opposing lane weren’t too keen to make space for the driverless car, as one normally would (or at least the more decent among us would) for a human-driven vehicle. Hence, we waited.
TenantSee Weekly: Cap Stack Woes
Recently, we have written about the importance of understanding the landlord’s “cap stack” (capital stack, meaning equity and debt). Understanding the cap stack that guides a landlord's decisions is more than just a business detail — it's an integral part of the current real estate landscape. Today, there is a massive chasm between what many owners can afford to do in the current market and what they need to make a deal accretive or even break-even, given the capital stack realities of the underlying market. In short, many owners simply cannot afford to transact at market. Why? Two primary reasons:
TenantSee Weekly: Q2 2023 The Tenant's Perspective
Occupiers continue to add sublease space to an already saturated market, and to downsize their occupancy requirement at lease expiration. Market participants, including investors, are now accepting as fact the new ways of using office space will result in less demand for their product. During the first couple of years of the pandemic, investors, enjoying record high levels of occupancy and strong cash flow, naturally chose to believe in a future narrative that included a rebound to 2019 demand levels. Their optimistic (if not realistic) outlook had them waking up in 2023 with 7m to 10m square feet of demand and 4% vacancy. But it’s now clear this is not how things are playing out.
TenantSee Weekly: A Game of Confidence
Commercial real estate, in all its many facets, has always been a confidence game. Developers make big financial bets their building will lease as they and their investors spend millions of dollars to build it. Then, they confidently sell the product, pitching its values to prospective occupiers against the backdrop of fluid markets. Ideally, they’ve underwritten the market correctly and it moves in their direction, meaning supply of comparable space diminishes, making the product more valuable. But sometimes the market is moving away from them, forcing them to maintain their confidence despite dwindling prospects for success.
TenantSee Weekly: Pandora's Office: Part IV - Wearable Work
Today, we examine the transformative role of Artificial Intelligence (AI) and automation in the workplace. AI will have broad impacts on work in the information economy, both in how and where work is done. While it's true AI and automation could lead to significant job displacement, it’s also true that AI will create new jobs. Studies suggest that AI will affect job transformation more than destroying jobs, altogether. It automates parts of jobs, not whole jobs. The nature of some roles may change, requiring a focus on skills that AI can't replicate – creativity, critical thinking, emotional intelligence, and complex problem-solving. For those at the top of the food chain, this shift will make jobs more strategic and rewarding, enhancing employee engagement and productivity. Yet jobs at the lower end of the white-collar spectrum will be susceptible to displacement.
TenantSee Weekly: Pandora's Office: Part III - Decoding Productivity
Productivity. The backbone of a company’s success. For decades, productivity has served as a key determinant of growth and profitability. Measuring productivity, however, is a different beast. Amid the shift towards remote working, understanding productivity dynamics in both office-based and work-from-home environments has become increasingly pertinent. Unfortunately, the idea of productivity has become one of the battle grounds on which the fight over RTO is being waged. Too often, companies and employees point to misleading and/or ill-defined measures of productivity as evidence their view is right. It’s important to be fact-based and sober in assessing productivity.
TenantSee Weekly: Pandora's Office: Part II - The Psychology of Workspace
One of the positive outcomes emerging from a more holistic contemplation of work is a better understanding of how the behavioral and design elements of the workplace impact well-being, the psychology of the workplace. Historically, the physical office and the culture that accompanied it, was largely a one-size fits all, top-down dictate that employees were not encouraged to question. While this one-dimensional approach may have been easier to conceive, it had the detrimental effect of failing to adequately support some percentage (maybe a large percentage) of the employees. But it’s a new day, a time when we have increased awareness of neurodiversity and sensory processing, an opportunity to provide optionality in support of the broad spectrum of employee (human) differences. It’s a moment when we can more fully contemplate the psychology of the workplace. Indeed, the more thoughtful we are in creating workplaces that cater to diverse employee needs, the better these environments will serve the organization.
TenantSee Weekly: Pandora's Office: Part I - Cost vs. Value
In this first issue of our series, “Pandora’s Office”, we explore a fundamental paradigm. Cost. Expense. Historically, for most companies, this has been among the top factors defining how office space was chosen. In all be the rarefied air of tech and high finance, companies must generally be smart about allocating a portion of their budget to real estate spending. But when the emphasis veers toward achieving the lowest possible cost, the result is often a suboptimal facility, an investment that yields a limited return.
TenantSee Weekly: Pandora's Office
In the end, there was hope. We’ve been thinking lately about the myriad challenges occupiers now face in defining workplace. For many leaders, addressing this topic is akin to opening Pandora’s Box. Indeed, there’s a lot at stake and more ways to get it wrong than right.
TenantSee Weekly: The Case for Diversity
Shawn Achor’s excellent book, “Big Potential” references a study by Alison Reynolds and David Lewis detailed in the Harvard Business Review which measured the performance of teams based on “cognitive diversity”, or the spectrum of thinking styles among the team members. It was found that more diverse teams consistently outperform their more homogenous counterparts. Achor notes that, in many cases, despite the benefits of diversity, corporate leaders instead favor like-mindedness among team members. This tendency stems from the misguided belief that diversity breeds discord, hindering the team's overall function. Herein lies a fascinating truth: diversity indeed catalyzes friction, but it's this very friction that fuels better outcomes, sparking innovation and creativity.
TenantSee Weekly: The Price of Innovation
In San Francisco, there’s not much standing between a near-term future in which office vacancies spike to 40% or higher. By not much, we mean demand for office space. What’s interesting is the cause. Many focus on the battle between employer and employee in which employers want the employee back in the office and the employee wants to work remotely. But it’s not that simple. Post-pandemic, employees (especially younger generations) are more inclined to embrace the benefits of technology which enable work to be done from anywhere and make it less compelling, even illogical, to commute to the office. No, this isn’t just about whether you like or don’t like being in an office. It’s about the ways in which tech has advanced to change work and generational differences in the adoption of and comfort with such technologies. Technology changes things. It’s changing the construct of white-collar work, and in the midst of such change there will be winners and losers. The fate of office markets, indeed of the office building as a product, hinges not on resolution of the remote work debate; but, rather, on the pace at which we adopt existing technologies and innovate new ones
