TenantSee Weekly: The Value of Your Lease
People sometimes (mistakenly) think office building values are based on location and architectural design (appearance). These are contributing factors, however, in most urban centers, investors use the income capitalization approach to valuation. Here, the building is valued on current and projected net operating income (“NOI”). To be sure, location and design will translate to differing levels of NOI. But other variables play a key role, as well. For example, the landlord’s cost basis which impacts its ability to lease space at market pricing. Where a landlord has paid too much for the asset, the underlying rental economics of the market may result in net negative leasing outcomes, causing the landlord to lose deals to other assets which have a lower cost basis and can productively transact at market.
TenantSee Weekly: I Was Told We'd Be Discussing the Office...
AI has summarized capitalism for me as follows:
“…an economic system where private individuals and corporations own and control the means of production, such as property, businesses, and industries. In capitalism, the core principles are profit motive, private property, and market competition. The government's role is limited to taxation and standard regulatory laws, and individuals are given the freedom to operate their businesses and manage their income as they choose.”
TenantSee Weekly: Friday
Walking the near empty streets of downtown San Francisco on this beautiful August Friday, inspired us to ask our friend ChatGPT to craft a poem about the economic impact of workless Fridays. Enjoy!
TenantSee Weekly: It's What's Inside That Counts
If you’re like me, growing up your mother told you no less than twice a day “…it’s what’s inside that counts” or “…don’t judge a book by its cover”. I’m grateful for that advice, as it helps me be more mindful of bias, more open minded. Did you know the same is true for office buildings? That it’s not just about how the building looks, or where it’s located. The nuanced details of the ownership, debt, and occupancy also matter…a lot.
TenantSee Weekly: Work
Over the past several years the concept of work has undergone more change than at any point in recent history. While there’s many narratives, one common discussion centers on changing where and when we work to make work less harmful to our health. This is exemplified by remote work.
Work can certainly be harmful. Yet few among us can avoid harm. Indeed, harm often comes to us in ways we cannot and do not anticipate. Sometimes what seems good turns out to be bad. The very world in which we live is full of harmful realities. I’m not convinced the absence of work brings less harm. Nor am I convinced the changes we’re seeing now around how and where we work are as good for us as we hope they will be. I think we’re generally failing to account for a variety of negative consequences that are slowly becoming more apparent.
TenantSee Weekly: Reinvention
Physical places, buildings, towns, cities, and even entire countries are always changing. Sometimes the change is progressive and less noticeable, sometimes it's more extreme and jarring. Near where I grew up is the town of White River Junction, Vermont. When I was a child, the town was mired in hard times. But it wasn’t always this way.
TenantSee Weekly: From Blend and Extend to End and Extend
The so called “blend and extend” deal structure has a number of applications, among them a scenario in which a landlord might account for a downward adjustment to a tenant’s rent by amortizing the value of the adjustment with interest into a new term. Say, for example, a tenant has 3 years remaining on a lease and the market value for the space has dropped from $75/sf to $60/sf. The landlord would adjust the rate to market ($60/sf) and spread the $15/sf differential over the new term. If the interest rate were 8%, and the term 7-years, this would add $2.80/sf to the rent.
TenantSee Weekly: Knowing Your When
We see a lot of confusion in the market around when to begin negotiations. It’s not an insignificant consideration. In fact, when you begin can make a huge difference in the outcome. It’s understandable that tenants would not know when to start. Brokers are not always keen to start at the right time, since compensation is derived by transacting and the closer the tenant is to lease expiration, the faster it will need to transact (and the fewer options it will have). Good for the broker, bad for the tenant. This creates a misalignment of interests that discourages thoughtful consultation on the front end – the more time a broker spends on a project, the lower the compensation.
TenantSee Weeky: A Big Decline in Rents, Four Years in the Making
Throughout 2020, the prevailing sentiment among investors in the San Francisco office market was one of relative optimism. After all, despite the fact tenants were prohibited from occupying their buildings, they continued to collect full rent. The buildings were full, with vacancy hovering around 4%. Sure, companies weren’t happy about paying for space they couldn’t use, but business was good. In many cases the tech sector (which makes up most of San Francisco’s office occupancy) was booming due to an even greater reliance on and usage of tech caused by pandemic driven changes in how people were living. Throughout the course of 2020 there was no reason for San Francisco investors to panic, as few (if any) office occupiers were showing signs of developing long-term hybrid or remote-first strategies. Most were simply focused on solving for ongoing operations as a temporary reaction to the pandemic. Yet early indicators did point to a future in which companies would be shedding office space, as some expiring leases were not replaced. This, coupled with the addition of new supply, caused a big increase in vacancy to nearly 12% by year end. Despite this large uptick, the brunt of the sluggish demand dynamic was being felt in the sublease markets, where rental economics more accurately reflected the true state of the market. Despite a total closing of the office market in 2020, average asking rents ended the year off just 6% from the pre-pandemic high.
TenantSee Weekly: Bottom?
Have we hit bottom in the pricing of San Francisco office assets? Maybe.
The historical measures by which office buildings were valued, a function of capitalized net operating income, doesn’t apply to assets having large vacancy and limited weighted average lease term (“WALT”). These assets are trading at a simple cost/sf metric. Investors take a long-term view of the investment, betting the value for San Francisco office will, ultimately, recover. They may or may not use debt to finance the acquisition – where there is limited occupancy, they may not be able to secure debt.
TenantSee Weekly: Modern Workplace Planning: Solving for Experience Part I: The Purpose
In the years leading up to the pandemic, most medium and small companies defined their office space need based on headcount (current and projected), space programming, and industry/sector norms. The exercise was mostly formulaic. The primary differences in the offices of a small, regional law firm compared to those of an AM Law 100 firm would be scale, the cost of finishes, and the quality of the building and views. It was planning for the same outcome, just at different levels on the cost spectrum. Companies having a larger portfolio of offices would typically create a “workplace strategy” that included guidelines around programming (e.g., space layout, office size, critical adjacencies, growth factor, finishes, FF&E, etc.). These guidelines could then be used to inform the real estate process across geography.
TenantSee Weekly: This, or That?
Negotiations are always about (or should always be about) this or that. There’s always something else, maybe that something else is nothing (as in sometimes the best thing to do is nothing at all). Decisions made without proper consideration of all relevant alternative scenarios are decisions made poorly. As important, in the context of office lease negotiations, the best negotiated outcomes are directly correlated to the extent to which we understand the alternatives of the landlord counterparty. This is a bit counter intuitive, allow us to explain.
TenantSee Weekly: The Office as Hotel
I participate in a lot of “conversations” on LinkedIn in which people argue that office buildings should be as flexible as hotels. I love to explore the possibilities, the idea the office can be something different, something better. But sometimes these conversations are so detached from reality it makes my head hurt.
TenantSee Weekly: The Negative Deal
Investors invest in office buildings to generate a positive return on their investment. Return is created in 2 primary ways, one is through ongoing profits generated from the individual leasing transactions completed within the project, and the other is through financing activities (taking on debt which allows the investor to pull equity from the investment or selling the asset). This TenantSee Weekly is focused on the first of these 2 scenarios, the one in which the landlord seeks to create positive cash flow through its leasing activities.
TenantSee Weekly: Conflict in Tenant Advisory
Years ago, I was a partner at The Staubach Company, one of the industry’s most prominent tenant-only advisory firms. The Staubach Company was a highly ethical business, full of skilled tenant advisors. One of the firm’s core value propositions was that its advisory services were free of conflict. The conflict narrative is powerful in how it seemingly separates the conflict-free advisor from most other brokerage firms which serve both occupiers and landlords. Tenant-only firms often differentiate themselves with statements like, “…when you hire us, you never have to be concerned that we’re beholden to a landlord who pays us millions of dollars each year in fees”; or “…we fight harder for you because we’re not concerned about our relationship with the landlord”. To the unknowing audience, these statements can make it seem that all so-called “full-service” firms (those with diverse practices) are incapable of providing ethical, conflict-free occupier advisory services. When you consider the spectrum of tenant-only firms is very small, as a sales tactic, this is a brilliant approach in that it significantly narrows the competitive landscape, making it more probably the tenant-only firm will be hired.
TenantSee Weekly: TenantSee Team San Francisco Market Predictions: 2024
Let us lend our TenantSee perspective to the coming year. Despite green shoots from 2 large AI sector leases (Open AI and Anthropic), demand for San Francisco office space remained low throughout 2023, yielding 4 more quarters of negative net absorption. We finished the year with vacancy at >35% - an historical record. The market is under significant stress, creating sizable opportunities for occupiers.
