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.
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.
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.
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.
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.
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.
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.
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.
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.
n March, we’ll hit the 4-year anniversary of the date when offices all over the city first shut down due to the pandemic, a time when just 5% of the city’s office inventory was available. Today, despite having more office workers now than we had then, just under 30m sf of our total supply sits vacant, and even more than that is available. Citywide average asking rental rates declined 17.5% during this period. We expect this trend to continue, possibly to accelerate in 2024. Sublease supply is pulling rates down as companies increasingly view any recovery as a net positive. There’s little on the near-term horizon to suggest we’ve begun (or will even begin in 2024) the long march toward recovery. The market dynamic is considerably worse than that which we experienced in the dot-com recession when it took 63 quarters to get from bottom to peak. We’ve not yet reached the bottom.
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.
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.
