When you look at an office building, what do you see? Maybe you see the architecture. Maybe it’s the neighborhood, the restaurants, and amenities. Perhaps, you see the views from within the building. This is what most people see. They’re all important. But it’s what you don’t see that matters most.
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.
In the business of advising office tenants on leasing space, services are provided by a wide range of firms—from solo practitioners to global public companies with thousands of employees. As in any competitive industry, each firm tries to differentiate itself by highlighting its strengths while casting doubt on the competition.
Fear sells. But that doesn’t mean you should buy it. So called “tenant only” firms sell the idea that they, alone, offer tenants conflict-free advisory. To be clear, the potential for conflict does exist in commercial real estate advisory (more on that later). Yes, as a consumer of such services, it’s important to be aware of how conflict can manifest. However, the conflict narrative being peddled by the tenant only firms is more myth than reality. It’s a clever sleight of hand, designed to distract the consumer from realizing the big gaps in knowledge that limit the tenant only firm’s ability to properly advise, while simultaneously suggesting great risk in hiring a full-service competitor.
The pace of investment sale activity in San Francisco is accelerating. This is the “Great Reset” about which we’ve written. It’s driven by capital partners (equity/lenders) deciding there is no viable pathway to own their way to an exit and choosing to sell (usually at a steep discount to what they paid and/or the value of the debt). Ultimately, these capital stack resets are healthy as they activate the asset, enabling new capital partners to transact at market.
In the 1990s, my pants fit more loosely. They were often pleated. Then, seemingly overnight, loose fitting, pleated pants were out of fashion. To be fashionable required an entirely new product, a new look. My now out of fashion, yet still perfectly serviceable, pleated trousers were initially (optimistically?) relegated to the back of the closet, ultimately to be unceremoniously delivered to Goodwill.
The office product offering is shifting to provide an array of hospitality-inspired experiences that, in some cases, rival those of a 5-Star hotel. San Francisco landlords have lagged other markets in providing such high-end amenities because in the 2 decades prior to the pandemic, the supply/demand dynamic favored landlords, making it easier to lease space (e.g., they didn’t have to). For the past several years, however, San Francisco landlords have begun to spend millions on targeted amenities. The typical playbook calls for some combination of health/fitness, conferencing and events, club/lounge/bar spaces, and specialty spaces, like golf simulator rooms and podcasting studios.
I grew up in a small town but I always dreamed about big cities. I sensed they were special places where, given the right amount of drive, the right mindset, one simply could not fail. Sure, there would be ups and downs, but cities provided access to a robust network of opportunity. This was in stark contrast to the small New England towns of my childhood, many of which never fully recovered from the demise of the textile mills in the early 1900s.
Our young children, now 8 and 9, have formed a special bond with Lucy and Jack, two elves assigned by Santa to watch over them. For the past several years, Lucy and Jack have demonstrated extraordinary commitment to our family. They’ve traveled during the holidays, magically appearing at our vacation destinations. They’ve even stayed on after Christmas, despite being needed at the North Pole. Just the other day, I found one of our children covering them in cinnamon (apparently this helps them get their magic back after being touched by humans). To be sure, their presence has sharpened our children’s focus, causing them to think twice about being naughty, providing a welcome assist on the parental front.
If you look at the quarterly market reports provided by all major real estate service firms (Cushman & Wakefield, included), you will find that rent data is typically expressed in terms of “Asking Rents”. Reports will cite the trend in Average Asking Rents by submarket, or by building class. This is a somewhat misleading indicator. Why? Because it does not reflect the rent after negotiations, which often includes reductions in rate from the Asking Rate and potentially significant landlord-funded concessions. In other words, Asking Rents reflect what landlords are asking, not what they’re getting.
These days, the resetting of capital stacks (the ownership structures for office buildings) is most often facilitated through selling the building. The current market sale dynamic typically involves one set of financial partners (equity, lenders) taking big losses to permit a new set of investors and lenders to “reset” the capital stack on economic terms that provide a pathway to success (e.g., a productive investment).
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.
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.”
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.
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.
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.
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.
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.
