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.
One often-overlooked section of your office lease is the part that sets limits on how many people you can have in the space—or how much electricity you can use. These “consumption limits” give the landlord the right to charge you extra if your usage exceeds what's considered standard (though that “standard” isn’t always clearly defined).
A debt coverage ratio (DCR) is calculated by dividing a building’s net operating income (NOI) by its debt service. In office buildings, NOI comes from rents minus expenses and taxes. Lenders typically require a DCR of 1.2–1.35. If it drops below that, the landlord is technically in default—even if they’re making payments.
We’ve written a lot over the past few years about the capital stack, the equity and debt structures that commonly define ownership of office assets. We’ve talked about “broken” capital stacks, situations in which the original equity is wiped out and some portion of the debt may also be under water. We’ve noted it’s very challenging to transact in these assets because the financial partners would need to invest more capital on transactions that would generate negative returns. In other words, good money after bad.
When companies select a real estate advisor, one crucial yet often overlooked factor is the advisor’s credibility with landlords. It’s understandable why this isn't top of mind — credibility is difficult to measure. But it can be among the most valuable assets your advisor brings to the table. Let's break down what "credibility with the landlord" means and why it matters.
If you’re a business professional—accountant, lawyer, engineer, or even (gulp) an office broker—you’ve probably wondered: Can AI do my job better than me?
As a broker who advises office tenants, I tested ChatGPT in a domain I know well. I asked it for average Class A office rents in downtown San Francisco over the last 30 years, including supply and demand dynamics. In less than a minute, it delivered a surprisingly accurate answer.
Negotiating office leases is like any other complex financial decision in that more information leads to better decisions. Yet companies face challenges acquiring the right information at the right time. Why? Because the services typically offered by real estate brokerages are centered on transacting based on site selection and the negotiation of basic rental economics. This is not enough. Sometimes, these services (at least) include a level of multi-building negotiation, exercising a degree of leverage, but too often they lack the proper structure to gather and assess critical data, data that will have a big impact on outcome.
For many companies, office space is among a variety of resources they make available to employees to help facilitate work. Other primary resources include technology. In fact, today, technology arguably contributes more to how work is done than the physical office. The diminished role of the office in facilitating work has resulted in changes in how companies look to use office space. One manifestation of this change is in flexible offices, or coworking spaces. This product segment, having grown considerably over the past decade, is tangible proof of shifting consumer sentiment.
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.
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.
We’ve noticed an interesting shift in how companies are thinking about their offices. For some time now, many companies have resolved to employ a hybrid approach to workplace, having employees work in office for a designated number of days each week. In many cases, this solution was chosen more for how it seemingly struck a compromise between employers who wanted employees in the office and employees who sought freedom to choose. To date, companies have been relatively lax in enforcing their workplace plan. What’s changed? Leadership is now becoming increasingly frustrated at spending on underutilized real estate. Companies track space usage, and they don’t like what they’re seeing. The occupancy reality is often way below what it would otherwise be if employees were following the hybrid work policy. The company leasing 10,000 sf to accommodate an average of 10 workers each day is (painfully) aware of the wasted spend.
Office lease negotiations are complex, involving numerous parties (the principals and their advisors), and covering a wide range of issues, from economic to legal. The most effective negotiators are those who possess both a deep understanding of the markets, and the ability to actively listen while negotiating.
Strategy is to occupier real estate what a recipe is to a great meal. A recipe is more than the sum of its parts. It’s about how each ingredient is prepared, how and when it’s added to the mix. As with any recipe in which there are primary ingredients, vital to its success, similarly, every great strategy requires 3 main parts:
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.
