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.
Imagine you invested in an office building in San Francisco in 2015. At the time, the building was 95% occupied. You paid $750/sf for the building and secured a loan on 50% of the value at the rate of 3.5%. 50% of the building’s tenant leases rolled in 2023/2024, a fact you underwrote as opportunity, opportunity to increase net operating income by achieving higher rents. Then the pandemic hit.
An encumbrance is a burden or impediment. Office leases often contain rights which are exclusive to a specific tenant and which place constraints on the landlord’s ability to lease space to other, 3rd party tenants. These rights are referred to as encumbrances. When tenants consider leasing space in a building, one of the first things they should qualify is the extent to which the landlord’s ability to lease the subject space is subject to any encumbrances. If so, the specific terms of these encumbrances must be understood before proceeding.
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.”
In cities like San Francisco, tenant broker fees have increased significantly since the pandemic. These fees are typically fronted by the landlord and recouped over the term of the lease through the rent paid by the tenant. You may be wondering why landlords would offer more fee when rental economics are on the decline. It’s because landlords think of the fee as an incentive to brokers to bring deals to their building. As soon as one landlord increases the fee, others marketing comparable buildings follow suit because they want to ensure their building gets equal consideration (and they think brokers select which buildings to show the client based on fee – they (mostly) don’t). When the markets are tight, as they were in the decade preceding the pandemic, landlords hold fees flat. They don’t need to pay more to attract demand – the simple fact they have available supply is sufficient.
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 market value of San Francisco office buildings has dropped by more than 30%. Indeed, in some cases, asset values have declined much more, as evidenced by valuations associated with vacancy-challenged asset sales over the past couple of years. Importantly, a large percentage of the San Francisco office market either traded or was financed in the years prior to the pandemic, when valuations were high and debt was cheap. These activities created increased tax revenue for the city.
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.
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.
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.
How do you know when you’ve fully accessed market leverage in negotiating a lease extension? It’s when you find the sweet spot, a place in which the economics of the potential relocation lease match the lowest value the existing landlord is willing to offer. This is not a simple exercise of identifying the asking rents for alternative sites and asking the landlord to match. No, instead, it’s a byproduct of a carefully orchestrated negotiation that involves 2 main elements:
I suspect most of us are caught off guard by change at scale. When thinking about the pace of change over the last 15 years, it’s clear we’ve entered a new era, one in which technology is enabling us to rethink EVERYTHING. Change in how we design and occupy physical space is inevitable. The skyscraper boom began in the late 1800s and the product playbook in urban core office markets has remained mostly unchanged for decades. Similarly, the ways in which the office product has been developed and owned, the investment thesis, has been largely unchanged in how it relies on capturing the best occupants in leases that reflect the highest possible pricing and the longest possible term to generate stable net operating income and bankable future value.
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.
One common mistake tenants and their advisors make when negotiating the office lease is failure to properly account for design and construction implications. These are important considerations. Space design plays a vital role in determining the efficacy of the space, how it translates in terms of value to the employees. Construction is expensive, representing a material component of the tenant’s total occupancy cost. Gaining understanding about design and construction at the right time in the transaction process provides useful data in the context of effective negotiations.
The letter of intent (“LOI”) is a non-binding document (although in unique circumstances they can be binding) which captures the terms and conditions upon which the parties have agreed and becomes the basis for a legally binding document (the lease). The best LOIs are highly detailed and cover a wide range of topics from rental economics to flexibility mechanisms (like expansion, contraction, termination, and extension options) to operating expense inclusions and exclusions, and much more. The occupier’s ability to include more items in the letter of intent varies somewhat by the circumstances of the market. In tight markets like San Francisco circa 2019, landlords could get away with limiting the level of detail covered in the LOI. Why would a landlord want to limit the LOI in this manner? Because they gain leverage. Most tenants don’t enter into the lease negotiation until late in their market process, meaning they’ve burned through a lot of the project schedule and will soon need to transition to design and construction in order to get the space ready on time. In short, limiting the terms of the LOI is a way for the landlord to jam the tenant on timing, forcing them to be more conciliatory to preserve schedule. In this current environment, nearly all tenants can enjoy the benefits of expanding the content of the LOI.
You’ve identified the purpose behind your physical space needs, you’ve created a thorough project budget and schedule, and you’ve developed the right strategy. It’s now time to implement a market process.
What is “…a market process”? In the context of office leasing, market process is how you engage the market. It ties to your strategy, with sensitivity to the objectives you seek to accomplish. The market is where you implement your strategy, where you take it from theory to reality.
Office lease negotiations typically cause pain for one party because leverage is rarely balanced such that the outcome is a true win/win. Sure, the actual winner will suggest the other party also won (after all, they got the deal), but sometimes winning feels a lot like losing. That’s OK. Markets ebb and flow. What matters is that you know how you’re hurting the other party.
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.
Many business executives know how to negotiate. Indeed, it’s a vital skillset essential to advancement in nearly all careers. But not all negotiations are equal. Negotiating leases on behalf of office tenants, for example, is a specialized undertaking. As with all negotiations, successful tenant lease negotiations are highly correlated with understanding the motivations of the counterparty. This means knowing everything about the landlord, including the equity and debt positions, the investment thesis, the leasing dynamic at the building (vacancy, lease rollover, etc.), the value of any recently completed comparable lease transactions in the building and in the market, and the overall market dynamic. These factors are fundamental to assessing leverage. Yet even when these basic elements are in place, the act of exercising leverage also requires special skills.
