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.
Most of what tenants need to see in order to make smart leasing decisions is not immediately visible. It must be uncovered through strategic discovery and analysis. That’s the mission of TenantSee: to provide the process and resources that bring hidden factors to light. We don’t make decisions for our clients—we make their decisions better.
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.
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).
Office leases are complicated undertakings comprised of many variables. The markets offer a variety of solutions, ranging from coworking to subleases to long and short-term direct leases. It’s always important for corporate leaders to understand the primary objectives they seek to achieve in leasing office space. But even when these objectives are well defined, it can be tricky to assess which solution is best.
Technology replaces that which it improves.
Not long ago, the streets of San Francisco were full of taxis. Simply by raising your arm, you could hail a taxi in minutes. Then, Uber and Lyft created their apps. Their intention was always to disrupt an industry that hadn’t changed in decades. Initially, many taxi drivers transitioned to become Uber and Lyft drivers, likely anticipating the technology would shift, not replace their work. But that’s not how this is turning out. Autonomous vehicles will replace human-driven, human transport solutions in major cities where taxi drivers once thrived.
Surveys indicate most workers favor a distributed workplace in which they can work from anywhere, any time. When it comes to work, individuals focus (mostly) on their own specific benefits, as opposed to thinking about how the ways in which their work gets done affects the broader organization. This makes sense, as one of the key benefits of our economic system is how it permits the individual to get ahead, to maximize its value. Employees realize value in a variety of ways, including compensation and other variables. Flexibility in where and when people work is high on the list of non-compensation related variables.
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.
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.
