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.
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.
