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.
Sometimes one need only look at the circumstances to determine the results are juiced. Barry Bonds, Lance Armstrong and this guy. Hopefully you’ve not been dieting on bull testicles and dried animal organs for the past couple of years striving to live your best “primal” life, only to be disappointed in the results. I’m no body builder, but at a glance, and absent any knowledge of this man’s history and supposed development of his physique, I’d instantly conclude one thing: juice.
40% Availability
The San Francisco office market consists of 86.3M sf. Presently 28% of the market is available for lease, including both direct space and sublease space, for a total of just over 24M sf. We’re on pace to finish the year with available supply of 30%. The trend in demand (downsizing) and the near certainty of continued macro-economic headwinds in 2023 make it likely we’ll add another 3% to 5% to available supply by the end of ‘23, bringing total availability as high as 35%. It’s too early to predict what 2024 will bring (hopefully a hockey stick graph showing increased demand for office space), but I believe it’s quite possible we’ll see available supply at or near 40%.
Ever consider how odd it is that “great” is the adjective of choice for some of our most challenging times? The Great Depression, The Great Recession, etc. Reflexively, when I think about what’s happening in the office market, the reset that’s playing out all over the world, the first adjective that comes to mind is “great”. Sorry about that.
Over the past couple of decades the long term office lease has become increasingly challenging for occupiers. Demand for space has always been cyclical, rising and falling with the economy, and technology has continued to make it easier for workers to be productive from anywhere. While shared space, or coworking solutions have been around for decades, the scale of the industry expanded rapidly during the period from 2010 to 2020, especially through the Softbank-funded expansion of WeWork. Coworking is a form of flex leasing that is characterized mostly by spaces that are broken into component parts, offering members shared access to services and amenities. The space between coworking and long term direct leasing of separately demised office space is a relatively new place in which a tenant can secure a flexible lease (shorter term of 6 months+) on a fully demised, prebuilt, furnished space which does not include managed services. This is the latest and perhaps most consequential form of flex leasing.
In 2020 most companies forced their workers to a fully remote posture. In 2021 companies started encouraging their employees back to the office, most with limited success. In 2022 this strained dialogue about return to office has continued. While some have sought to fully address the new realities of the workplace by developing and committing to an approach that both clearly addresses expectations for employees and supports these expectations with modifications to the physical workplace, many have chosen to communicate “soft” messaging about return to office while not making any changes to the physical office.
I have a lot of suits and ties. The ties are folded neatly in a drawer that I rarely open. Some are solid, some have stripes, some have little animal prints. I also have a lot of suits. These are mostly tucked into the back of my closet. Oh, I have some expensive leather shoes in a variety of styles, as well. These, too, are stored in various states of disuse. I no longer wear this stuff (but for rare exceptions). The ties were the first to go. I stopped wearing them sometime around 2015/2016. At that time, I still wore suits and nice shoes, just no tie. Shortly thereafter, the suits were replaced by sport coats and slacks. These were still tailored, not casual. But then, at some point, everything became more casual. The nice leather shoes were traded in for the new style sneakers that everyone now wears, or Allbirds or some other more casual footwear. These days I may not even wear a sport coat. Vests are a nice option. They’re flexible and nearly always sure to fit in with the prevailing attire of the day. Plus they make me look sporty, or maybe techy. A little more like I get it (even though I probably don’t).
For decades the San Francisco office market was a unique and seemingly irreplaceable technology hub. The city had so many variables essential to startup tech success that companies believed they had to be here, regardless of the cost. Proximity to Stanford and UC Berkeley, the epicenter of venture capital on Sand Hill Road, the Silicon Valley - - - home to major tech headquarters, including Google, Apple and Facebook and the abundance of bright young tech talent that flocked here from all over the world to be part of the innovation economy. All this in one place. It was a compelling narrative (and true). The city’s beauty and appeal to younger tech workers was obvious. Like New York City was (and remains) for those seeking their fortune in finance, until fairly recently, if tech was your thing, you had to be in San Francisco.
The price of San Francisco office space is mostly falling. Sure, there’s some outlier examples of premier view space where the price is stable, even increasing. But, on balance, we’re talking about a significantly declining market. A silver lining for occupiers who’ve otherwise endured a long period of limited supply and record high costs. Yet while on paper the cost of the market looks better, the effects of the downturn can (and will) render some landlords incapable of effectively running the building. Because most lease negotiations are set up as a sort of “David and Goliath” battle in which the tenant is David and the landlord Goliath, it’s not necessarily common for tenants to ask too many questions about a landlord’s financial position. Yet like the tenant, the landlord has many obligations under the lease, the performance of which require its financial health. Tenants must share their financials and often provide security mechanisms to secure their performance under the lease. This typically comes in the form of a letter of credit or security deposit. The landlord version of security for the tenant would be things like a self-help provision and/or an SNDA. Self-help enables the tenant to solve for issues the landlord is otherwise obligated to solve, but for which it does not have the capital to do so, by paying to have the work done and deducting the cost from Rent. The SNDA, or subordination non-disturbance agreement, is a legal document that protects the terms of the lease in the event a lender takes over building (e.g., the landlord defaults on the loan). These are examples of protective mechanisms against a failing landlord.
When it comes to negotiating with landlords for office space, today the San Francisco market and many like it officially fall in the “…it doesn’t hurt to ask” zone. In this rare market space, occupiers have the luxury of translating their concerns as challenges for landlords to solve, or not. This includes many challenges that stood zero chance of being addressed (or even considered) in the years prior to the pandemic.
In the context of lease negotiations, counter parties seek to leverage market dynamics to maximize their advantage. For office markets, the primary dynamic being leveraged is that of supply/demand. When supply is scarce and demand is strong, the landlord counter party leverages scarcity to increase rents and reduce concessions. Alternatively, when supply is plentiful and demand is low, tenants leverage their options to lower rent and increase concessions. Basic stuff, right? Perhaps more interesting is the mass psychology that evolves around a marketplace which has experienced a prolonged run of one-sided leverage
Every industry and company has unique labor needs. These needs can be synthesized into target demographic profiles which can be used to evaluate global markets in search of the best places to grow the business. Certainly there is more that goes into where a company elects to establish a presence than just the amount of available talent. Among other factors, companies might consider proximity to key clients, proximity to investors (e.g., venture capital), proximity to educational institutions graduating the target demographic, cost of living, cost of office space, government incentives, even proximity to competitors from whom talent may be poached. Indeed, discovering the best markets is a complex undertaking.
Why do you get these weekly communications from us? What is TenantSee? We figured it’s time to explain a few things.
Let’s start with the second question first. TenantSee is the name we’ve given to our approach to tenant real estate services. We chose this name because we believe its important for tenants to see more. To see more what, you may ask. To see more of the big picture and the little details that make for better real estate outcomes. To see more of the data and analytics that drive good decision making. To see more transparently, the specific strategies we employ to maximize value. To de-mystify good tenant real estate. For us, the traditional approach to tenant advisory was opaque and failed to get some basic things right, exposing occupiers to an unnecessary knowledge deficit when compared to the landlord counter-party.
Prop 8 allows owners to appeal for a temporary reduction in taxes when property values have declined. When granted, the relief is for a period of one year, after which point the owner must reapply. This is a important topic, as given the current state of the San Francisco office market, we anticipate a lot of owners will go to the city seeking relief.
The San Francisco office market consists of 86M sf. Currently, 18.7M sf is available, 13.7M direct from landlords and 5M for sublease. This means that 72.3M sf is leased and not being marketed for sublease. We can assume there will not be much (if any) new supply added to the market over the next several years. Demand will be the key factor in determining the market’s trajectory.
This San Francisco office market report is provided compliments of Samantha S. Low and Greg Fogg, Co-Creators of TenantSee. TenantSee is a tenant real estate product combining a team of subject-matter experts with powerful technology to make tenant real estate smarter, faster, and better. Our report is intended to provide you, the tenant, with meaningful insights, not raw data. To learn more about TenantSee,. please visit www.lowfogg.com
What may not be readily apparent to some occupiers is the extent to which the San Francisco office market presents an opportunity to restructure leases. What does it mean to “restructure” a lease, you may ask. Well, it can mean a lot of different things, but in this case we’re talking about negotiating new terms ahead of an expiration such that the tenant receives immediate benefit. For example, say a lease has 3 years remaining at rents that are significantly above market and the tenant requires improvements to modify the space. If the tenant is willing to commit to the building for a term extension beyond the existing expiration, depending on the circumstances at the asset level, there may be an opportunity to recast the lease. The trade for the landlord is one of near term pain for long term gain. The trade for the tenant is one of near term gain for (potentially) less future gain. In a perfect world scenario, timing would work just right and the tenant would make the trade early, only to see the market turn less favorable thereby making the restructure look genius.
The office lease is a complicated contract. Once executed, but for its expiration, there’s no easy way out. In our experience, companies often give too little consideration to the exit. It’s understandable amidst the excitement of signing a new lease. Thinking about how to unwind the lease before signing it is a bit like sliding a prenup across the table to your future bride a few days before the wedding. But things happen. And things especially happen over a period of years.
Rent, or net operating income, is 100% correlated with value. When an owner lowers the rent, they reduce the value of their building. This is why many investors will do all sorts of things before lowering rent. For example, the most common approach is to provide big allowances and/or large amounts of free rent in exchange for rate preservation. It doesn’t feel great, but since it protects asset value, it’s in chapter one of every institutional owner’s playbook.
When it comes to office space, corporate leaders now find themselves stuck in the space between the forced closure of their offices in 2020 and having to conceive new workplace approaches that (somehow) foster productivity, enhance recruitment and retention and (generally) satisfy the diverse (and conflicting) needs of the employees. This is not a comfortable place. Indeed, we’re finding that many corporate leaders are unwilling to take responsibility for conceiving and executing a future workplace strategy. They fear making the wrong decision. Who can blame them? After all, given the extent and pace of change, it seems more likely for future oriented workplace strategies to fail than succeed. Who wants to take on that risk?
Finding high quality real estate services is easiest when a company is small, solving for one lease or a few leases in a small region; or, when a company is large and looking to hire a global partner that can provide a spectrum of services for managing a complex portfolio. These are the “bookends” of the market where there is the greatest alignment between the structure of the services and the client need. It’s in the middle, companies of 250 – 5,000 employees, where things get challenging. This week, we’ll explore important considerations when searching for a real estate advisor in this middle market.
