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.
US office markets are not healthy. The symptoms include reduced demand due to remote work, eroding rental economics due to mounting vacancy and broken capital stacks. The pandemic was the catalyst, but technology is the true source of the suffering. Technology is where many aspects of white-collar work are now done. I asked Chat GPT to define the office and then I asked it to define the office in 1990. Here’s how it responded:
One of the more fascinating aspects of the conversation around where, when and how white-collar workers work is how it breaks through the guardrails of societal norms. The catalyst for such thinking was the pandemic. People are quick to point out that technologies have been around for decades which enable people to work from anywhere, and that many workers preferred remote work long before the pandemic - - - it’s also true some people preferred not to work even before the pandemic. Yet absent the Black Swan Event that was the pandemic, we simply would not be having this conversation about work. It takes a powerfully disruptive force to cause so much change.
In markets like San Francisco where availability stands at ~30% and continues to rise, landlords of all stripes have either experienced or are poised to experience gaping holes in their occupancy. At the same time, occupiers having remaining term and paying pre-pandemic rents (meaning rents that are way above current market) are watching the building bleed tenants and seeing the landlord market comparable space at a substantial discount to their in-place cost with massive concessions. This is the perfect environment for restructure transactions.
We’re excited to promote our upcoming event at Café TenantSee, “Why Are You Doing That?”. For the uninitiated, Café TenantSee is an intimate quarterly in-person event designed to provide highly relevant, useful insights and perspectives for office occupiers. The café opens at 8:45 am on Tuesday, April 25, 2023. Come and order a specialty coffee or tea drink from our expert baristas. Light breakfast is also provided. Our program runs from 9:30 to 10:30. Unfortunately, our café is small. We can only accommodate 50 attendees, so space is limited.
We normally reserve discussion of market fundamentals for our Quarterly market updated, “The Tenant’s Perspective” (which we release just after the close of the quarter). However, as we near the close of Q1 2023, there are several narratives playing out which we deem significant in shaping the near and mid-term market dynamic. We think it’s important to share these now.
This week we’re exploring what happens when companies define their own bespoke approach to the office vs. when they default to their pre-pandemic office construct, despite significant changes in how they work. To date, many small to mid-size organizations have chosen not to formulate a definitive new approach, instead relying on the old office design and a loosely defined hybrid approach. In a time when the mere discussion of corporate office policy has the potential to trigger highly negative reactions among employees, it takes courage and leadership to advocate a new plan that reflects a vision for the future. Understandably, as we’ve crept out of full pandemic mode and begun to look to the future, many companies have been uneasy about taking a definitive position.
Despite being awash in available space, the San Francisco office market can be tricky to navigate. By now, everyone knows the market is distressed. When companies explore leasing options, they do so with the expectation they will be able to trade up for better quality space at substantially reduced pricing; or, they expect to significantly decrease the cost of their existing space with a lease extension. These are reasonable expectations, yet they can be elusive for several reasons.
Lately, something has been bothering me (IRL). I’m losing sleep. I don’t understand how life can be IRL and URL. To me, life is only IRL – there is no such thing as URL. Technology is merely a construct that we created, presumably to make IRL better. What began slowly, now rapidly causes big shifts in how we experience life, IRL. Not all change is good. The modern office is among the high value social constructs which technology seeks to upend. The office IRL is fast becoming the office URL. Is this a good thing?
When the pandemic hit in 2020, emptying San Francisco office buildings, landlords were mostly unfazed given high levels of occupancy and income. As the pandemic gained momentum, some owners began to quietly wonder if this could be bad enough to render their buildings empty for a prolonged period. Yet it wasn’t until late 2021/early 2022 that investors began to fully grasp that appetite for their product had changed in significant ways.
There’s been a lot written over the past 3 years about the negative aspects of office life, about how it harms our health, distracts us from what really matters and makes us less productive. The freedom to choose where and when we work, it’s argued, is transformative, enabling us all to create our own perfectly tuned work-life balance. It sounds nice, the idea that no one (at least no white collar worker) will remain oppressed by the constraints of working at an office, or working on a fixed schedule. Turbo-charged gig workers, calling our own shots. What could go wrong? Maybe a lot.
Over the past decade the San Francisco office market was among the most desirable global markets for institutional office investment. Valuations increased by 100%+, and many assets traded…some multiple times. Even those that didn’t trade were often refinanced at substantially higher values, enabling the equity partners to take out significant amounts of capital. Today values are dropping as demand for office space in San Francisco is at historical lows, causing rental economics to decline rapidly. This presents unique challenges that are (typically) not entirely obvious to occupiers; namely, a full understanding of the debt and equity stack and the landlord’s ability to perform.
While change is generally a constant state, big changes in one area can have the effect of spurring many additional changes in related areas. In most cases we’re not very good at forecasting all the add-on changes that may follow the initial change. We’re like low skill chess players, unable to see the full spectrum of opportunity and vulnerability created by our moves. And when big change requires us to take action, we often seek the comfort of doing what everyone else does as opposed to formulating our own approach. In the business world, this is a byproduct of risk aversion, or what can be called CYA at scale. Our corporate structures don’t typically provide incentive for creative, individualized responses to business challenges.
The “flex” in flexible office solutions is about the occupier’s ability to limit commitment. A one-year lease is more flexible than a two-year lease, so on and so forth. With occupier uncertainty about why, where and when they should provide office solutions for their employees at an all-time high, you’d think landlords would be eager to offer high flex options in order to meet demand where it’s at. However, it’s difficult for landlords to provide the flex product, despite its potential to command premium rents and increase demand. Why? Because it’s expensive to build office space, and it’s difficult to design space that has broad residual appeal to a large swath of occupiers.
Selling is important. It’s what makes the world go round. But sometimes selling crosses the line and gets a little too close to misrepresenting or worse, lying. After all, there’s always been a healthy dose of deception built into selling. In sports, teams and athletes sell their opponents on the idea they’re going to zig when they in fact zag. Governments seek to sell a vision in order to successfully lead their people. Sometimes the vision is wrong, out of synch with what the people want. Look no further than China’s Zero Covid policy. Companies must sell their products and services to succeed. Startup founders must sell investors on the merits of investing in their companies. Buyers don’t want to buy an “OK” product or service. No one ever said, “…hey, let’s go with those guys, their product seems flawed but they’re really honest about it”. Much of what is sold is imperfect. Sellers have incentive to craft approaches that distract from imperfection while accentuating strengths. Even the salesman with a crappy product has to eat. It’s no wonder we’ve become skeptical. It’s essential to our survival. Storytelling is a form of selling. It often seems the best storytellers are selling the worst products. Sam Bankman-Fried of FTX and Adam Neuman of WeWork come to mind. My family loves the classic Christmas movie “Elf” starring Will Ferrell. There’s this great scene when his character, “Buddy”, first arrives in New York. He passes by a coffee shop with a sign in the window that reads, “World’s Best Cup of Coffee”. He sees the sign and runs inside full of excitement to congratulate everyone, much to their bewilderment.
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.
