Market Insight Editorial & Advice to Tenants: 3Q2001

A Call to War, a Dream of Peace

From Dan Mihalovich, Principal of Mihalovich Partners; Founder of The Space Place®:

The atrocities of September 11, 2001, will unfortunately live on in our minds for the rest of our lives. Our hearts go out to all those who have suffered human or economic loss from the tragedies of that day. We are a resilient people, with enormous faith and eternal optimism. Our economy will not crumble under the emotional weight of this trauma; rather we will be strengthened by enduring these difficult times together. Launching an attack on terrorism will be costly, both in human terms and financially, and many will wrestle with the details—but none can debate the notion that only good can come from creating a more peaceful planet over the long term. Let’s stay positive, to the extent we are able. If Mayor Giuliani is right, we should all head to the Big Apple, take in some shows, spend some money shopping and restaurant hopping, and try to have a good time. Perhaps, in some small way, we can honor the dead this way. Nothing will bring them back. Medication will not alleviate the nausea in the pit of our stomachs. We will live with this, and thrive, for a long, long time. I wish you all a speedy recovery, and a healing of wounds. Here’s to peace among all the nations.

Recession Cuts Deep into Bay Area: Unreal Vacancies

There are 14 million square feet of space standing vacant at this moment in San Francisco, and we’ll be pushing 16-18 million within the next several months or less. It’s become unpleasant to watch (even though we specialize in representing tenants—we don’t like to see business failures). Just last week another 500,000 square feet of space hit the market. We’ve stated here, in prior Editorials, that the San Francisco Bay Area is in recessionary mode. Some months ago, John Doerr (Kleiner Perkins) stated that we are in a recession. Now Warren Buffet (Berkshire Hathaway) has thrown in that towel. Perhaps there is truth to the rumor. While the “good news” for tenants is that absorption rates (demand) for office space are significantly negative and rental rates continue to plummet, there are few tenants active in the marketplace to enjoy the benefits. Our friends and neighbors are being laid off from their career jobs, and find themselves unemployed for many months at a time. Employers throughout the Bay Area are doing everything possible to cut costs and return, if possible, to profitability. It is clear from the retrenching in San Francisco that NO industry has been spared, whether it be traditional or investment banking, stock brokerage, CPA consultancies, advertising, or any categories related to the Web. For the first time in recent history we are experiencing significant downsizings and dissolutions by law firms. But what are landlords doing about the downturn?

What is “Cheap Space”? Who says so?

Being creatures of habit, we are guilty of getting used to new trends, and oftentimes being slow to adjust to shifting paradigms. Tenants/employers in the area, to their credit, have reacted far faster than the landlord community to the avalanche that has ripped our market apart. There is now 300% more overall vacancy in the San Francisco Bay Area than in Q4 2000. Focusing on the sublease market, though, there is now 500% more vacancy than in Q4 2000. Yet asking rates for space are still too high, for the most part. The devastation is too unclear for many, for some reason, and spaces go begging, vacant, for 6-12 months. The vast majority of spaces, in fact, are marketed with “negotiable” rates, since as many landlords and sublessors fear that they may turn off a prospect if they ask too much.

Many of the City’s largest landlords remain in decent shape, for the moment. When the markets were burning hot, they leased and preleased—and expanded many of their tenancies—all at rates roughly double, or more, than what is currently achievable. They view current market rates as “cheap”, relatively, of course. But relative to what? Tenants today are completely focused on financial performance, net profits and operating containment. Taking on new lease commitments must be done at levels that ensure profitability. The old rule of thumb should be in vogue once again: Don’t devote more than 8-10% of your gross revenues to office space rent. For most companies and firms we know, those rental levels must necessarily remain well below $50 per square foot per year (for fully improved space; fully serviced; and potentially wired and furnished). We view the top of the market to be at this $50 level, for the best space there is, maximum. Please call us to discuss.

We are back to an age where tenants’ budgets and good credit will dictate rates and terms. Landlords should not be sitting on their hands at this point—and tenants should beware of owners displaying anything but complacent behavior. Some owners are voluntarily approaching their tenants long before lease expiration dates to offer—for free— an early adjustment to rents, just to keep their tenants happy, healthy and, most importantly, in place.

Cutting to the Bone: Are We Overcompensating?

The double-edged sword of the “new economy” promotes the independence of the worker bee; fluidity to allow, if not glorify, short term stints at various places of employment; and the resolve that in tight times, it’s OK to slash the staff in order to survive until tomorrow. The labor markets and employers empowered workers during the last few years of meteoric expansion; now the same employers are having their day. Challenger Gray & Christmas, an outplacement firm we trust, reported that the rate of firing of “Internet workers” may have plateaued by Q3, but the sheer number of such companies has dwindled to a reasonable number of survivors as well. Unemployment rates remain a critical bellwether for this part of the country, as major employers throughout the Bay Area continue to slash their way to profitability. Wall Street, as usual, will applaud the restructurings. The mood in the neighborhood, unfortunately, is grim and downtrodden.

No market falls forever. Our stock portfolios probably look a lot alike. “The market climbs a wall of worry”, we’ve been told for many years by our stock analysts. Perhaps cutting to the bone in these tight times is a cut too far. The business cycle will swing again, some day, and we’ll wish that we had more resources—and people—at the ready, to handle that new business and expansion. We seem to have become a “just-in-time” economy. When the markets turn, will you be ready?

Subleases Looking Good? Hidden Issues to Consider

The most motivated “sellers” of space in the market are the tenants, by a huge margin. These are tenants whose businesses, for a variety of reasons, are jettisoning space. Tenants aren’t budgeted to withstand long term vacancy, payment of tenant improvement allowances and brokerage fees—and certainly not budgeted to eat enormous losses from subleasing. Landlords, since the beginning of time, have chosen to ignore the sublease market whenever possible. Not now. The sheer weight of 14 million square feet of vacant space has everyone nervous. The sublease market is overflowing with long term sublease opportunities, in all types of buildings, many including furniture and equipment. Landlords will be facing off with tenant-sublessors in aggressive competition for replacement tenancies, probably for the next five years or more. If sublease space is cheaper than direct space from the landlord, why not just go for the sublease space?

Proceed with caution, but proceed. Credit, below, is given in part to Doug Van Gessel, Esq., ([email protected]), partner at Cox, Castle & Nicholson LLP in San Francisco. Read Doug’s article, “A Subtenant’s Guide to Subleasing”, here at The Space Place®.

  1. Non-Disturbance. One of the hottest issues surrounding subleasing is the ability of the subtenant to secure a non-disturbance agreement from the landlord. The non-disturbance agreement will, in effect, automatically create a new and direct lease between the landlord and subtenant in the event that the master tenant defaults on its lease (or if the master lease is otherwise terminated). In the absence of a non-disturbance agreement, the subtenant may find themselves on the street, at the landlord’s sole discretion. In most sublease situations, the landlord is a completely disinterested party; they made a deal with the master tenant (probably at rental rates far exceeding current market); they secured a letter of credit from the master tenant to enforce performance; and they are happy to continue clipping rent coupons for the balance of the lease term. Why should the landlord go out of their way to assist one of their tenants in a subleasing effort?!

    If the landlord recognizes that the incoming subtenant is creditworthy, and that the sublease rent is in the realm of reason—in the landlord’s opinion—a non-disturbance agreement may be granted.

  2. Subordination, Attornment and Non-Disturbance Agreement from Landlord. When direct leases are originally negotiated, oftentimes larger tenants are able to secure such agreements from the landlord’s lender. This agreement, when provided, offers protection by current and future lenders to the master tenant from potentially losing its tenancy in the event of a foreclosure on the property. In all likelihood, if the master tenant did not secure such protections, the subtenant will go unprotected.

  3. Relocation Rights. The master lease may contain the landlord’s right to relocate the master tenant. Hopefully in its Consent to Sublease, the landlord will remove this right, but there is no guarantee. Beware.

  4. Protection from Sublessor Defaults. As in item 1, above, the Non-Disturbance Agreement, if one can secure it, will protect the subtenant in the event of a Sublessor default. In addition, however, the subtenant may attempt further measures to preempt such a default by: (a) paying rent directly to the landlord; (b) having the right to cure a default by Sublessor under the master lease and then offsetting such amounts against the base rent; and (c) getting an indemnity from Sublessor (or a parent company) with respect to such a default.

  5. Master lease issues. Representations and warranties from the Sublessor about the space, their FF&E and compliance with laws. Sale of Sublessor’s property. Security deposit issues. Executing an improvement plan in a sublease space. Securing Sublessor’s approvals to comply with the master lease. There are MANY other issues to consider, so you should give us a call to meet and discuss and plan your way through to a successful sublease transaction.

San Francisco Bay Area Market Stats:

Please note: We provide Bay Area market data and analyses for the current year only. To request commercial real estate market data for previous quarters, please contact us.

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