Market Insight Editorial & Advice to Tenants: 2Q2003

From Dan Mihalovich [[email protected]], Principal of Mihalovich Partners and Founder of The Space Place®:

After 21 years of representing tenants in leasing negotiations, I remind our readers at the top of this report that we are here to serve you—in ways that I believe none of our competitors can or do. These quarterly reports are far from the industry norm, and to our knowledge represent the only regularly published professional broker opinion about the San Francisco office market. We present you with more than basic statistics, which most would have you analyze yourselves and reach your own conclusions. My 25-years of market analysis and negotiating experience are put to work for you, here, offering up valuable advice on market timing; specific market trends; critical lease issues; rental analysis; and scores of other topics facing tenants and shaping the outcome of lease negotiations for tenants. We are proud to present these commentaries and share these insights, in the hope and expectation that interested tenants will respond with questions and requests for meetings. We are available to meet, and to meet the Press to elaborate about the plight of tenants in the markets we serve. We are pleased to go on record, and have provided you with an archive of our previously released opinions. Thank you for visiting us. I hope that you will join our family of Clients.

Office Market Deflation: 10 Straight Quarters of Negative Growth

Economists everywhere are right to be fearful of deflation, and we can see its ravages right here in the San Francisco area. Even when the pricing of space drops precipitously, buyers don’t buy. This phenomenon begins to feed on itself, as neighboring markets have to reduce their pricing to remain competitive in courting large tenants; and tenants with excess space perfume their sublease offerings even more so to compete with direct space. Spaces remain vacant for longer periods, as tenants take more time being selective about their choices. As of Q2, 2003, San Francisco experienced an unprecedented 10th consecutive quarter of [less than zero] negative growth, at -809,000 square feet. The Bay Area counties posted a total of -1.522 million square feet of negative absorption, versus -1.611 million square feet negative in Q1, 2003. For our local readers in San Francisco, this means that all leasing activity combined, when offset by new spaces made available, resulted in an 809,000 square foot net loss in absorption levels. At 200 square feet per employee, Q2’s “activity” resulted in an equivalent loss of more than 4,000 jobs. In the last 45 days of the Q2, ~760,000 square feet of newly listed space came on the market. The pace of new additions is not slowing.

Vacancies in San Francisco remained in the stratosphere, at ~19 million square feet. Santa Clara County, containing Silicon Valley, suffered another pitiful performance in Q2, at -650,000 square feet of net absorption; East Bay counties continued running in the red, at -97,000 square feet. The only “bright spot” was San Mateo County, with the only positive net absorption in the Bay Area, at 35,000 square feet, the first positive reading in San Mateo in six quarters. Note, however, that San Mateo’s asking rent rates declined substantially, under the weight of a 23% vacancy rate.

Tenants, properly represented, will continue to negotiate more compelling transactions throughout the area—more compelling in Q3 than previously. Pricing levels and concessions, after all, are softer than we recall from the early 1980s, and will continue to unfold until significant positive net absorption returns. At a time when the economy is flat-to-reeling, depending on your industry, we find that many of our clients benefit from our abilities to leverage a competition among landlords, which effectively reduces expenses for renewal rates and renovation costs at existing locations. The economic environment begs tenants to make do with current premises, whenever possible, and avoid incremental expenses by relocating. In theory, landlords and tenants should equally benefit from renewals. Invariably, though, landlords tend to treat existing tenants as captives, so our work on renewals is quite rigorous. If a landlord refuses to share the benefits of maintaining a good credit tenant, why should the renewing tenant provide this subsidy? Renewal economics pose a different negotiation and strategy than for relocations. Please ask us about our methodologies.

Market “Recovery” Meets Economic Reality: We’re Broke

About every seven seconds, a notable economist or Wall Street analyst predicts a market “recovery”. At some point, hopefully soon, one of them will be right. For the time being, though, Mr. Greenspan and the leadership of U.S. trading partners are focused on the lowest interest rates in 45 years and the fear of deflation and lack of sustainable growth in our economies. We’ve written here previously about our more local calamity, California’s swirl of debt and junk rating; but we can’t ignore international forces working against us. Lower interest rates yet may provide a stimulus for businesses in the U.S., but cheap money has not been a panacea. With a weakening dollar, we are effectively exporting our troubles elsewhere since our trading partners’ interest rates and currencies remain high in comparison. What does this have to do with the price of space in San Francisco?

Corporate investment in U.S. from abroad plunged by 80% in 2002, according to the Organization for Economic Cooperation and Development [www.oecd.org]. Trade partners’ flight to other markets has wreaked havoc on the value of the almighty dollar. Our actions in the interest-rate market increase the value of other currencies, like the euro, at a time when economic powerhouses like Germany are sputtering, edging into deflation themselves. Deflation, a sustained period of falling prices, ravaged Japan into a 13-year slump. The 12-nation euro zone is scheduled to expand by 10 countries within the next 18 months. This merger, in our view, is of necessity to stimulate their respective economies. Reaction from the euro zone will not be favorable to the U.S., unfortunately, since they can ill afford to absorb our deficits, nor can anyone else for that matter. We are looking for a meaningful and real recovery in the San Francisco marketplace, but can only find negative forces pressuring our regional economy, with anticipated deep cuts from Sacramento on the horizon.

Jobless claims [from the U.S. Department of Labor - www.bls.gov] continue to confound the pundits on Wall Street, but they do not seem surprising to those of us on the street. We are happy to hear the bullish sound of Schwab’s and other analysts, a refreshing new trend which had to begin sometime. Meanwhile, all telltales from those companies and firms making long term leasing commitments in our markets tell us that the till is under lock and key, and that less space is better than more. Money is going begging. Go figure. Could you use a loan?

Landlords Battle Their Tenants for Deals

Declining rental rates aren’t the only telltale of softening markets. We also note the change in landscape as tenants with excess space try to get more aggressive than their very-own landlords—landlords offering competing, direct space. During Q2, we noted that the spread between asking direct rates and asking sublease rates increased by a significant margin:

In San Francisco, asking rates for sublease space are $7.20 per rentable square foot per year cheaper than for direct space. (In Q1, the spread was $5.40/rsf/yr).

In San Mateo County, the spread was $3.50/rsf/yr in Q2, vs. $2.60/rsf/yr in Q1.

We note spreads of $2.50/rsf/yr and $4.30/rsf/yr in Santa Clara and East Bay counties, respectively.

The discounts associated with sublease spaces are a common phenomenon in every market. The duration of subleases tend to be shorter than direct leases, so most of the time sublessors must discount their offering to attract the same quality tenant who would otherwise sign a longer term direct deal with the building owner. But at what discount would a tenant take the sublease space instead? Evidently those spreads are growing, indicating a higher level of motivation by sublessors (i.e. tenants, whose staying power, of course, is dwarfed by that of landlords—especially landlords working with OPM [other people’s money], such as REITs and large pension funds) than their landlords.

Isn’t there a “win-win” outcome possible, where the sublessor’s lease is terminated (good, so far) in favor of the landlord writing a new lease with the prospect (also sounds good)? In markets where your space is competing directly with the landlord’s, the possibility is remote—but nevertheless a possibility. Please call us to review your situation. We have enormous experience in this area. With respect to the trends in asking rates, however, we foresee markets in this area continuing to devastate tenants to a far greater degree than landlords. These spreads will remain wide, and widen further as long as net absorption levels remain near or below zero. In other words, as long as 2/3 of San Francisco’s 19 million square feet of vacancy is direct space, landlords will be as uncooperative as ever in accommodating their tenants who are choking on excess space.

Trend in Asking Rents—Current v. Year-end 2000

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.

Vacancy Rates—Current v. Last Quarter + Forecast

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.

Who Has the Most Space in San Francisco? Surprise…

When we approach a prospective new tenant client, we tell them that we NEVER represent landlords, always avoiding this conflict of interest. So, which leasing firms do the most landlord representation, and who controls the most space in San Francisco? And, most importantly, would you feel comfortable having them represent YOU?

Below we’ve surveyed the entire 106 million square foot inventory of San Francisco, and illustrated the companies with the most control of space on the market, the Top 25. You know from our other stats that 20 million square feet is now on the market in San Francisco. The top 4 companies, all office leasing brokerage firms, control nearly 50% of the City’s vacancy, more than Equity Office Properties (#5), the country’s largest REIT; more than Shorenstein (#11); and more than Hines (#12) or Boston Properties (Embarcadero Center). Surprised, are you not?

Top 25 companies By Space Inventory

% Market Share Square Feet
1 The CAC Group 11.6 % 2,459,694
2 Cushman & Wakefield of California 10.8 % 2,278,148
3 CB Richard Ellis 9.9 % 2,086,312
4 Colliers International 8.0 % 1,684,754
5 Equity Office 4.3 % 917,294
6 Tishman Speyer Properties 4.3 % 903,663
7 Insignia/ESG, Inc. 3.7 % 777,130
8 Catellus Urban Development Corp. 3.4 % 718,548
9 Grubb & Ellis 3.3 % 701,497
10 GVA Whitney Cressman 3.3 % 693,689
11 Shorenstein Realty Services, LLC 2.9 % 604,542
12 Hines 2.8 % 593,208
13 Jones Lang LaSalle Inc. 2.6 % 538,920
14 BT Commercial Real Estate - NAI 2.5 % 533,549
15 Boston Properties 1.8 % 370,966
16 Newmark Pacific 1.6 % 346,357
17 The Presidio Trust 1.5 % 323,912
18 Starboard TCN Worldwide Real Estate 1.4 % 306,358
19 Coldwell Banker Walker Pacific 1.3 % 280,419
20 TRI Commercial/ONCOR International 1.2 % 261,163
21 Wilson Meany Sullivan LLC 1.2 % 249,214
22 HC&M Commercial Properties, Inc. 1.1 % 222,356
23 Transwestern Commercial Services 1.0 % 204,960
24 Arroyo & Coates 0.8 % 159,509
25 McCarthy Cook & Co. 0.7 % 153,189
% refers to the percentage of vacant space under exclusive listing by each company. The accompanying figure is the actual square footage available for lease.

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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