Market InsightEditorial & Advice to Tenants: 4Q2014

EDITORIAL from Dan Mihalovich, Principal of Mihalovich Partners and Founder of The Space Place



Tenants---how many alternative spaces are available to YOU to suit your requirement? Isn't this part of the core litmus test of how soft or tight the market really is? See our chart, below. We track the changes for all size ranges of tenants in these reports….from quarter to quarter. If you want real-time data, please call me.

If you're in search of intelligent life in the brokerage community…please enjoy this Editorial with my compliments. And, here are the last 10 years of pearls of wisdom in our Editorial Archives.

Dan Mihalovich
President, Mihalovich Partners
Founder, The Space Place®
[email protected]
415-434-2820

San Francisco. Incubator Inferno.

Happy red-hot times to all and to a spectacular 2015! Kudos to local companies, startups and beyond, who've blossomed this past year and enjoyed the spoils of the City and its surrounds. Welcome to the Tech Movement. We've been known to host many a movement in the City by the Bay (earthquake pun intended). The allure of the City has obviously spread far and wide, to the point that any commercial tenant even thinking about a new lease or planting here anew needs to ramp up preparations, strategy, office leasing Team….and rockin' advice, fast. "Winning The Beauty Contest: Brokers Position The Deals" and "Value of TEAM. Who's YOUR Quarterback?", will help you get started.

It's a small town and everyone "feels it" when the movement is on. Those of us who've made a career in commercial real estate can recall a time when the Canadians ruled the cranes in the City. And when the Japanese owned virtually every major building on California Street. We recall long-term building ownership, relative to today's culture of speculative flipping (tenants: beware of Prop 13 tax increases! Ask us how to protect yourselves). Of course we've seen our market crashes, too.

What is intriguing about the San Francisco marketplace is that the City has become so utterly popular that regardless of the price (so far), commercial tenants … and residents … keep paying up to be here. This is where the legions of young guns want to be. But at what price? The old rule of thumb is to keep your rent down to 8% (or less) of gross revenue. In any event, the financial objective is to create a long-term horizon of profitability for your company, so that your office space works FOR you….rather than you working for your space. Make sense? We'd love to help you maximize all fronts during your next lease negotiation (renewals, relocations – we quarterback all office leasing negotiations and strategic planning for our tenant clients).

2014 Year-End Factoids:

  • Deal flow is down everywhere around the Bay. San Francisco remains the demand-Star, with 2.5M square feet of net absorption for the year…and 19 straight quarters of increasing rental rates. The City's rates are at a huge premium to outlying areas in the East Bay, for example. Meaning, the spread will have to expand further before suburban demand picks up. Otherwise, the rage in the City may party on!
  • SF's landlords have enjoyed four straight years of consistent record leasing activity….yet those levels have not grown year over year. 10M square feet remain on the market. See below to see how many alternative spaces you have to choose from, tenants.
  • San Mateo County has maintained great momentum since mid-2013, and wrapped up 2014 with over 1M square feet of positive absorption….although 2012/13 were flat.
  • Alameda/Contra Costa Counties: Bombed out in 2014. Nearly 400,000 square feet of NEGATIVE absorption for the year, yet Q4 was positive. Leasing activity was 1M square feet below that of 2013.
  • Marin County: Bombed out. Net absorption was close to zero for 2014. Leasing activity was a bit more than half of 2013's performance.

Printing $80 Billion Per Month: A Fairytale of Epic Returns

Reporting from ever-sunny Camelot (San Francisco), skies are blue, VC-backed tech companies continue to drive rental rates wild and nary a thought of the downside to locking in record-high overhead. What do us veterans of office leasing wars know, anyway. The markets appear to absorb the most spectacular news as only memory-challenged Americans can:

  • The Fed's printing of $80 billion per month for so many years, coupled with essentially free capital, has caused massive inflation of the CRE markets. Although QE is easing and the Fed is considering raising interest rates in 2015, it still measures inflation at low single digits. It's folly to mask true inflation, as it is to mask under-employment rates and call it unemployment. Building owners acquired properties three years ago and just flipped them for 50%-100% returns around the San Francisco Bay Area. Employee costs and benefit package pricing has soared! College tuition increases are staggering. But just as the Fed ignores the under-employed who are no longer considered to be looking for work (or are working multiple part-time jobs just to stay afloat), the Fed's inflation basket doesn't contain any of the elements described herein. Pay no mind in Never Never Land, where rental rates will never decline. And forget the AIG spectacle and the fact that nothing is more transparent about the credit default swap markets today than it was when the global economy disintegrated last go round. Too big to fail is perfectly positioned to fail once again.

  • Bill Gross, in his Dec Outlook for Janus Fund wrote: "Can a debt crisis be cured with more debt? It is difficult to envision a return to normalcy within my lifetime (shorter than it is for most of you). I suspect future generations will be asking current policymakers the same thing that many of us now ask about public smoking, or discrimination against gays, or any other wrong turn in the process of being righted. How could they? How could policymakers have allowed so much debt to be created in the first place, and then failed to regulate their own system accordingly? How could they have thought that money printing and debt creation could create wealth instead of just more and more debt? How could fiscal authorities have stood by and attempted to balance budgets as opposed to borrowing cheaply and investing the proceeds in infrastructure and innovation? It has been a nursery rhyme experience for sure, but more than likely without a fairytale ending. Markets are reaching the point of low return and diminishing liquidity. Investors may want to begin to take some chips off the table: raise asset quality, reduce duration, and prepare for at least a halt of asset appreciation engineered upon a false central bank premise of artificial yields, QE and the trickling down of faux wealth to the working class. If the nursery rhyme theme is apropos to the future, as well as the past, investors should remember that while 'Jack and Jill went up the hill,' that 'Jack fell down, broke his crown, and Jill came tumbling after.' Someday soon, perhaps."

You Can't Predict Office Tenant Demand. Without it, Go Take a Leap.

Yes, the Bay Area office market has been on fire. Hair's on fire. No one has time to think, breathe or make sense of the flowery reports from UCLAAnderson, Rosen, CBRE and others. Brokerages clutch their Tenants in the Market reports as "evidence" of demand, but such reports are hearsay and change with the wind. As an industry, CRE is just not good at accurately predicting demand. What's much easier to do is to quantify the supply side. And so it goes, the reports eloquently foretell landlord sentiment; the cost of construction and always-in-step higher rental rates that tenants will be obliged -- and willing -- to pay since every developer and lender must be made whole in these scenarios. The only problem is that in a supply-demand analysis, if one can't accurately document demand….it's essentially bunk. The requisite demand statement in these reports: Tech and other demand will continue on its current tear into the foreseeable future. Right. Maybe. Maybe not.

A common theme around major brokerages, VCs, angels and other pundits is that "this time it's different" (reference being to the notion that the current tech booms barely resembles that of the Dot Com boom). We've written on this theme, and will continue. Let's be really clear on a couple of things:

1. History is a trap. If you'd like to predict the future based on the past, you're fired. Sorry.

2. If you've told the marketplace that "this time is different" and that the startup landscape has evolved since the Dot Com, don't come to us with rental rate projections which illustrate how much higher rates will go to equate to those of the Dot Com! Especially when you have no evidence of demand to prove your case.

What's a Ruble Got to Do With It?

Ask around town. Isn't the office leasing environment, here, impervious to all of the following factors? Let's get a handle on this. During the past six months, the Ruble has lost 50% of its value against the Dollar. Granted, the U.S. has aggregated sanctions against Russia; yet they are a major trading partner. The Japanese launched a currency shock storm, now enveloping China/SE Asia and Europe. According to Nouriel Roubini, "The recent decision by the Bank of Japan to increase the scope of its quantitative easing is a signal that another round of currency wars may be under way. The BOJ's effort to weaken the yen is a beggar-thy-neighbor approach that is inducing policy reactions throughout Asia and around the world. Central banks in China, South Korea, Taiwan, Singapore, and Thailand, fearful of losing competitiveness relative to Japan, are easing their own monetary policies – or will soon ease more. The European Central Bank and the central banks of Switzerland, Sweden, Norway, and a few Central European countries are likely to embrace quantitative easing or use other unconventional policies to prevent their currencies from appreciating." And... oil markets are tanking, creating other economic shockwaves to our trading partners.

Avoiding the Representation of Adverse Interests

Those of you in executive roles within your organizations hold to an extremely high standard when selecting legal counsel to represent your interests. As you should. In California, lawyers are expected to do the same --- meaning that right after the how-do-you-do, your prospective counsel will run a conflict-check and observe the State Bar of California Rule 3-310 to ensure that all is copasetic. So, tenants, why would you hold a different standard when hiring a commercial real estate broker to represent your interests?

Tenants seeking purely objective advice and aggressive advocacy of their interests should hire brokers who represent tenants – and only tenants. Mihalovich Partners is such a firm, but there are others to choose from as well. Unfortunately the commercial real estate industry (which has experienced dramatic consolidation during the past couple of years) does not hold itself to the higher ethical standards of the legal profession. The largest brokerage firms which purport to be omnipotent in the industry play both sides of the negotiations simulataneously --- on a daily basis. Some of these major brokerage companies also take equity ownership in office buildings, literally functioning as landlord at the same moment they purport to objectively advice a tenant in lease negotiations.

Corporate America, professional services tenants and other "large" tenants seem to find comfort in selecting a national or regional brand – another large corporate entity – to serve as their broker. We understand; rather we acknowledge the faulty logic. Corporate Real Estate Departments around the country want to make a "safe choice" in their selection of an office leasing broker. But is it a safe choice to select one of the most conflicted companies in America to represent you, or rather a choice that assures you of compromised fiduciary obligations, diluted interest in seeking the most protective and aggressive terms for you, and the propensity to be a victim of insider information? The unfortunate truth is, you may never know.

If Your Lease Will Expire Within The Next Three Years…

or if there is another compelling reason to discuss your firm's office leasing situation, please call us. For qualified tenants, we offer the following pre-contract services:

  • Free preliminary office lease and operating expense review;
  • Free consultation to discuss project management, Team formation and project schedule;
  • Market surveys and our specific tenant-driven leasing recommendations ; and
  • Assistance in selection and coordination of all Team members throughout planning and negotiation phases.

Vacancy Rates: Are Your Options Fading?

Tenants should watch carefully to detect how and to what extent your field of options changes. Which size blocks of space are getting leased? Discussing vacancy and absorption rates can be confusing to some. What language makes sense to tenants? Tenants ask, "Tell me about my specific options. How many choices do I have?" Are your options fading, as a result of leasing activity? Review the chart, below, and let's discuss.

HOW MANY BLOCKS OF SPACE ARE AVAILABLE FOR YOU? San Francisco County San Mateo County Santa Clara County East Bay Counties
Q3’14 Q4’14
5,000–9,999 sq. ft. 277 276 Call us for more info
0%
10,000–19,999 173 177
▲ 2%
20,000–29,999 58 55
▼ 5%
30,000–39,999 15 26
▲ 73%
40,000–49,999 10 10
0%
50,000+ 31 41
▲ 32%

You can request a free space survey, containing all direct and sublease space meeting your specific requirements. We can also provide building photographs, floor plans, leasing histories and more. To discuss your space needs in person, call 415-434-2820 or email [email protected].

Who Has the Most Incentive to Drive Up Rental Rates In San Francisco?

When we approach a prospective new tenant client, we tell them that we NEVER represent landlords, always avoiding this conflict of interest. So, which of our competitors—leasing firms—do the most landlord representation? Who's marketing the most space in San Francisco?

The top companies controlling the most space available are NOT landlords….Rather, they are office leasing brokerage firms acting with the landlord's interest in mind. They are:

CBRE
JLL
Cushman & Wakefield
Colliers
Newmark, Cornish & Carey

These brokerage firms control over 60% of all listings and are beholden to 200 local landlords, paid to drive up rental rates and drive down concessions for tenants.

Since their allegiance is committed to so many landlords, how can they possibly represent YOUR interests—the tenant's interests—objectively and aggressively?

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