Market Insight Editorial & Advice to Tenants: 2Q1998

San Francisco will go down in history, during these times, for having the tightest office market in the country. While vacancy rates plummeted, investors on buying binges have forecasted lasting positive absorption and have finally driven prospective returns on acquisitions into the ground. Landlords have pumped asking rental rates straight from the $30s to the $40s and now, the $50s for lowrise space! As we discussed in previous Commentary, unimpressive volume of square footage has been leased at these stratospheric levels. Interesting, then, isn't it, that REITs and other investors bid up deals on the expectation that they can turn over lease renewals from current teens and $20s to $40+?? It appears to us that there is a fundamental lack of understanding of the demand base.

“Negative Absorption”: Can this be Positive?

Years ago, in 1981, when San Francisco's vacancy rate hovered around 1%, the tenant community demonstrated its creativity and resourcefulness by packing up and moving out of town. During the past eighteen months that this market has skyrocketed (as have many other major markets around the country), the function of the market was to defer demand and price in new construction. Our “trend” toward negative absorption continues, since many of our tenants are either relocating outside the Bay Area; moving back-office staff; downsizing through layoffs or contrived “attrition”; or simply moving to less wasteful space. Some of the larger brokerage houses which maintain significant listings for sale or lease have created their own twisted logic on the “negative absorption” phenomenon: Leasing activity is significantly lower than last year…due to a lack of space! Rates are projected to continue their climb, they maintain, but don't explain why.

As you can see from the statistics for the Bay Area, construction starts and large vacancies are looming around the corner. Once again, as in the 80s, we will have excess space and a calming of the rental rate hysteria.

The Squeeze of 1998

We thought it would be useful to illustrate what the current market does to tenants trapped in the “Squeeze of 1998”. In the following example we looked at a law firm's occupancy cost. General rule-of-thumb tells us that maintaining rent in the range of 5-8% of gross revenue (less is better, of course) is comfortable. When we see firms pushing to 10-12%, we issue a warning. Firms operating at higher levels are tempting disaster.


20,000 rentable square foot Law Firm, with 29 lawyers @ ~700 rsf/lawyer Lease continues at 20,000 rsf
Currently paying $25/rsf/year for Class A space, with “turnkey” improvements, paid by Landlord Relocate to similar space, in comparable Class A building, at $42/rsf/year, with $10/rsf TI allowance
Firm pays $500,000/yr, total rent. Firm pays $840,000/yr, plus amortized TIs of $47,000/yr (Firm borrows $15/rsf to complete TIs) = $887,000/yr
Assume all attorneys bill 1900 hours per year, at average $175/hour. Total firm revenue = $9,642,500/yr Assume all attorneys bill 2000 hours per year, at average $190/hour. Total firm revenue = $11,020,000/yr
5.2% of gross revenue goes to Rent 8.1% of gross revenue goes to Rent

Nothing For Sale? Buy a REIT

The evolution of developers has been interesting to track during the past 15 years. If one survived the risk-taking of the 80s, a logical move was to fee development, then asset management (until the margins were exhausted) and, finally, to luring the public's savings and diversifying their real estate risk by offering shares of enormous portfolio REITs. Average returns during 1996 and 1997 were impressive, at about 36% and 19% respectively. Expectations for 1998 were about 12%, but real earnings this year are heading for double-digit negative! Since competition for product has been so intense, many a REIT and portfolio manager have literally stopped shopping and sought to enhance shareholder value by (a) selling to a larger REIT; (b) buying a distressed REIT; (c) taking on higher levels of debt [watch out for excessive leveraging]; and (d) commencing new construction, since existing properties are trading at replacement value or greater. We should have a look at the developer's projected income stream. How do you stay in the game and increase shareholder value from here?

Hell Freezes Over

For those of you tuning in from outside the Bay Area, simply focus for a moment on those buildings far from your core downtown, where few have ventured because of lack of transportation and services or for security reasons. These buildings, in San Francisco, used to command rates of $18, when comparable space traded for $25 or more in the CBD. Recently announced was the twice-baked and then burned sale of one such large property in the deep-south-of-Market Street district, for in excess of $200/sf. What is the upside on this investment for the foreseeable future? Rental rates there have pushed $40/sf. How can businesses sustain this rental level, especially the venture-backed multimedia and other technology companies?

Live-work lofts in SOMA are not for live-ins. These mixed-use projects, ballyhooed by the City, lease for about $32-$36/sf. At 3,000 sf for a unit, $8-9,000/month does not make a residence. Rather, the lofts provide a haven for creative users as alternatives to the $40 highrises. Much of this type of product is not on the radar at large brokerage houses.

Embarcadero Center, of course, sold for in excess of $300/sf. Back in '88, the Alcoa Building (now One Maritime Plaza) sold for $300/sf…the highest price paid for a highrise in the City, until now. Of course history isn't repeating itself; this just appears to be so familiar.

Asia Fading. Stocks Reel. Capital Fades. Chips Fall.

The “Asia factor” has continued to hit earnings all around us. The recent turmoil in the capital markets has compounded our problems, but the general populous appears to be taking every 250 point day in stride, whether up or down. Watch carefully for surging trade imbalances, and be ready for the Tums if the latest regime in Japan doesn't turn things around. Lending for new projects has tightened considerably, and based upon projected returns, lending criteria will begin to slow the flow of new projects around the country.

Merger mania continues, as forecast, and look for dramatic consolidation and reduction in demand as a result. A few of the highlighted deals follow:

AIG bought SunAmerica ($18 billion)
AT&T bought TCI ($48 billion)
BP bought Amoco ($47.9 billion)
Nortel bought Bay Networks ($9.1 billion)
Wells merged with Norwest ($34 billion)
Learning Co. bought Broderbund ($420 million)
Merrill bought Midland Walwyn (Canada's largest ind. retail broker, $875 million)
Comp USA bought Computer City from Tandy ($275 million)

Where do the chips fall? Where are we seeing evidence of consolidation? Let's continue to keep track of corporate layoffs. We noticed these recent announcements:

3M 4,000 (5% of workforce)
Adobe Systems 300 (10% of worldwide workforce)
Applied Materials 2,300 (reducing from 16,300 to 14,000 employees)
Boeing 28,000 (12% of workforce)
CNA Financial 2,400 (10% of workforce)
Compaq 5,000 (part of previously announced 17,000 layoffs)
Crown Bookstores 1,250 (Chapter 11; closing 79 of 171 stores)
Diebold 500-600 (8.5% of workforce)
Harnischfeger Industries 3,100 (20% of workforce)
Hewlett Packard Imposed 5% pay cut on 2,400. Closing Dec. 25-31
Komag 480 (10% of workforce; closing 1 of its 2 plants)
National Semiconductor 13,000 forced to take 10 days off without pay
Novellus Systems 360 (20% of workforce)
Northrop 2,100 (in addition to 8,400 previously announced)
Rockwell International l 4,800 (10% of workforce)
Texas Instruments 3,500
TRW 7,500 (14% of workforce; closing 13-20 of 137 plants

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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