Market Insight Editorial & Advice to Tenants: 4Q2002

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

Representing San Francisco Tenants for 20 Years.

Happy New Year. We can all use a happy and healthy one. Thank you for stopping by our website. It’s important that you recognize the enormity of information and professional free advice given to you here, at The Space Place®. One of my first priorities has always been to create a tenant-centric “community”, where we can address commercial tenants’ issues, give away tons of valuable, sensitive market data and entice prospective clients to fall in love with us on the spot. Well, here you have it. Every quarter, we pour out our market assessment—in gory detail—directed at tenants only. Where is the market? Where is it heading? Why? We are immensely qualified to offer these opinions, having worked in this marketplace for 20 years and handled literally hundreds of representation assignments for many of the City’s finest companies and professional firms. Few brokers in San Francisco offer competitive resumes of pure tenant representation. Remember, we NEVER represent landlords, by design.

You have the right to representation, especially for renewal transactions. The results of your negotiations will depend upon the broker you select to represent you. That’s pretty straightforward. My intent is to help you with your due diligence. Please check out our analyses. Check our references. Speak to some of our clients (we can easily arrange this for you). Let’s get together in person, and give us an opportunity to review your situation and share some of our experience.

The Space Place®, now in its 5th year, is a valuable tool to the tenant community. We are here to educate and service your community. Let us help you, too. We represent a small number of clients each year. You could be one. Here’s to a successful year, and a mighty turnaround. Be brave.

Office Markets in Peril: Vulture Economy Forcing Landlord Concessions

The proverbial trough is deep, and has gotten deeper still. Q4, 2002 delivered another blow in the form of staggering negative absorption—again—in every Bay Area county. Around the Bay, tenants and landlords have now put 55 million square feet on the market. San Francisco alone hangs 20 million out for the taking. We have returned to zero or negative NPV deals, where landlords will make deals just to keep buildings operating…but without profit of any kind. Lenders are forced to restructure landlord debt, rather than foreclose and sit on empty buildings. This is the stuff vulture markets are made of, some of which we’ve seen in the late 80’s when a much smaller market went 20% vacant.

One of our local real estate lawyers, Ted Bayer (Pinnacle Law Group), represents landlords in tax appeals, and suggests that ownership is in much stronger hands than in years past. That may be so, but our demand base is weaker than ever, and the combined dynamic is wreaking havoc in the landlord community. Sublease space, which accounts for about 1/3 of the total availabilities, is also adding pressure to the cooker. In Silicon Valley, for example, during Q4 the spread between direct and sublease space rates closed from $7.30/square foot/year to $3.40. Asking rates for direct space plummeted 14% in just one quarter. Jobless claims continue to disappoint Wall Street. Downsizing is simply not complete. Consumer confidence is waning, in the face of unemployment levels, pending war in Iraq, and general distrust of Corporate America. Retail sales are the worst in thirty years. Locally, we have said good-bye to our favorite kingdom-of-toys retailer, FAO Schwartz. Restaurants are folding left and right. Our hotel vacancy rate is 26%. Insurance costs are soaring. We need a break, and we’re not getting one!

In the big picture, however, the office markets are “working”—performing their function. Just what is that? To price in demand. Tenants are obviously not yet responding in a meaningful way, so absorption continues at a negative rate. Tenants require even lower rates, more free rent, greater tenant improvement allowances, bigger lease assumptions, more relaxed security deposit provisions—and tenants will get it, or the markets will simply languish further. That is clear. There will be NO market turnaround as long as net absorption of space continues anywhere near present.

What is truly perilous for many a landlord is that they literally cannot afford to make deals under these types of conditions. Unfortunately the landscape will have to change to the point where the lender or a new [vulture] owner will have to step in at a significantly lower basis.

Real estate, everywhere around the Bay, will be rewritten in parts. Market conditions such as these will create casualties. It is unfortunate, but a necessary economic function to be performed during these times. Of course, tenants properly protected will benefit from shrewd negotiations, keeping in mind that their tenancy may be the lifeline for an owner.

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.

California Businesses, Taxpayers: Your IOU, $35 BILLION.

The office market landscape is connected at the hip to Governor Davis’ efforts to battle our $35 billion State deficit. The San Francisco Chronicle has reported that our deficit is larger than in all other states combined. President Bush will try to stimulate the national economy while Davis raises State taxes, gas and cigarette taxes, slashes school budgets and social welfare programs. Local impact will be significant, especially for submerged landlords seeking tax relief at the County level.

In these declining markets, it has become practice for most landlords to appeal their tax bases, rationally arguing that as their assets have declined in value, so should their real estate taxes. However, under pressure from the State to preserve and increase tax revenue wherever possible, Counties throughout the State will clamp down on landlords, and probably try to create new and unforeseen sources of tax revenue. For example, last year San Francisco County assessed all commercial owners a 2% tax increase, allowable under Prop 13 yet flying in the face of widespread erosion in value. Counties will be slow to respond—or simply ignore for as long as possible—landlord tax appeals.

In fully serviced leases of most varieties, landlords have the ability to pass tax increases through to their tenants. However, when tax appeals are unsuccessful, or not heard, the absence of much needed tax savings for the landlord will further erode their plight in these down markets. Everyone will be affected by the State’s massive deficit. Assuming that personal incomes and attitudes will suffer as a result, the much-acclaimed “recovery” will have to wait.

Landlords Battle Their Own Tenants: Direct vs. Sublease Space

As tenant representation specialists, we more than earn our fees on the topic of direct versus sublease space. There is so much more happening than what meets the eye. Tenants constantly notice the huge discounts associated with sublease space, and naturally gravitate toward those opportunities. Tenants are not without justification. In office markets around the Bay, the spread between direct and sublease rates is in the $4-$5 per square foot per year range. Bearing in mind that typically sublessors (tenants with excess space) are more motivated than landlords, the spreads can widen. So, why is sublease space so (relatively) cheap? And why don’t we simply pursue sublease deals?

  1. Landlords: Like it or not, sublease space rates will drive down direct space rates. Sublessors generally have far more to lose, and have less time to waste trying to cut costs and survive. If tenants find that subleases, for whatever reason, are intolerable, the sublease market can and should provide great leverage in direct lease negotiations.

  2. Surround yourselves with the proper experts on this topic, since you are on shaky ground from the start. We like to refer tenants to Attorney Doug Van Gessel’s awesome article, “A Subtenant’s Guide to Subleasing”, in which he enumerates the various potential pitfalls of subleasing. Hear it from us, but hear it from Cox, Castle & Nicholson’s top real estate partner as well, there will be “hair” on your deal, but not all is bad news.

  3. Check the term on the sublease. If it’s less than a conventional direct term of 5-10 years the rate is being discounted to offset the likelihood that your tenancy will be limited to the sublease term. Who wants to go through the headache of moving for the short term? The answer: Some folks do. We have a “market” then, albeit a limited one.

  4. Check the master lease for the space. In all likelihood, you will be unsuccessful in compelling the landlord or sublessor to make material changes to the master lease. Its provisions may include obnoxious points, or lack certain protections.
    • Should you agree to a sublease if there is no non-disturbance agreement?
    • What if the landlord is foreclosed by the current or future lender? Could you be out on the street? Yes!
    • What if the sublessor files bankruptcy? Does your tenancy automatically convert to a direct lease with Ownership? Could you be out on the street? Yes!
    • Are there excessive management fees to the landlord?
    • Are there excessive construction supervision fees? (Why do tenants agree to pay these fees, and what value do they actually receive from their landlord?)
    • Are the options to expand and extend the lease “personal” to the sublessor?
    These issues, and others, can be complicated to resolve, especially in the face of a soft market where the landlord (whose approval is necessary for your deal to go through) has competing space to offer and is completely uninterested in your sublease.

  5. Check to see who is responsible for code-related upgrades to the space and common areas on your floor and in the building. Make sure that your architect and contractor survey these areas and report their findings and construction estimates to bring matters current. In a recent transaction, a landlord (unreasonably) withheld approval of a sublease unless and until the sublessor promised to completely upgrade all of the common area restrooms and hallways on the multi-tenant floor. Code did not require such improvements, but the landlord took advantage of the sublessor’s dire need to make deals. In direct deals, of course, we look to the landlord to absorb all such code-related improvement costs.

There are myriad machinations of other subleasing scenarios, and we would be pleased to discuss them with you. The cleanest approach, with a willing landlord, is to bring about the termination of the sublessor’s master lease, in conjunction with writing a new long-term direct lease. The sublessor may compensate both landlord and incoming tenant to subsidize the new deal. Unfortunately, these days most landlords are more concerned about their own vacancy and their own skin. If the sublessor is financially weak, you have more leverage since the landlord is about to inherit vacant space from bankruptcy.

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? 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 listed the Top 25 companies with the most control of space on the market. 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 (#8), 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 12.3 % 2,603,767
2 Colliers International 8.8 % 1,860,247
3 Cushman & Wakefield of California 8.8 % 1,857,983
4 CB Richard Ellis 7.0 % 1,481,986
5 Wilson Meany Sullivan LLC 4.5 % 955,575
6 Insignia/ESG, Inc. 4.4 % 923,929
7 GVA Whitney Cressman 4.3 % 913,567
8 Equity Office 3.4 % 719,971
9 Catellus Urban Development Corp. 3.1 % 648,548
10 Grubb & Ellis 3.0 % 633,121
11 Shorenstein Realty Services LP 2.9 % 622,598
12 Hines 2.5 % 540,544
13 BT Commercial Real Estate - NAI 2.4 % 501,098
14 Starboard TCN Worldwide Real Estate 1.9 % 405,885
15 Jones Lang LaSalle Inc. 1.7 % 354,015
16 Tishman Speyer Properties 1.6 % 344,663
17 TRI Commercial/ONCOR International 1.5 % 317,403
18 Boston Properties 1.5 % 316,150
19 Coldwell Banker Walker Pacific 1.3 % 281,157
20 The Staubach Company 1.3 % 278,800
21 The Presidio Trust 1.3 % 274,620
22 Rosen Realty Group 1.1 % 242,072
23 William Spencer Co. Inc. 1.1 % 240,000
24 Newmark Pacific 1.0 % 218,383
25 McCarthy Cook & Co. 1.0 % 206,450
% 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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