Market Insight Editorial & Advice to Tenants: 4Q2004

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

Market “Recovery”: Presage to Recession?

Welcome, 2005. Just when your eyes were glazing over from the barrage of political commercials, wham! The Election is behind (most of) us; we’re focused as ever; and ready for the Recovery! Bring it on! Venture capital is back, posting $20 Billion for start-ups in ’04, up slightly from ’03, although not the irrational exuberance of $106 Billion of ’00. Admit it: The economy feels so good, you bought into IPOs again, didn’t you? There were about 250 of them in ’04, screaming ahead of only 85 in ’03. Thomson Financial reported about 385 in ’00, so that gives Wall Street something to shoot for in thrive-in-’05. M&A is back. Law firms are back, many reporting their best year ever in 2004. Demand in our office leasing markets is back. Big money is buying up our supply of highrises. Inflation is “under control”. Interest rates have climbed a bit, but, hey, they’re still at 40-year lows, so let our home prices continue soaring! Across the nation we’re adding 150,000 new jobs every month. Free elections are taking (and re-taking) place in some of our old vacation spots abroad. There is a prospect for at least a little peace in parts of the Middle East. We have a lot to be hopeful for.

Please. Sit down.

Our first toast of the New Year is to all short-minded Americans, short on memory, of course. Who can recall campaign promises, or wants to remember by the time it’s too late? In all the hoopla, many of us don’t exactly remember how we ventured into Iraq, or how long it was going to take, or at what cost. Today, two years later, we can postulate that the $250+ Billion Invasion, swept out from Deficit accounting, will sneak up somewhere else—not that we should worry. Only 35% of our GDP goes to paying our debt. But the 35% figure? Well, that number comes from the Fed, the folks tucking the $250 Billion away. What looked like a $500+ Billion deficit, according to the Administration, now looks closer to be $415 Billion. Hmmm. Unpopular as it may have been on both sides of the aisle, Bush’s policy choice to cut taxes while democratizing Iraq may push us into the proverbial financial deep-fryer: Our foreign trade partners, in a move to reject our massive and growing debt, could force a dramatic increase in interest rates (Fed Funds started ’04 at 1%, ended at 2.25%; perhaps heading to 3.25-3.5% in ’05), and a rapidly declining dollar. All at a time when our annual trade deficit already exceeds $500 Billion. We’ve somehow managed to get used to the “jobless recovery”, but how will we fare without the almighty American consumer if and when rising interest rates take their toll?

To further address and clarify deficit issues, I turned to Bill Gross, Managing Director of PIMCO. Last Fall he wrote a terrific article entitled, “Haute Con Job”, in which he does a yeoman’s job explaining the mess which lies ahead—understanding real inflation, real growth and what has to take place in our economy to reduce the deficit. Letting the dollar sag, alone, isn’t doing the trick. Here’s what Mr. Gross had to say:

“Government statisticians manipulate the price increases for cars and just about any durable good that comes off an assembly line but find it difficult to extend that theory to underwear or a pair of shoes. Perhaps that’s next. Talk about Uncle Sam getting into your shorts!

“Actually, to make the case for the government con job, it’s important to point out that the bulk of these hedonic adjustments have come only in the past few years, when it became necessary to buttress Greenspan’s concept of our New Age Economy. Back in the 1990s the Clinton Administration blessed a start to quality-adjust inflation statistics…The BLS has expanded the concept to include audio equipment, video equipment, washers/dryers, DVDs, refrigerators, and of all things, college textbooks! Today no less than 46% of the weight of the U.S. CPI comes from products subject to hedonic adjustments. PIMCO calculates that without them, and similarly disinflating substitution biases, Greenspan’s favorite inflation measure, the PCE, would be between 0.5% and 1.1% higher each year since 1987. This implies as well that since inflation was higher than actually reported, that conversely, real growth must have been lower by the same amount.”

Gross continues:

“The CPI as calculated may not be a conspiracy but it’s definitely a con job foisted on an unwitting public by government officials who choose to look the other way or who convince themselves that they are fostering some logical adjustment in a New Age Economy dependent on the markets and not on the marketplace for its survival. If the CPI is so low and therefore real wages in the black, tell me why U.S. consumers are resorting to hundreds of billions in home equity takeouts to keep consumption above the line. If real GDP growth is so high, tell me why this economy hasn’t created any jobs over the past four years. High productivity? Nonsense, in part—statistical, hedonically created nonsense. My sense is that the CPI is really 1% higher than official figures and that real GDP is 1% less. You are witnessing an “haute con job”…If [investors] are holders of government bonds based on a benign outlook for inflation, they had better cash some of them in, especially at today’s 4.0% yield for 10-year Treasuries.”

From the Bureau of Public Debt, we thought you’d like to know:

How do you make a contribution to reduce the debt?

  1. Make check payable to the “Bureau of the Public Debt”.
  2. In the memo section of the check, make sure you write “Gift to reduce the Debt Held by the Public”.
  3. Mail check to:
    PO BOX 2188
    PARKERSBURG, WV 26106-2188

Greater Fool Theory: Buying On Assumptions

During the dot-com years, too few of us pushed away from the IPO-candy counter and said, “Enough!” We ate up those non-revenue producing companies along with their meteoric P/Es and post-pubescent Board members. The markets were heading up and we chased after them, rationalizing the whole way. The numbers didn’t make sense. So, we’ve been asking around San Francisco about the latest phenom—one of the hottest investment markets in the entire country—where nearly anyone who’s owned a highrise office building has been selling them! Bearing in mind rental rates, cheaper now than anytime during our Principal’s 23-year tenure, WHY do these building purchases at $400 per square foot make any sense?

We quizzed one of the freshest, new building owners who just closed a deal in the CBD, where earlier in the year we had negotiated a lease for one of our clients in the lowrise. A beautiful, Class A building. Our client’s deal was very attractive—granted, in part, due to the landlord’s interest in filling the building prior to packaging it for sale. We settled at $23/sf/year for a 6-year term, with a $20/sf tenant improvement allowance. Although our client leased an entire floor, there remain additional floors for the new owner to lease. How did the purchase fly, and what are the new owner’s leasing objectives?

First, the new owner must assume that they can do a much better job leasing than the prior. One must “add value” to justify this kind of acquisition. Projected rent for the remaining space available is…$32/sf/year! So, reaping an additional $7 or $8/sf/year shouldn’t be so difficult if you beef up your marketing campaign. Right? Next, assume that rents will adjust by a modest 3% per year during the first couple of years; then, perhaps at 4%; on to 6% for a couple of years; and how about 10% for a year or two after that. While the percentages may appear “reasonable” to an analyst somewhere east of Fostoria (or to a foreign investor who’s making beaucoup bucks on the falling dollar), the impact on the tenant is huge! Bear in mind that tax and operating expenses are on the rise as well. It’s not unusual for Class A buildings to be operating at $15/sf/year, or greater, so be sure to consider escalating that figure by another “reasonable” factor of about 5% per year. Under this scenario, the tenants will be paying ~$49/sf/year for lowrise space by ~2012. Does this seem plausible to you?

We’re always counseling our clients to try to maintain rent at or below 8% of their gross revenues. So, the client who moved in at $23/sf is figuring revenues of ~$4.3 million/year to fit our guideline. At $49/sf rent, however, their revenues will have to be $9.2 million/year! Somewhere along the way, a clashing of spreadsheets will take place. The Financial District has never sustained nor can it support such underwriting over an extended period. These numbers do not justify the acquisitions. Unfortunately, new owners will remain under tremendous pressure to deliver on their promises to investors. For a time, then, we expect to have to work harder for our tenant clients (our only clients, since we never represent landlords) to weed through all the alternatives to craft sensible deals in buildings owned by still-hungry landlords. Much of the CBD has changed hands. We have a lot of new owners to educate.

evangelical Brokers, Owners

Please note the small “e”, since we’re not making any religious commentary, but underscore the widespread impact that brokers and building owners can have on the press, the hype, and the innuendo about rising rental rates, tightening market conditions, and your opportunities—as an important tenant in the marketplace—to secure advantageous economic and other concessions for your new lease. At present, the local markets are rumbling with chatter, since—finally—we’ve seen some impressive absorption of office space. Although rental rates remain historically low, in the face of this increased activity, combined with the massive number of large properties being sold—talk on the street will likely goose a number of tenants into paying more than they should. Has this happened to you before? Sure. It’s the dot-com, pants-on-fire, come-on. It’s the last-chance-sale before things really go nuts. Bearing in mind all we’ve discussed, here, it’s time to settle down, give us a call to get organized and map out a sensible strategy. The market isn’t going to run away. There remains 16.6 million square feet on the market in San Francisco; 52.5 million square feet around the Bay. By the way, those brokers who talk up the market and whose firms publish reports suggesting that the activity is yielding “good news”…“Good news” for whom?! Please keep in mind: Mihalovich Partners never represents landlords. We’re here to protect and advocate for the interests of tenants, only.

Tenants: Get it Straight

Mihalovich Partners represents tenants, only. Our core business is driven toward educating and objectively and aggressively representing TENANTS, only. If you are looking for biased market information serving the LANDLORD community, please see one of Cushman & Wakefield; CAC Group; Colliers; or CB Richard Ellis—whom collectively represent over 38% of the 16 million square feet of space currently on the market. Those four firms have pledged their allegiance to over 200 local landlords.

Strange as it may seem, bearing in mind their conflicts of interest, we compete with them every day for YOUR business—for the opportunity to represent you, the tenant, in leasing negotiations. C&W, CAC, Colliers and CB control more space than any landlord in San Francisco. Mihalovich Partners’ business and approach is diametrically opposed to that of brokers who represent landlords. Are you, the tenant, looking for advice and counsel? You can count on straight talk from us. Advice for tenants, pure and simple. Serving the tenant community in San Francisco for 23 years.

San Francisco Market Overview

Demand: The Good, The Bad, The Misinformed

Tenants want to know. How did ’04 wind up? In San Francisco, absorption of space was HUGE. Tenants produced net positive absorption of 1.3 MILLION square feet in Q4 alone; 2.4 MILLION square feet, positive, for the year. In 23 years of leasing in the City, this magnitude of action is rare. Are landlords and landlord brokers excited? Yes. Is the Tenant’s market over? No, not by a mile. To make our point and provide you with some perspective, we only need to look back a few years to the total devastation of the marketplace, when dot-commers and other tenants created annual HUGELY negative absorption. During 2001, 2002 and 2003, the tenant base in San Francisco eroded (creating negative absorption) to the tune of 5.14 MILLION square feet (11.2 million square feet, negative, for the Bay Area). Meaning that tenants, during those years, dumped more space on the market than they leased (scores of companies literally disappeared). The net effect, then, was “negative” growth. So, an exceptional 2004 of absorption later, the City has chipped away at its earlier losses. The net LOSS of tenant-demand, from 2001 to date, remains at 2.7 MILLION square feet. Market conditions remain very soft, with rents at historic lows.

What caused so much absorption of space in 2004? Let’s see. Cheapest interest rates in 40 years. Cheapest rental rates in 23 years. High unemployment, giving leverage to employers. Massive consolidations in numerous industries, industries served by professionals in this marketplace. Return of venture capital. Landlord incentives (free rent, huge tenant improvement and moving allowances). Broker incentives. Returning tenants from the burbs. OK, we like our Mayor. Let’s say: Mayor Newsom.

Vacancy Rates: Are Your Options Fading?

Logically, whenever vacancy rates decline (an impressive 9% decline in Q4), the field of options declines. The evangelists, to whom we referred earlier, would have you believe that only “bad space” remains, which is of course, nonsense. 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 the impressive activity in Q3 and Q4 of 2004? Review the chart below and let’s discuss:

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.

In San Francisco, there was a marked decrease in the number of options for tenants in the 10-20,000 square foot range; as well as in the 30,000+ range. Activity was undoubtedly impressive. However, one should note that the average size tenant in the City is ~5,000 square feet. Many of the largest blocks of space, which typically have sat vacant for 18 months or more, have been divided to accommodate smaller users. There were [only] 15 deals exceeding 20,000 square feet in Q4, with a net reduction in only 6 parcels of space to fit these tenants. There were 29 deals in the 10-20,000 square foot category, who collectively reduced the field by 10%. This is significant, but bear in mind there remain 237 options!

Here’s a note to the irrationally exuberant about a market “recovery” in San Francisco. The “flight to quality”, to which so many “bullish” enthusiasts refer—the move from Class B and C buildings to Class A—isn’t going all that well. Citywide vacancy rates may have declined to ~16%, but Class A vacancies in the CBD are hovering above, at 20%. Big Bay View space, always at a premium in the City, is still hard to find in quantity and at reasonable rates—but how many of you want to pay the premium? And you’ve got plenty of options remaining. Ask us. We’ll be happy to send you all the details.

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. You’ll receive your survey within one business day. To discuss your space needs in person, call 415-434-2820 or email

Asking Rental Rates

Asking rates for direct space in San Francisco actually declined by 1%, whereas sublease space offerings increased by 11% over Q3. This change in direct rates supports our view that while demand has absorbed significant blocks of space, huge vacancy remains—and landlords cannot yet achieve marked increases in rent. As we’ve noted above, though, new building ownership in much of the CBD will test the market with higher rates—to justify their purchase pricing. Buyer beware! Asking rental rates in surrounding counties changed very little, but the trend was down (direct space rates down 1% in San Mateo and Santa Clara counties; unchanged in the East Bay). These changes in spite of a 5% reduction in vacancies throughout the Bay Area counties.

Take Me Straight to the Numbers: San Francisco Bay Area Rental Rates. Supply/Demand.

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 of our competitors—leasing firms—do the most landlord representation, and who controls the most space in San Francisco? And, most importantly, why would you feel comfortable having them represent YOU?

Below we’ve surveyed the entire 103 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 16.6 million square feet is now on the market in San Francisco. The top 4 companies, all office leasing brokerage firms, control over 37% of the City’s vacancy! These brokerage firms are beholden to more than 220 local landlords. Since their allegiance is committed to so many landlords, how can they possibly represent YOUR interests—the tenant’s interests—objectively and aggressively? The top 4 companies on the list control more of the City’s vacancy than Equity Office Properties, the country’s largest REIT (#5); Boston Properties (Embarcadero Center, #6); Hines (#7); and more than Shorenstein (#16). Surprised, are you not?

% Market Share Square Feet # of Landlords/ Buildings

% refers to the percentage of vacant space under exclusive listing by each company. The accompanying figure is the actual square footage available for lease. We have also noted the number of landlords/buildings represented by each entity.

* denotes listing brokers. All other companies listed are landlordselopers.

1 *Cushman & Wakefield of California 13.00% 2,285,252 57
2 *The CAC Group 11.10% 1,951,931 39
3 *Colliers International 7.00% 1,228,869 88
4 *CB Richard Ellis 6.40% 1,117,888 39
5 Equity Office 4.80% 840,214 12
6 Boston Properties 4.80% 837,161 6
7 Hines 4.30% 761,750 8
8 *Grubb & Ellis 4.30% 748,338 58
9 Tishman Speyer Properties 4.20% 743,110 3
10 *Jones Lang LaSalle Americas, Inc. 3.20% 557,437 6
11 *Cornish & Carey Commercial - ONCOR International 2.80% 496,366 10
12 *BT Commercial Real Estate - NAI 2.70% 479,795 33
13 Research in Progress 2.20% 389,542 6
14 *Starboard TCN Worldwide Real Estate 2.20% 378,770 96
15 *HC&M Commercial Properties, Inc. 2.00% 355,897  
16 Shorenstein Realty Services, LLC 1.90% 341,307 5
17 *GVA Whitney Cressman 1.90% 338,713 43
18 *TRI Commercial/CORFAC International 1.60% 284,198 41
19 The Gap, Inc. 1.60% 283,000 1
20 *Newmark Pacific, Inc. 1.00% 179,754 6
21 Studley 0.90% 158,743 4
22 The Presidio Trust 0.90% 157,485 39
23 *Arroyo & Coates 0.80% 139,456 13
24 *Ritchie Commercial 0.80% 132,182 39
25 Coldwell Banker Walker Pacific 0.70% 127,302 20
  All Others 13.00% 2,280,718  
  Total   17,595,178  

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