Market Insight Editorial & Advice to Tenants: 1Q2005

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

Why Your Landlord is Wrong About the Market (How Can So Many Investors Be Wrong?!)

  1. The San Francisco Bay Area offers greater than 50 million square feet of office space available for lease—right now. In the City (San Francisco), 15.3 million square feet remains available. The average size tenant in the City is ~5,000 square feet. There remain several hundred choices of space for such tenants. Note the table, below, which shows tenants HOW MANY BLOCKS OF SPACE are available…and how these stats changed since last quarter. Recent changes are miniscule.
  2. The “Soft Patch” you’ve been hearing about in the news of the national economy has affected us locally, too. While Q3 and Q4 of last year produced hugely positive absorption of office space, Q1 of 2005 resulted in NEGATIVE ABSORPTION IN EVERY BAY AREA COUNTY. Only vacancy rates in San Mateo County dropped, by just 2%. In EVERY other county, vacancy rates were up. The City: Up 1%.
  3. Asking rental rates (emphasis on “Asking”) were up in the City: Up 2% for direct space; 4% for sublease. Contrast though, with all other Bay counties, where rates were essentially flat to lower.
  4. All the hoopla surrounding the investment market is trying to spill over to the leasing market—with little success. Investors are paying too much for buildings, and expecting MBA-baked, miraculous returns. The hype has carried into the “view space” market, where landlords, buyers and developers anxiously expound on the way this small sector of the local economy is going to bring about “The Turn” in office market rates. Nonsense. The bulk of the 102 million square foot market in San Francisco is NOT view space. It is the exception, rather than the rule, that any particular tenant MUST be in view space. Our recent negotiations for one of our clients in view space came out this way: Renew at $42, or relocate to a comparable quality, Class A building in the CBD at $25 for non-view (still pleasant space and light), with the new landlord paying for all the new tenant improvements, moving expenses and design fees. Our client gladly gave up their Bay views.
  5. To new building owners: Your building’s rates are NOT worth more than last year simply because you paid $400 per square foot to purchase. Did anyone care what you paid for your car, new, when you sold it, used? Defies economic logic. The market for each tenant’s business will be determined through a competitive negotiation process. What you’ve paid to purchase your building is irrelevant to the tenants. Tenants cannot (and should not) sustain an operating budget which commits greater than 8% of their gross revenue to office rent. Tenants make economic decisions based on budgetary constraints and what they choose to afford in the marketplace—not the least bit to do with generating profits for the landlord.
  6. Landlords argue with us about “the recovery” from recession and a return to economic expansion, amidst a long list of obvious impediments:
    1. Rising inflation, as we’ve discussed at length in our previous Editorial.
    2. Rising interest rates. Are you feeling it, yet?
    3. Rising cost of oil. Note Goldman Sachs’ report on the potential for a super-spike to $100+/barrel. Are we impervious to price increases? We think not. From wine to wheat, your surfing safaris, limos, cabs, deliveries…You’ll pay a lot more for the same. Businesses suffer as a result.
    4. “Unsustainable” Budget Deficits, according to Greenspan: “It turns out that we were all wrong”, Greenspan said, now arguing with Republican law makers. Greenspan relied on Bush’s rosy surplus forecasts in 2001 as he supported Bush’s tax cuts. We’ll have to severely cut spending or increase taxes. Here comes stagflation.
    5. Trade imbalances. Every month the U.S. is importing $50-$60 billion more than we’re exporting. We’d rather buy a Prius than a GM. Perhaps this is why GM’s credit rating (along with California’s) is just above junk rating.
    6. Slowing earnings growth. Q1 average small cap growth funds fell 4.5% in value; the large cap growth funds fell 4.3%.
    7. San Francisco Bay Area home prices continue to soar, making it all the more difficult for businesses to expand in the area. Median prices are up an astonishing 36% in the last two years. It is interesting to note, however, that residential rental rates have remained flat during the same period.
    8. Whatever happened to the nightly reports we used to hear about the cost of the Iraq War and the War on Terror? Is the U.S. spending $1 billion/month? $3 billion? $6 billion? The Feds figured out a way to bury these costs, somehow. The Cost of War is not reflected in Budget Deficit figures.
    9. The job market is NOT materializing. With credit to Steve Radwell, CNN Business columnist, his job research reported the following:

      With 132.6 million Americans working, according to the Labor Department, and another 7.7 million unemployed, the labor market in the United States is obviously vast and enormously complex.

      Among the factors hurting job growth in the current expansion: companies facing stiff competition from overseas, especially from China and Latin America; productivity growing at better than double the historical average; jobs moving overseas in services and not just in manufacturing; the growing use of temp workers; and the nation’s shrinking manufacturing base.

      “I can’t see the state of job creation changing for the better anytime soon,” said Richard Yamarone, chief economist at Argus Research in New York. He noted that already cautious employers are getting hit by the rising cost of oil and other raw materials, on top of health care costs growing well above the pace of inflation.

      With costs rising and profit growth under pressure, “that’s going to squeeze hiring,” added Yamarone, who’s been closer than many Wall Street economists to accurately forecasting the sluggish job growth over the last year to 18 months.

  7. Shadow Space, space which is un(der)utilized but not officially “on the market”, abounds. Eventually, especially in such a soft economy, all space comes to light. But if a struggling REIT, for example, can keep such space from the official count for a while, they can potentially “bury” the space from their vacancy reports. Examples include:
    • The Presidio brimming with hundreds of thousands of square feet which it cannot afford (due to staffing limitations and the cost of marketing) to bring to market. George Lucas will off an additional 80-100,000 square feet.
    • Equity Office Properties will announce seven (7) floors of view-space, 140,000 square feet available at the top of the old Alcoa Building (One Maritime Plaza).
    • Schwab, the discount broker under competitive pressure, will unload several floors, 70,000 square feet at 345 California Street.

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; CB Richard Ellis or Grubb & Ellis—whom collectively represent over 44% of the 15 million square feet of space currently on the market. Those five firms have pledged their allegiance to over 280 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, CB and G&E 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

New Office Development in the City: No Cents

In spite of the fact that rental rates for most office space in and around San Francisco hover in the $20s, the hype stemming from an overheated investment market has prompted discussion about building new office buildings. What would it take? Do we need more office product? Which developers, in their right minds, would seriously consider such an endeavor? With 15 million square feet on the market in the City, and a total of 50 million available around the Bay, our advice is simple: Forget about it!

Assuming a cost of construction of ~$450 per square foot, a developer would need to achieve upper $50s to low $60s AVERAGE gross rent to justify their project. The notion that, in today’s market, some landlords believe that rents will approach those levels within the next 2-3 years, is to believe in fairy tales.

For all the reasons we mentioned above, the economy is dragging and, accordingly, forecasts cannot rationalize exponential expansion in the Bay Area within the foreseeable future. We’ve hardly recovered from the dot-bomb period. Permit applications haven’t even been signed yet, to convert office space in numerous buildings to residential. At $20-$30/sf rent, those office buildings are going into conversion. What effect will rents have in the hypothetical $55-$65 range? Conversions back to office. Think back to the dot-com period. Large tenants eagerly sought after multi-unit, live/work lofts—just to get all of their people under one roof. No one lived in live/work lofts; they were all leased to office tenants. Every square foot of development-entitled space came to market. Not just in San Francisco, mind you. Current vacancy rates are 12%, 16% and 21% in the East Bay; Silicon Valley; and San Mateo counties, respectively. Those markets would have to have absorbed much of its 35 million square feet of availabilities before rents would climb dramatically.

San Francisco cannot and will not rise to justify new construction on its own. The neighboring counties are always at the ready to steal demand from the City—with highly discounted rates, cheaper parking, lower taxes and less political contrafibularities. Now you’re paying attention. Developers will need a screaming economy to get to first base with a new office building. When you see the cranes appear in the skyline in San Francisco, you’ll know that it’s time to short the REITs…if not before. Tenant demand is an interesting phenomenon; when the going gets tough, tenants get very creative—and responsive. Terms that didn’t exist years ago: Suburban office parks. Decentralizing. Video-conferencing. Hoteling. Hot-desking. Telecommuting. Off-shoring. IM. Starbucks. Kinko’s. PDF-me.

Remember that every market, no matter what kind, has a function. With rental rates and demand where they are, the function of the marketplace is to lure more tenants to absorb what’s out there. We’re in the market with clients whose leases expire in 2006 and 2007. Why? Landlords are full of incentives to create early commitments. On average, spaces just leased have been sitting around for nearly 18 months. We envision those incentives will be with us for at least several more years…until that explosive economy booms. Or not.

Vacancy Rates: Are Your Options Fading?

Landlords, their listing brokers and developers dance to the tune of lower vacancy rates, so tenants should watch carefully to detect how and to what extent your field of options declines. Of course, in the City, Q1 vacancy rates actually increased by 1%. The evangelists, to whom we referred in last quarter’s Editorial, 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 recent leasing activity? 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.

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

To View, Or To Non-View. That’s the Que$tion.

During the past several weeks we’ve been negotiating terms for one of clients—seeking Class A, CBD space. Within the same highrise building, our client had a few options ranging from lowrise, pleasant outlooks across the street and surrounding neighborhood; to splashy, unobstructed Bay views. To keep the story simple, our client decided on the more economical lowrise space—a nearly $25 per square foot per year discount to the space upstairs, leased by a law firm (represented by one of our competitors). How do these economics make sense, especially to a service firm? We have the numbers for you to peruse:

The law firm leased 25,000 square feet. At an efficiency of 650 sf/lawyer, the floor’s capacity will be 38 lawyers. Like most service firms, the law firm should commit not greater than 8% of its gross revenue to pay its $70/sf/year rent [8% of their annual gross = $1.75 million/year]. So, the 38 lawyers of the firm must gross at least $22 million/year to comfortably afford to pay $70/sf/year in rent. That’s $576,000/year in annual billings for each and every lawyer. If they bill 40 hours/week and do so for 50 weeks of the year, each and every lawyer will only need to charge an average of $288/hour…all to afford $70/sf/year rent.

At $45/sf/year in rent, instead, the same law firm’s rent would be $1.125M/year. So, the same group of lawyers—capable of producing $22 million/year in revenues—could maintain rent at 5% of gross revenues. Or, the partners could decide to work fewer than 2,000 hours per year. At lower rental rates, there appear to be a lot more options available to the firm—to craft its practice and manage its team with less strain on the engine. Which direction would YOU want to take? Perhaps, through this example, you can see why the view-space market in the City is reserved for the select few.

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 102 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 15.3 million square feet is now on the market in San Francisco. The top 5 companies, all office leasing brokerage firms, control over 44% of the City’s vacancy! These brokerage firms are beholden to more than 280 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 5 companies on the list control more of the City’s vacancy than Boston Properties (Embarcadero Center, #8); Equity Office Properties, the country’s largest REIT (#9); Hines (#14); 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 *The CAC Group 12.1% 1,966,511 92
2 *Cushman & Wakefield of California 10.0% 1,631,722 53
3 *CB Richard Ellis 9.3% 1,507,599 43
4 *Colliers International 7.9% 1,285,248 92
5 *Grubb & Ellis 4.9% 798,547 59
6 Tishman Speyer Properties 4.5% 735,108 3
7 *Cornish & Carey Commercial - ONCOR International 4.4% 712,265 12
8 Boston Properties 4.3% 694,286 6
9 Equity Office 4.1% 659,529 12
10 *Starboard TCN Worldwide Real Estate 2.7% 444,607 105
11 *BT Commercial Real Estate - NAI 2.6% 419,771 30
12 *Jones Lang LaSalle Americas, Inc. 2.3% 378,519 7
13 *GVA Whitney Cressman 2.3% 371,370 40
14 Hines 2.2% 354,708 8
15 *HC&M Commercial Properties, Inc. 2.1% 342,109  
16 Shorenstein Realty Services, LLC 1.9% 304,454 5
17 *TRI Commercial/CORFAC International 1.8% 295,635 37
18 The Gap, Inc. 1.7% 283,000 1
19 *Ritchie Commercial 1.5% 241,238 44
20 Research in Progress 1.2% 202,684 13
21 *Newmark Pacific, Inc. 1.1% 171,858  
22 The Presidio Trust 1.0% 164,002 40
23 Studley 0.9% 149,944  
24 The Staubach Company 0.8% 127,044  
25 Blatteis Realty Co. Inc. 0.8% 127,031 81
  All Others 11.6% 1,880,425  
  Total   16,249,214  

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