Market Insight Editorial & Advice to Tenants: 3Q2005

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

If you’re a commercial tenant in the San Francisco area, you’ve come to the right place, The Space Place®. Thanks for being with us and for taking the time to read through this report—our quarterly in-depth study of the marketplace and compilation of observations and recommendations for you, our clients and prospective clients—all, tenants!

If you are a first-timer at our site, know that we are totally and unequivocally committed to serving the tenant community—and that my Editorials are not only meant to be instructive; they are a written record of our market analyses and recommendations; and, from my perspective, an easy way for you to differentiate the quality of our thinking and strategy with those of our competitors.

During the past several quarters, we’ve been keeping watch for signs of the proverbial “trends”, versus aberrations, in market dynamics. As you’ll read below, demand for office space during Q3 tracked at an astounding rate—record pace for San Francisco. Before we jump into the statistical fray, however, we begin with a broad-brush about the larger economy and fundamental issues which continue to concern us and dampen our enthusiasm. We prefer that you take pen in hand as you read this. Write to us. Write to your Congressman or Senator.

At-Risk Economy: Trouble at Ground Level

Finger-pointing: One of our favorite American sports. Our first impulse should be to identify the guilty parties. Perhaps the guilty would rather step forward, admit that they’ve mismanaged, misled and deceived us into our consumer-stuperism. Thankfully, in the midst of the darkest of headlines since 9/11, the almighty American consumer is too busy, confused, stressed, overworked and probably too pissed to play the blame-game. While you were busy scraping private school tuition together so your kids won’t see the joys of our City public schools, you dropped another $18 billion in Iraq this last quarter. And California’s bond rating remains in the #50-spot of 50 states. American companies cut 784,000 jobs through September, 8.4% higher than the same period last year. Thirty-seven million Americans continue to live below the Federal poverty level. Consumer confidence has dropped to a 15-year low. The trade deficit has worsened sharply, most recently reported at $59 billion for the month. The budget deficit, now at $319 billion (not including WOT expenditures) is the 3rd largest on record, “better” only than in ’03 and ’04. Inflation (see our discussion, below, on its effects on commercial real estate values), allegedly under control, posted its largest upward change since 1991. Of course, energy costs rising 35% boosted the Fed’s artificially tamed calculations. Not even the raging destruction of Katrina, Rita or Wilma seems to tick up the Fed-meter on inflation. In an emergency session, Congress quickly approved a three-page law for “disaster relief”: $51.8 billion (incredulous, considering that we take three pages to define “fair market value” in our office leases). Make that $100 billion to really do the job. Perhaps $200 billion. We simply cannot afford to stop spending.

Our economy is fortunate to be supported by the wealthy, whose upper quintile soaks up 40% of the supply of fuel. The rest of the country doesn’t feel as much pain, then. Rising interest rates may finally be taking their toll on the housing market. According to a recent UCLA Anderson Forecast, 42% of all net jobs in the Vallejo-Fairfield economic zone came from folks pounding nails and supporting the construction industry (27% for all California). If/when interest rates continue to rise (see discussion, below, about Exporting Recession), there will be an oversupply of tool belts. You may find your checkbook in a sling, too.

Life with the herd is tranquil, otherwise. We stumbled over this compelling stat from the Bureau of Labor & Survey of Consumer Expenditures: From 1984 through 2004, households, they say, spent a steady 5% of total income on health care; and 31% on housing. Let’s see, then: If a Bay Area family of four gets its health coverage from an employer, swell! However, the same family working as independent contractors or simply without employee benefits may likely spend $16,000/year on heath care premiums. They must be earning $320,000 per year! As for housing, 31% simply isn’t close to accurate. Our mortgage industry source claims that at least 40% of the family’s gross income is being pledged to pay for interest-only payments, on average for purchases in the San Francisco area. Consumers appear to be following the example of our government, spending far beyond their means and leveraging to heightened levels of susceptibility to “economic correction”.

10 Billion Doughnuts Can’t Be Wrong

Appalling, isn’t it, that Americans produce ten billion doughnuts each year? You don’t need to be Dr. Dean Ornish to know that doughnuts can kill. Evidently, though, the health message isn’t quite as deafening and alluring as the PR from the other side of the board room. Doughnuts, like a lot of sugar-coated ideas, sell big-time. “Spin” works wonders. Why? Because people believe it and act on it. Does the proposition make sense and stand up to intense research? Oftentimes, not. But we buy anyway. Did you chase a dot-com stock or two? Well, the stock was climbing at a meteoric rate, so you bought it…and made money for a while. Until you lost it. The investment community is out there right now, armed with billions upon billions of investment dollars—shopping for trophy buildings, REIT portfolios, corporate buyouts—all with cheap-interest money; foreigners with cheap dollars; and banking on sugar-coating and repackaging these investments to deliver to your front door. Never mind that the numbers don’t make sense. It’s the sizzle, friends, that sells. Here’s a quick glimpse at the handiwork of a few investors who purchased highrise buildings in San Francisco during 2005 (except as noted):

1390 Market $618/sf
BofA World HQ $584
One Market $503
Cost of New Construction $450
One Market Street $435
50 Fremont $410
123 Mission $406
One Sansome $390
100 Pine $370
505 Montgomery $340
111 Sutter $333
33 New Montgomery $310
225 Bush $310
Embarcadero Center (1999) $300
185 Berry $293
50 Beale $254
405 Howard $247
301 Howard $242
333 Market $222
160 Spear $198

Jaws dropped in 1999 as Boston Properties paid a titillating $300/sf for Embarcadero Center, a number not seen in the previous decade. Average sales were then in the $225-$250/sf range. With cheap money in hand, however, investors have chased the soaring cost of construction in justifying purchases which now average more than $350/sf. The underlying office leases certainly do not provide rational foundation for underwriting. At this point, though, who cares? There is too little product being sought by too much money…and pricing continues to climb! Lenders will lend. Buyers will pound one another until we start seeing underperforming buildings, overextended landlords and deeds in lieu of foreclosure. Office tenants cannot—cannot—afford to pay the debt service and return required to justify these purchases. But when will the buying subside? How deep is foreign appetite for U.S. property? And when they’re done, what will become of their own domestic economic landscape? We recall a time when nearly every building on California Street was owned by the Japanese.

According to REIS, a New York commercial real estate company, buyers have become “overly aggressive”, paying an average of 33% over actual value. Wall Street has adjusted its attitude and appraisal of the REIT community, as a result. In expectation of higher interest rates, and acknowledging unprecedented valuations, REITs are being assessed as “high” or “speculative” risks—many with projections of flat-to-down 10% for the next year.

The 50-Years War: Can the U.S. Economy Afford It?

There is no rule of law stipulating that the War On Terror will ever end. Could it go on for fifty years? Are there not examples around the globe of unresolved conflict continuing for such periods? We have, then, fair warning. But we do not heed warnings, oftentimes, as discussed above. How is it impossible that our monthly commitment of $6-7 billion won’t continue indefinitely and how can we afford the bill? We were warned about faulty levies in the South. Aside from the cataclysmic human loss, our failed warning system will cost us $100 billion or more. We’ve been warned of global warming, shortages in refining capacity and the bird flu. Will we need a recession or widespread blackouts to snap us back into shape?

An old economics professor explained it this way. In difficult times, for prolonged periods as necessary, the United States will “export its recession”. This is accomplished through monetary policies, in part, with historically low interest rates to stimulate job growth, development and business investment at home; and cheap money for foreigners to stimulate investment in and exports from the U.S. Our labor and products become relatively inexpensive—at the expense of foreigners. Our companies and other prime assets become relatively cheap—at the expense of foreigners. Our economy, under this policy, is expected to outgrow its hard times—at the expense of foreigners. We “export” our troubles. Thank you, especially if you bought the ten billion doughnuts.

The war machine is no slouch for the U.S. economy. At 160,000 troops in Iraq and Afghanistan (and growing), we’ll hit $348 billion in “emergency spending” from the inception through 2006. Fathom such an investment in our economy at home. The investment abroad, however, knows no end. While there are feeble attempts to scratch out a few reductions in Fed spending, the transportation bill, according to the New York Times, is $30 billion higher than the president initially demanded; permanent extensions of (2001-2003) tax cuts and dissing the alt-min tax would add $2.4 trillion in debt (plus interest) over the next ten years. A trillion here, a trillion there. We can’t afford it. Bright ideas accepted, although it would be better if you’d just run for office.

Is this affecting us locally? You bet. But do you have time to pay attention?

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; The CAC Group; Colliers; CB Richard Ellis; Grubb & Ellis; or Cornish & Carey—whom collectively represent over 53% of the 13.4 million square feet of space currently on the market. Those six firms have pledged their allegiance to over 225 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, G&E and C&C 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

Tenants Snap Up Opportunities

Tenants blew the doors off any semblance of subtlety, taking down enormous blocks of space last quarter. As you’ll see in the section immediately below, 26 blocks of spaces over 20,000 square feet (12 of them greater than 50,000 square feet) disappeared from vacancies. In fact, the supply of large blocks of 50,000 square feet or greater declined by 71% during Q3—impressive! Mihalovich Partners had an active quarter, too. We are pleased to announce that we negotiated and completed several San Francisco office lease transactions, representing these tenants during Q3 2005.

Vacancy rates declined significantly in each Bay region. San Francisco’s 10% reduction now leaves 12.8 million square feet vacant, down from 15.8 million just a year ago. After more than ten consecutive quarters of trickling downward vacancies, subscribers to “the recovery” will be believers. The trend has arrived, stood up and finally dragged rental rates from the ditch to the country club for all to notice. That said, average asking rental rates—while continuing to climb to $26.26/sf/year (fully serviced, average for all classes of space, Citywide)—remain below rates posted 23 years ago, when our Principal, Dan Mihalovich, began representing tenants. In fact, even though vacancies declined in all Bay counties, asking rental rates actually declined in San Mateo, Santa Clara and East Bay counties (3%, 1% and 1% declines, respectively).

Absorption of space in San Francisco, at 2.3 million square feet, dwarfs any reading we’ve ever seen. Surrounding counties all posted net positive absorption, all marked increases over the prior two quarters of 2005. In all, the four regions posted a total reduction of 7% of the supply, now listed at 44.2 million square feet available.

Perspective is always helpful, Tenants. If there are only three huge parcels of 150,000 square feet, for example, and there are no 150,000 square foot tenants—why get excited? The great unpredictable in this office space economy is DEMAND. No one, not Mayor Newsom, nor Sam Zell, nor Ken Rosen nor Kris Kringle has been able to accurately forecast demand for space (or retail sales). We do not know how many more law firms will merge or implode; nor how many companies will take leave because of the cost of Bay Area employees; nor how many tenants will leave the Financial District for Mission Bay once the folks down there figure out that biotech isn’t coming. We don’t know who will back fill Barclay’s 230,000 square feet of space at 45 Fremont when they vacate in 6/08. We know that companies have been growing slowly and cautiously. We also know that VC and private equity accounts are overflowing with cash and will eventually pump life into companies such as those who tend to gravitate to these parts of the country. And, we know that to be eternally bearish is simply hard to take.

For the average size tenant in the City, below 10,000 square feet, you’re still swimming in options (see below). Even a 30,000-footer has over a hundred options. We should relax with that notion, but keep a mindful eye over one’s shoulder for the look of concern from gorillas behind. These will not be times to drift and ponder for long. If the deal looks right, settle down and don’t blow a good thing. Locking in rates for 5-10 years? If the matter is negotiated properly, you’ll be pleased with your timing.

As for the View-Space-Market, it’s the proverbial tail wagging the dog in the City. We have few clients who simply must have big-view space. For those, the market requires oxygen masks. Our origins are more humble and we gravitate toward better values in what many are now calling “commodity space”. Why pay for space in the $50s or more when plenty of alternatives exist in the $20s and $30s? Tenants will continue to arbitrage in this manner until the view-market settles down.

Tenant improvement allowances are rumored to be declining as vacancies decline. But don’t believe it. Construction costs continue to ascend and every landlord knows it. If they want to make deals, landlords have to kick in to foot the lion’s share of the cost of the job—within reason. In the City, allowances are peaking at around $50-$55 per square foot, depending on the length of the term; the creditworthiness of the tenant; and the size of the deal, of course. At current pricing, however, that allowance will only build the most modest of office spaces. Hard to believe but true. Yes, San Francisco is still a union town.

There is a market for lease guarantees; letters of credit; security deposits. Our feeling, though, is that we give away so much information on these pages that we don’t feel compelled to tell all of our secrets. Our clients will tell you our story, though—and they’re willing to talk with you about the manner in which we advocated for their interests. Negotiating a security provision in a Letter of Intent is at the heart of what we do best. Pledging monies you could be using to infuse into your business instead—well, that’s a huge deal we’re happy to speak with you about. Please give us a call.

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. In the City, Q3 vacancy rates decreased by 10% (!). The evangelists, to whom we referred in a recent 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

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 13.4 million square feet is now on the market in San Francisco. The top 6 companies, all office leasing brokerage firms, control over 53% of the City’s vacancy! These brokerage firms are beholden to more than 225 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 6 companies on the list control more of the City’s vacancy than Boston Properties (#8); Equity Office Properties, the country’s largest REIT (#9); Hines (#10); and more than Shorenstein (#15). 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 10.7% 1,559,288 51
2 *The CAC Group 10.0% 1,453,411 41
3 *CB Richard Ellis 9.8% 1,422,565 36
4 *Colliers International 9.4% 1,373,886 89
5 *Grubb & Ellis 4.4% 634,947 59
6 *Cornish & Carey Commercial - ONCOR 4.3% 633,395 15
7 Tishman Speyer Properties 4.1% 592,788 3
8 Boston Properties, Inc. 3.9% 568,529 5
9 Equity Office 3.7% 535,325 10
10 *BT Commercial Real Estate - NAI 3.3% 475,889 24
11 Hines 3.0% 435,511 8
12 *Jones Lang LaSalle Americas, Inc. 2.9% 415,562 9
13 *GVA Whitney Cressman 2.4% 346,002 37
14 *Starboard TCN Worldwide Real Estate 2.3% 329,997 103
15 Shorenstein Company, LLC 1.7% 251,799 8
16 *TRI Commercial / CORFAC International 1.5% 221,685 36
17 *Ritchie Commercial 1.5% 219,203 49
18 *HC&M Commercial Properties, Inc. 1.4% 196,863 30
19 The Presidio Trust 1.1% 158,161 40
20 Pacific Eagle Holdings Corporation 1.1% 154,760 2
21 Bently Holdings California, LP 1.0% 151,942 1
22 Blatteis Realty Co. Inc. 1.0% 151,061 81
23 Johnson Hoke Limited 0.9% 124,528 16
24 *Newmark 0.8% 123,069 15
25 Studley 0.8% 117,935 5
  All Others 13.2% 1,917,727  
  Total   14,565,828  

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