Market Insight Editorial & Advice to Tenants: 1Q2006

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. If you are a first-timer at our site, know that we are totally and unequivocally committed to serving and representing 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.

Market Run-Up, Net Absorption Don’t ADD Up

Dear Tenants, you won’t get much sympathy from the landlord community. After all, we’ve enjoyed a tenant’s market for about 21 of the 24 years we’ve been representing your interests! As previously reported here, during much of 2005, leasing activity and net absorption of space rocked all records…and tenants drove rental rates to new recent highs. Perspective is crucial, though, as the “herd” of landlords and landlord-brokers would have you believe that opportunity is dying everywhere and that one must pay loftier rates than last week to get a deal done. In spite of all of the underlying weakness in our economy and turbulence from waging the War On Terror, the posture of much of the landlord community has been a bit strange. Are landlords justified in pushing asking rental rates $10+ per square foot per year higher this year than last? Is the attitude appropriate? Is the herd correct, or are they as surprised as you are? A bit compunctious, landlords are. Flatulent, perhaps even ADD.

What is “ADD” about our negotiations at present:

  • Difficulty paying attention to details or prone to making careless mistakes. Interesting, isn’t it, how deals take so long to complete even though the market is tightening. If our clients are ready, willing and able to perform in transactions—and they have impressive credit—landlords should be doing hoops to close deals…yet most are waiting for a better deal to come along.
  • Easily distracted by irrelevant stimuli and frequently interrupt ongoing tasks to attend to trivial noises or events that are usually ignored by others. In last quarter’s Editorial, we wrote a section called “While Rome is Burning”, the macroeconomic implication being that our financial underbelly is seasick as ever—yet landlords will get distracted by any sign of more money from a higher offer. “More” is better, until “more” disappears. When the economy sours, rental rates will decline.
  • Inability to sustain attention on tasks or activities. Landlords have promised the sun, moon and stars to their investors. And they’ll take months of negotiating time to extract what they need from you. Be prepared to go the distance; and be prepared with solid alternatives when it’s time to bail.
  • Frequent shifts from one uncompleted activity to another. The irony in the marketplace is that those who’ve held onto vacant space the longest are now being rewarded for their inability to lease their space. They chased deal after deal, never giving in enough to close. Many of these landlords have simply sold their buildings and moved on to new challenges…all the way to the bank.
  • Procrastination. When rental rates are rising, why stop to make a deal when you can delay the process? But this cuts both ways, Tenants. What is the market saying to you? If you’re having to choke down a deal, perhaps you should step back from the fire and re-evaluate whether or not it’s worth it. If the San Francisco marketplace is hardly affordable for YOU, don’t you think the rest of the tenant-community is feeling the same pressure? Should you charge ahead full steam, or fight harder to get what you can afford?
  • ADD can be a bear to handle…but it’s done every day. Patience is required, in plenty of supply at our firm. But enough psycho-comparative analyses. What do the stats tell us about the office market? What’s been the TENANT response to the run-up in rental rates (caused by a burst in demand)? In Q1, direct space absorption in San Francisco was unimpressive (133,000 square feet) and total net absorption was among the lowest in nine quarters. The total number of completed deals in the City was its lowest in nine quarters. True to form, though, landlords still bumped asking rental rates to $27.34/sf/year (average, all classes of space, Citywide). That makes twelve consecutive quarters of increases in asking rental rates. Q1 rates, though, remain less than half of the peak average in Q4, 2000.

NEGATIVE ABSORPTION of space came back, both in Silicon Valley and East Bay Counties (-495,000 square feet; and -390,000 square feet, where asking rental rates DECLINED 16% and 3% respectively). Vacancy rates in San Francisco, San Mateo and Santa Clara Counties remained unchanged. East Bay vacancies rose 9%. The number of space alternatives for tenants INCREASED during the past quarter.

Value of TEAM. Who’s YOUR Quarterback?

Since beginning of my career in tenant representative in San Francisco in 1982, my philosophy remains unchanged: surround our clients with experts and aggressively lead the Team through a thoughtful, well-managed process - whether to accomplish a renewal or relocation transaction. Our experience is extremely deep and broad, having represented virtually every kind and size of tenant in the City. We are never surprised by what we find inside the organizations of the clients we represent. They are, after all, of the most sophisticated of professional and other types of firms. We have represented over three dozen law firms in leasing negotiations—lawyers whom the rest of the tenant community look up to for overseeing business and litigation matters. We represent those lawyers and other professionals from whom you expect perfection, honesty and integrity. Yet we still find a lot of confusion, mismanagement, struggles amongst partners, Management vs. User Group disagreements, and reluctance to take enough time to carefully assemble and fully charge THE most qualified Team to take the reins of the office leasing project. Our job, among many others, is one of diplomacy and consensus-building. As Broker, we must answer EVERY question of EVERY partner or decision-maker or influencer within our client’s organization…and ensure that all parties are armed with the facts to proceed on our strategy and course of action. Our extensive collection of letters of recommendation speak to this level of organization, quality of negotiations and advocacy on behalf of our clients.

Broker. Architect. General Contractor. Real Estate Lawyer. This Team will make your day. The appropriate Team will organize your entire process and absorb most of the time-consuming tasks required, so you can do what you do best: your day-job. Your Broker (Mihalovich Partners, for example) should lead the Team, from the outset of the project through move-in. Yes, through move-in. We will explain, in gory detail, the importance of Team and make specific recommendations for your consideration. Our list of recommended service providers (architects, contractors, real estate lawyers, accountants, movers, IT consultants, etc.) is published on our website for your ease of reference. In fact, for the minority of professionals who still have time to read, Mihalovich Partners makes it easy to study up on tenant-related issues, including numerous purely educational articles, all on our website.

In selecting Team members, our philosophy is consistently applied across trades: Don’t volunteer to do the work required by our client unless (a) you’re the best at what you do; (b) you have no potential conflicts of interest in working with our client; and (c) you will devote your personal time to this project. Principals only. No “bait and switch”. Don’t bring “marketing” people to our meetings. We never recommend large companies as service providers—but you’ll notice that we have relationships, formed over 24 years of working experience in many cases, with individuals within those large companies whom we do highly recommend for your consideration.

“Loyalty” is a commodity in limited supply, these days. Anyone in the service business knows how difficult it is to earn a client’s complete trust—but it is exactly that level of total confidence in the Team that brings about the “win” in implementing the overall strategy and negotiation for concessions for YOU. Your Team will invest a tremendous amount of time, energy and money in getting to know you, our Tenant-client; to understand your objectives; to appreciate your financial goals in the office leasing project; and to going out of their way to achieve those goals. Mihalovich Partners will make sure that the Team stays on target and that each Team member delivers on its promises. If your office leasing requirement is critical to you (as always), you deserve to be represented by the best of the best—in every category of service provider. Begin with the Quarterback. Build the Team from there.

Your Rent = 8% of Gross Revenue. But for How Long?

We’re surprised that more tenants don’t have this calculation on the tip of their tongue. With the exception of the dot-com days, when many a tenant had NO revenue (funny, then, how the market crashed thereafter), 24 years of experience suggests that the old tried-and-true formula WORKS. The question that few landlords (and Landlord Brokers) ask, though, while pumping up rental rates is—what can tenants really afford? For example:

During the past year, many a building owner—especially new owners who over-paid for the new property—pushed rental rates $10/square foot/year higher. How does this impact the tenant’s budget?

ASSUME:

  • You’re a 20,000 square foot tenant. Your employees occupy an average of 200 square feet/person. So, you have 100 people.
  • If you signed a long-term lease one year ago at $25/sf/year, and committed 8% of your gross revenue to rent, you committed $500,000 to annual rent of your $6.25 million of gross revenue. OK?

Fast forward to this year’s unsuspecting 20,000 square foot tenant going through the same drill, except that market rent for the same space is $35/sf/year. Now annual rent is $700,000 (vs. $500k) and it will take 11.2% of your gross revenue to pay the office rent bill. 11.2% of your gross vs. 8% last year…a 40% increase in commitment! Can San Francisco tenants, on average, afford this kind of dramatic change in their finances? We think not…or at least not for long. Perhaps we should change the old rule-of-thumb to adjust for inflation—even though the Gov would have you believe that inflation is under control? Do your own math, but tenants should be cautious as ever about jumping into long-term commitments which look to begin a choke-hold on revenues. Once you’ve leveraged your future revenue in a long-term lease, how will you finance growth? How will you bring more profits to your revenue producers? There’s a limit to how far tenants can be pushed before the demand base withers or fails. We saw that in the late 1990s. Landlords should never underestimate the creativity of tenants. Perhaps it’s survival tactics. Call it what you want to. Keep the 8% in mind and call us to discuss it further.

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 12.7 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 24 years.

Dan Mihalovich (dan@TheSpacePlace.net)
Principal of Mihalovich Partners and Founder of The Space Place®

San Francisco Market Overview

Tenants Get Scorched

During Q1, net absorption of space (i.e. demand) was “normal”, at annualized rate of ~1.3 million square feet, far off the pace of last year. In fact, the pace was lower than in the last nine (9) quarters. Deal flow lagged, too, such that the number of transactions was also its lowest in nine quarters. Nevertheless, tenants chased the market up, yielding higher rates to landlords for the 12th consecutive quarter. Asking rates for direct space shot up 5%; up 8% for sublease space. Landlords and sublessors are asking more—but leasing less space. The most spectacular rents, of course, are found in the unobstructed-Bay view sector, where rates are exceeding $60 per square foot per year…right back to the dot-com rates of the late-1990s. Are you getting dizzy, yet?

In the lowrise and midrise portions of buildings in the Central Business District, it became difficult to find ANY landlord quoting rates below $30/sf/year. Is it coercion or just an awful coincidence that most of the landlord community now believes that ANY space is worth over $30/sf? Perhaps another coincidence insofar as over 50% of the space on the market is in the hands of 4 or 5 landlord-brokerage firms…Can the market be manipulated? Old, historic landmark buildings with no air conditioning? Sure, $30+. Mid-Market Street buildings, with vacancies longer than two years? Absolutely, $30. Does this make sense, based on everything we know? Of course not. But in the meantime, tenants keep signing deals at those lofty rates and set the tone for the rest of the market.

Your Lease is an Asset, Again.

Take the challenge: Leave your lease in the file folder until you’ve completed this challenge…

  • What date does your lease expire?
  • How many square feet do you control, both in the space you occupy currently plus any expansion option space?
  • Do you have an option to renew and, if so, on what terms?
  • How much rent are you paying, being certain to also include all of the landlord’s escalation bills? Do you have the right to audit the landlord’s books and have you exercised your rights?
  • From start to finish, how long will it take you and your firm to get yourselves to that day when you can make an intelligent decision and sign the paperwork for a renewal or relocation?

Chances are great that due to market conditions, the lease you have has become more of an asset than a liability. The rates you’re likely to be paying are probably under “market” rates at present. You should take an accounting of the few basic issues mentioned above (we have many more questions for you) and call us to help you evaluate the asset-value of your present lease. If and when you need something from your landlord, you’ll be better prepared to understand and articulate your position—once you’ve studied your rights and your leverage.

We will prepare a detailed review of your lease and escalation invoices to assist you in planning ahead.

Sublease Clauses. Read Yours Lately?

While your lease is sitting out, ready to send to us for review, did you check your Sublease/Assignment provisions to see what rights you maintain? If you wanted to sublease your space to a neighboring tenant in the building, will your lease allow it? Can you assign your expansion or renewal options to another tenant (especially if that means you’ll retain a much higher salvage-value)? Does the landlord have the right to “recapture” your space in the event you sublease, precluding you from enjoying any profits from subleasing? If there is a significant change in ownership within your company or partnership, will that event trigger the landlord’s right to approve of the new entity?

There are numerous issues to study in your sublease provision, which we’ll be happy to review for you—in cooperation with your real estate counsel, if preferable. Landlords can get tough, even cranky, in a tightening marketplace. We believe it's best to be prepared with an understanding of the potential issues and where your lease may serve yoiur interests as your progress in negotiations.

A Subtenant’s Guide to Subleasing(*)

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, Q1/2006 vacancy rates remained FLAT (!) 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 dan@TheSpacePlace.net.

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 12.7 million square feet is now on the market in San Francisco. The top 5 companies, all office leasing brokerage firms, control over 46% 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 5 companies on the list control more of the City’s vacancy than Boston Properties (#6); Shorenstein (#7); Equity Office Properties, the country’s largest REIT (#9); and more than Hines (#11). 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 12.0% 1,646,870 43
2 *Cushman & Wakefield of California 11.5% 1,578,623 51
3 *Colliers International 10.1% 1,396,490 86
4 *CB Richard Ellis 7.2% 986,071 25
5 *Cornish & Carey Commercial - ONCOR International 5.2% 716,340 10
6 Boston Properties, Inc. 4.9% 668,461 4
7 Shorenstein Company, LLC 4.8% 661,677 11
8 *Grubb & Ellis 4.6% 631,291 60
9 Equity Office Management, LLC 4.4% 599,610 9
10 Tishman Speyer 4.2% 571,738 2
11 Hines 3.2% 440,140 9
12 *Starboard TCN Worldwide Real Estate 1.6% 222,374 98
13 *Jones Lang LaSalle Americas, Inc. 1.6% 221,975 8
14 *GVA Whitney Cressman 1.5% 201,237 33
15 *Studley 1.4% 193,039  
16 Bently Holdings California, LP 1.1% 155,742  
17 *Ritchie Commercial 1.1% 154,230 46
18 Blatteis Realty Co. Inc. 1.0% 142,790 74
19 The Presidio trust 1.0% 141,710  
20 Strom & Associates 1.0% 134,198  
21 McCarthy Cook & Co. 0.9% 126,088 5
22 Pacific Eagle Holdings Corporation 0.9% 122,472  
23 *BT Commercial Real Estate—NAI 0.9% 122,196  
24 *TRI Commercial/CORFAC International 0.8% 108,355 35
25 Johnson Hoke Limited 0.7% 97,426 6
  All Others 12.5% 1,726,786  
  Total   13,767,929  

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