Market Insight Editorial & Advice to Tenants: 2Q2010

Welcome To Our House.

It took me 32 years to write this column, starting with 4 years of basis trading at one of the largest grain trading companies in the world (“What on earth is basis trading?” many have asked, so I’ve addressed this in my discussion below about “Commodity Space”). The past 28 years as an advocate for the commercial real estate Tenant Community led me to today’s missives, all for you, tenants. Study. Digest. Share this information with your tenant-friends and colleagues. Consider hiring our team to represent your interests in renewal and relocation negotiations.

Obviously, I highly value the notion of publishing a written record of my market analyses and recommendations to commercial tenants. If you’re in search of intelligent life in the brokerage community, please enjoy with my compliments. And, peruse the archives for the last ten years of my pearls of wisdom.

Dan Mihalovich
President, Mihalovich Partners
Founder, The Space Place®

San Francisco Office Market Overview

Transaction Volume Soars; Still Negative Growth

History, the ultimate rear view mirror, tells us that current office rental rates are at record lows (during my 28-year tenure)…with a few exceptions, which I’ll enumerate. But the markets won’t remain “dead” forever; not with these combined economic forces at play:

There are a few pockets of “destination” areas in San Francisco, for example, where rental rates are fetching well beyond the norm (the range for Class A deals should be $25-$40 per square foot per year; premiums for the views). As is historically true, if you’d like to lease unobstructed Bay view space at the top of Embarcadero Center, Bank of America Center or One Market Plaza, you’ll need to venture to withering heights to make it happen there, pushing $45 to upper $50s. A few have paid higher. (Why go there, tenants?) Deep in SOMA, near the coveted AT&T Ballpark, techies have decided that loft-style, high-performance buildings are worth upper $30s to $40s. The same can be said for deals at Letterman in the Presidio. Again, why go there unless absolutely necessary?

So, while vacancy rates in San Francisco climbed steadily (15 straight quarters) to Dot-Bomb levels, transaction levels are at a 13-year high. AND the City recorded its 7th straight quarter of NEGATIVE growth. Transaction volume, while impressive, consisted of smaller deals on average. What can be said about this… and where does the market go from here?

  1. Unless and until a trend arises of sustained positive net absorption of space, rental rates will trend lower. This does not portend well for the building owners already on the sidelines since they cannot compete at current rates. This begs the question: Of the 20 million square feet on the market in San Francisco, what percentage is effectively “off the market”, since “market” economics to complete leases would put the owner under?
  2. Rates in San Francisco are relative to rates elsewhere in the Bay Area. The demand FOR tenants (not BY tenants) is far reaching. The markets will cannibalize themselves to create and lure demand.
  3. Corporate consolidation is far from over. Relocation volume is picking up, but the results (as stated already) are reductions in the amount of space leased.
  4. At close to even money, tenants will step up to higher quality, better managed, green, efficient buildings with friendly ownership. Reasonably priced access to high-speed Internet and tech-friendly buildings are a must.
  5. Unless and until net growth persists, pressure will remain on architectural fees, construction costs, furniture and other infrastructure. This trend is GOOD for you, tenants, provided that you refrain from Killing the Vendors Who Serve You.
  6. Macro-economic trends look abysmal.
  7. Pressure from the state and local municipalities to balance budgets and resolve daunting deficits has given rise to new tax proposals — targeting the business and commercial real estate community. Rest assured that every building owner will try to figure out a way to pass through any new “taxes” to you, tenants. San Francisco’s payroll tax is already a bed sore; increased taxes or additional levies on businesses — coupled with soaring medical and pension benefit costs, $400 parking spaces, and the general anti-business sentiment here — will wreak havoc on our tenant demand base.

Fundamental Truth: All Office Space Is “Commodity Space”

“Commodity space” is a badly abused term bantered around by commercial real estate people who, quite frankly, know next to nothing about (a) commodities, nor (b) the trading of commodities. What’s their point, referring to “commodity space”? Supposedly, it’s fungible space; every-day space; nothing-special space; discounted space, because it’s mundane space; who’d-want-to-be-in-it kind of space. Landlords and listing brokers price and market their space relative to “commodity space” to perfume the pig. But these are unfair mischaracterizations since ALL space is a commodity.

“Commodity” A:
Webster’s: “Anything bought and sold.” Like office space.
“Commodity” B:
Tenants. Yes, tenancies are essentially “bought and sold.”

An analogy, from the real world, to explain my point:

See the Chicago Board of Trade, or the Chicago Mercantile Exchange, or the Kansas City Board of Trade. Find corn, wheat, soybeans… all commodities. Think of the supply of corn as you would the supply of tenants. When a bushel of corn in central Illinois needs to figure out where it’s most economical to go (with the help of a “basis trader”, my first career), there are usually a bunch of options:

  1. Train loading station to head to the Atlantic
  2. Barge to NOLA
  3. Miller in Chicago
  4. Exporter out of the Lakes…

So, who has the best terms for that bushel of corn (tenant)? Where is it most profitable, timely and sensible to sell to?

If all of the objectives of the seller are met in this trade, keeping in mind that the “seller” is a bushel of corn (a tenant, in this example), does the ultimate destination really matter? Why not?

Tenants use so many different criterion to select buildings; we don’t have time to enumerate the litany of factors in this article. But suffice it to say that leased “office space” is a “place” companies park their people for a finite period. Companies put their people on the road. They hotel / hot-desk. They Go-to-Meeting. They Skype. Tenants improvise and morph, depending on market conditions. They may stay and pay the payroll tax; they may leave the state.

Office space is where we put butts in “seats”, where oftentimes the chair resides in your home.

Tenants must decide whether the premium or discount (the “basis”) is worthwhile based on location; efficiency of the space; total occupancy costs; views; quality of management; HVAC or operable windows; etc. But it’s the tenant’s selection of criterion and their choice as to which commodity to gravitate toward. In the example, above, the basis trader evaluates the demand arcs to determine the “best” direction for that bushel of corn. So, too, must tenants examine the demand arcs reaching for their tenancy. Will it be Building A, B, or C? Perhaps more alluring will be a relocation to the suburbs; an outsourcing of support functions; a move out of state; or a move out of the core to a building offering its own shuttle service to mass transit.

Must the tech tenant be in “creative”, “funky”, brick and timber, high-ceiling space? Of course not. Those are all choices the tenant must make… which, depending upon the premium/pain or discount/savings is up for grabs. But let’s not get confused on the fundamental issue: Tenants dictate their own needs and desires and adjust accordingly. Landlords best be prepared to deal with the reality that their space availability exists not in a vacuum, but in an open and quite efficient marketplace of choices. Lots of choices (see below).

Vacancy Rates: Are Your Options Growing?

Tenants should watch carefully to detect how and to what extent your field of options changes.

Tenants ask, “Tell me about my specific options. How many choices do I have?” Are your options growing, as a result of leasing inactivity? Review the chart, below, and let’s discuss.

Here’s perspective. BET YOU’LL BE BAFFLED: In Q2 of 2001, the period just before our markets crashed (the Dot Bomb), Bay Area Counties had a supply of 42 million square feet available for lease on the market. Today the Bay Area markets have 64 million square feet on the market. Therefore, tenants have a MUCH LARGER number of parcels to choose from; the trend for absorption is negative (less than zero); and the stats should give you reason to wonder — what could possibly make a landlord bullish right now?

[In Q2, 2001, there were only 202 parcels of spaces available in San Francisco in the 5-10,000 sf range; 173 parcels in the 10-20,000 sf range; and only 67 parcels in the 20-40,000 sf range.]

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

Who Has the Most Incentive to Drive Up Rental Rates In San Francisco?

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? Who’s marketing the most space in San Francisco?

Below we’ve surveyed the entire 113 million square foot inventory of San Francisco, and illustrated the Top 25 companies listing the most space on the market. Of the top 8 companies, ALL are office leasing brokerage firms, controlling 65% of the City’s vacancy!

These brokerage firms are beholden to more than 350 local landlords, paid to drive up rental rates and drive down concessions for tenants.

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 brokerage companies on the list control more of the City’s vacancy than Shorenstein (#9); Boston Properties (#10); RREEF (#11); Hines (#12); and Tishman Speyer (#15). Surprised, are you not?

% Market Share Square Feet # of Landlords/ Buildings

The % in the chart below 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 landlords/developers.

1 *The CAC Group 12.7% 2,984,280 58
2 *Jones Lang LaSalle 10.7% 2,504,318 27
3 *Cornish & Carey Commercial—ONCOR 8.5% 2,002,465 24
4 *Cushman & Wakefield of California 7.9% 1,851,900 61
5 *Colliers International 6.8% 1,600,792 81
6 *CB Richard Ellis 6.8% 1,597,784 28
7 *Grubb & Ellis 6.2% 1,447,714 68
8 *GVA Kidder Mathews 4.8% 1,140,082 38
9 Shorenstein Company, LLC 2.2% 522,436 8
10 Boston Properties Limited Partnership 1.9% 441,726 4
11 RREEF America LLC 1.7% 400,000 2
12 Hines 1.6% 378,786 9
13 *Newmark Knight Frank 1.6% 371,676 14
14 Beacon Capital Partners, Inc. 1.3% 307,000 1
15 Tishman Speyer 1.2% 282,124 3
16 *Cassidy Turley BT Commercial 1.1% 250,574 23
17 Retail West 1.0% 241,068 1
18 *TRI Commercial / CORFAC International 1.0% 224,544 58
19 The Presidio Trust 0.9% 206,873 45
20 McCarthy Cook & Co. 0.8% 198,196 3
21 *Starboard TCN Worldwide Real Estate 0.6% 150,943 56
22 *Johnson Hoke Ltd 0.6% 135,830 7
23 JRT Realty Group, Inc. 0.5% 119,000 1
24 *HC&M Commercial Properties, Inc. 0.5% 105,870 15
25 *Pacific Union International, Inc 0.4% 84,029 10
  Total   23,513,532  

Why Cheap Interest Rates Aren’t Stimulating The Economy

The central boiler for the economy, consumer spending, has been accounting for ~70% of GDP. Responding to the sub-prime collapse, the Fed Reserve has brought us the cheapest interest rates in 50 years. As we’ve written previously, this has done wonders for the banking community — which lock in guaranteed profits on every dollar they borrow from the Fed (at our expense) — but have done little to stimulate consumers at the mall or the mortgage trough. Much is being reported about the fat-cash positions of corporations around the country, well-stocked with “savings” from layoffs and austerity programs. They’re not running to the well, either. Are we too scared… or injured… to borrow against our futures?

In the old “normal,” cheap money meant loose money; highly leveraged deals; no-doc, non-recourse loans. Not any more. With few exceptions, the go-go interest-only loans are history. Platinum credit buyers must wait for weeks for approval. Lending sources are still locked up, with more stringent requirements than ever. Pressure on home pricing is attracting more of the vulture community than anyone else. So, where is “the recovery”? We don’t see it. And neither do the folks, below…

With thanks to Bob Herbert of the New York Times, his “Long Term Economic Pain” column poses an answer to our question:

Rockefeller Foundation hired a team of analysts led by Professor Jacob Hacker of Yale University. They created an economic security index, which measures the percentage of Americans who experience a decrease in their household income of 25% or more in one year without having the financial resources to offset that loss…. The team’s findings were grim.

Simply stated, more and more families are facing utter economic devastation: completely out of money, with their jobs, savings and retirement funds gone, and nowhere to turn for the next dollar. Economic insecurity has been increasing for at least a generation and perhaps longer, with very dangerous levels being reached in this latest recession.

In 1985, at a time when the unemployment rate was 7.2 percent, the portion of American families that would be counted as economically insecure by the terms of this new index was 12 percent…. In 2002, coming out of a mild recession, there was a 5.8 percent unemployment rate, but the percentage of economically insecure families had jumped to 17 percent. All of the data for 2009 are not yet in, but the research team projects, conservatively, that more than 20 percent of Americans experienced a 25 percent or greater loss of household income (without a financial cushion) over the prior year — the highest in at least a quarter of a century.

As the study points out, “The typical individual who experiences a decline of at least 25 percent in household income requires between six and eight years for income to return to its previous level.” “What we’re seeing, basically, is what we’re calling ‘the new normal,’” said Mr. Hacker. “We’re slowly ratcheting up this level of economic insecurity.”

Put another way, the bottom is falling out for increasing numbers of Americans, and with the national employment situation stuck in an extended horror zone there is little to stop the free fall. In addition to tracking the percentage of Americans suffering household income losses of 25 percent or more, the index also shows that families are suffering steeper income declines than in previous decades. According to the study, “Between 1985 and 1995, the typical (median) drop among those experiencing a 25 percent or greater available income loss was about 38.2 percent; between 1997 and 2007, it was 41.4 percent.

Policy makers seem bewildered by the terrible economic state of ordinary working Americans, including those once considered solidly in the middle class. Despite warnings back in 2008 that we were on the verge of another great depression, the big financial institutions and corporate America seem to be doing just fine now. But average Americans are hurting with no end to the pain in sight.

More than 14 million people are out of work and many more are either underemployed or so discouraged they’ve just stopped looking. Big corporations, sitting on fat profits even as the economy continues to struggle, have made it clear that they are not interested in putting a lot more people back to work any time soon.

Policy makers have dropped the ball completely in terms of dealing with this devastating long-term trend of ever-increasing economic insecurity for American families. Long-term solutions that have to do with extensive job creation and a strengthening of the safety net are required. But that doesn’t seem to be on anyone’s agenda.

Bill Gross, Managing Director of PIMCO, concluded his July remarks with this clear explanation of what’s happening to the markets and the global economy:

Consumption when brought forward must be financed, and that financing is a two-way bargain between borrower and creditor. When debt levels become too high, lenders balk and even lenders of last resort — the sovereigns, the central banks, the supranational agencies — approach limits beyond which private enterprise’s productivity itself is threatened. We have arrived at a New Normal where, despite the introduction of 3 billion new consumers over the past several decades in “Chindia” and beyond, there is a lack of global aggregate demand or perhaps an inability or unwillingness to finance it. Slow growth in the developed world, insufficiently high levels of consumption in the emerging world, and seemingly inexplicable low total returns on investment portfolios — bonds and stocks — lie ahead.

Eric Edmondson, principal of San Francisco’s Seven Hills Partners, offered up a slightly more optimistic, albeit cautious outlook:

From our vantage point, overall deal activity is clearly on the rise, despite what the second quarter statistics might indicate. Buyers and sellers and investors alike seem more willing to find ways to complete a deal, rather than to delay or defer it, which had become a frustratingly common pattern of behavior over the past year.

Our advice to clients remains the same as it was last quarter: there are deals to do, but be prepared for protracted transaction cycles; consider and pursue creative solutions to all strategic and financing needs; and be sure to have a Plan B, because Plan A, even if well-considered, may simply not be feasible in the current environment. Hard work, ingenuity, and perseverance almost always pay off, in the long run if not the short run — and are essential in times like these.

Stanford Investment Group’s August Outlook suggests that the recovery is leveling off:

Banks are reluctant to expand credit — preferring to use their deposits to finance purchases of Treasury securities instead of supplying loans to households and small businesses. Weak income growth and inadequate job creation have combined to diminish consumers’ appetite for additional credit. Small businesses, which create almost 70% of all new jobs, will continue to be cautious and reluctant to add employees. As a result, job growth will remain insufficient to boost the consumer spending that supports a strong sustainable recovery.

On the heels of a major recession and financial crisis, unprecedented government intervention, and a fragile recovery, we think that unusually high uncertainty could be with us for years to come. As a result, the investment strategy that makes the most sense is one of rational diversification.

Peter Ingersoll, CEO of Safe Harbour Equity and author of The Real Estate Tsunami Survivor’s Guide (to be published in November) floats the wave this way:

The mountain of commercial real estate debt will deflate on its own timetable until it is back to its historic mean. In the next several years we will all watch the equivalent of high-stakes musical chairs: Not everyone is going to get a seat; not everyone is going to get a loan. Those left without a seat will sadly see their movie end in tears. Those who keep their seats will see many acquisition opportunities as loans mature and are refinanced, discounted or foreclosed. The process equates to a marketplace processing the toxins of a hangover. It looks like we are going to have a headache until 2013.

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