Market Insight Editorial & Advice to Tenants: 4Q2011

Warning on Global Risks — Not a Care in San Francisco

Welcome to one of the hottest incubators in the world: San Francisco. Here, in this Teflon-coated hamlet, none of the dire and destructive elements of the national or global economy have any effect…at least not this week. Tech and social media companies have led a charge-up of rental rates unprecedented since the Dot Com.

What’s particularly disturbing to the rest of the tenants waiting to be victimized by these horrid conditions is the myopia — or just plain recklessness — of tenants paying almost any price to land space in our fair city. All in spite of fundamental indicators surrounding this island that suggest that there is no economic recovery, that more pain is yet to come, and that avoiding making long-term commitments at these heady rental levels is the only sage advice one should take.

In 3Q 2006, we pumped an article from Eric Sprott, of Sprott Asset Management, entitled “A Requiem for a Housing Bubble”, which eerily foretold the plight of the U.S. economy.

Now Sprott has issued another warning, but who’s listening? Not the landlord community around here.

Sprott warns of drawn out debt restructuring in Greece, a prolonged period of low growth in the U.S., and a hard landing in China:

  • Greece is largely controlled by hedge funds that own the bonds.
  • “There is no recovery” in the U.S., he states. Consumers face significant headwinds. Housing continues to struggle and the expiration of tax incentives will further wreak havoc.
  • “China is in a slowdown today.” Auto, housing sales and industrial production are all in decline.

Sprott also warns of moves by G6 countries to provide “unlimited lines of credit” to national banks—with unintended consequences.

“We have already seen evidence of the Chinese selling bonds and buying huge amounts of gold.”

“There is way too much optimism and I don’t think it’s based on analysis of the data.”

“All the banks are leveraged 20 to one. That means if they lose 5% they have no capital left. The risk is unbelievable. You have to wonder if there is any capital.”

Bill Gross of PIMCO is also no beacon of optimism: “Leveraging has turned into deleveraging. 15% yields have turned into 0% money.”

Our experience during the past few decades would have shown that “accelerating asset prices [think office buildings] weren’t due to any particular wisdom on the part of academia or the investment community, but an offensively minded Federal Reserve and their global counterparts who were printing money, lowering yields and bringing forward a false sense of monetary wealth that was dependent on perpetual motion.”

“Low yields, instead of fostering capital gains for investors via the magic of present value discounting and lower credit spreads, begin to reduce household incomes, lower corporate profit margins and wreak havoc on historical business models connected to banking, money market funds and the pension industry.”

It’s a good thing that most of the local tech and social media companies are venture-backed. And good for them, I suppose, that most investors are too busy watching rising revenues to notice that Rome is afire all around.

The looming fiscal crisis is a steady theme and national tour topic of (Alan) Simpson (Erskine) Bowles, whose National Commission on Fiscal Responsibility and Reform detailed the crisis alongside the Committee’s recommendations. Their ultimate conclusion? Our economy is in a “structural contraction.” We cannot produce our way out of trouble, not even if we have back-to-back growth years for the next 30 years. We cannot “cut” our way out of trouble either.

We’re spending 14 times as much as any nation on defense. And our defense budget cannot be audited! The DOD says they have between one and ten million subcontractors, none of whom are audited!

We spend twice as much as any nation on healthcare.

And we have the worst tax code in the world.

Simpson Bowles continue to stump for their agenda, with a sense of pragmatism and certain fear that our nation has run out of money and time. Simpson suggested, “We’re the healthiest horse in the glue factory.” Bowles reminds us that the European fiscal crisis is embedded in banks throughout the U.S. We own a massive dose of all of that bad debt. He suggested that there’s a 30-35% chance that the Euro will fail.

“The Moment of Truth”, the December, 2010 report of the Commission, issued this synopsis of the U.S. fiscal crisis:

Our nation is on an unsustainable fiscal path. Spending is rising and revenues are falling short, requiring the government to borrow huge sums each year to make up the difference. We face staggering deficits. In 2010, federal spending was nearly 24 percent of Gross Domestic Product (GDP), the value of all goods and services produced in the economy. Only during World War II was federal spending a larger part of the economy. Tax revenues stood at 15 percent of GDP this year, the lowest level since 1950. The gap between spending and revenue – the budget deficit – was just under nine percent of GDP.

Since the last time our budget was balanced in 2001, the federal debt has increased dramatically, rising from 33 percent of GDP to 62 percent of GDP in 2010. The escalation was driven in large part by two wars and a slew of fiscally irresponsible policies, along with a deep economic downturn. We have arrived at the moment of truth, and neither political party is without blame.

Economic recovery will improve the deficit situation in the short run because revenues will rise as people go back to work, and money spent on the social safety net will decline as fewer people are forced to rely on it. But even after the economy recovers, federal spending is projected to increase faster than revenues, so the government will have to continue borrowing money to spend. The Congressional Budget Office (CBO) projects if we continue on our current course, deficits will remain high throughout the rest of this decade and beyond, and debt will spiral ever higher, reaching 90 percent of GDP in 2020.

Over the long run, as the baby boomers retire and health care costs continue to grow, the situation will become far worse. By 2025 revenue will be able to finance only interest payments, Medicare, Medicaid, and Social Security. Every other federal government activity – from national defense and homeland security to transportation and energy – will have to be paid for with borrowed money. Debt held by the public will outstrip the entire American economy, growing to as much as 185 percent of GDP by 2035. Interest on the debt could rise to nearly $1 trillion by 2020. These mandatory payments – which buy absolutely no goods or services – will squeeze out funding for all other priorities.

Federal debt this high is unsustainable. It will drive up interest rates for all borrowers – businesses and individuals – and curtail economic growth by crowding out private investment. By making it more expensive for entrepreneurs and businesses to raise capital, innovate, and create jobs, rising debt could reduce per-capita GDP, each American’s share of the nation’s economy, by as much as 15 percent by 2035.

Rising debt will also hamstring the government, depriving it of the resources needed to respond to future crises and invest in other priorities. Deficit spending is often used to respond to short- term financial “emergency” needs such as wars or recessions. If our national debt grows higher, the federal government may even have difficulty borrowing funds at an affordable interest rate, preventing it from effectively responding.

Large debt will put America at risk by exposing it to foreign creditors. They currently own more than half our public debt, and the interest we pay them reduces our own standard of living. The single largest foreign holder of our debt is China, a nation that may not share our country’s aspirations and strategic interests. In a worst-case scenario, investors could lose confidence that our nation is able or willing to repay its loans – possibly triggering a debt crisis that would force the government to implement the most stringent of austerity measures.

Predicting the precise level of public debt that would trigger such a crisis is difficult, but a key factor may be whether the debt has been stabilized as a share of the economy or if it continues to rise. Investors, reluctant to risk throwing good money after bad, are sure to be far more concerned about rising debt than stable debt. In a recent briefing on the risk of a fiscal crisis, CBO explained that while “there is no identifiable tipping point of debt relative to GDP indicating that a crisis is likely or imminent,” the U.S. debt-to-GDP ratio is “climbing into unfamiliar territory” and “the higher the debt, the greater the risk of such a crisis.”

If we do not act soon to reassure the markets, the risk of a crisis will increase, and the options available to avert or remedy the crisis will both narrow and become more stringent. If we wait ten years, CBO projects our economy could shrink by as much as 2 percent, and spending cuts and tax increases needed to plug the hole could nearly double what is needed today. Continued inaction is not a viable option, and not an acceptable course for a responsible government.

The San Francisco Bubble: Where Deals Make No Sense

Dear Tenants: The stats don’t lie. 2011 wrapped up on a euphoric high for the landlord community. As you’ll read in our charts, the tenant community’s appetite for office space was dramatic, impressive even, but not at all historic.

Ruminate on that for a moment.

Then, notice the source of the fire in rising rental rates: The surge in the number of simultaneous transactions—up 45%.

Are we at historic high rental rates? No. But they’re damned unaffordable—or sustainable—for the typical tenant in the area: professional firms, service firms, banks, and non-profits.

The concentration of activity is at record performance throughout the San Francisco Bay Area. It’s no wonder that the landlord community has gotten frothy at the mouth and will hardly stand still long enough to commit to terms. The bird in hand isn’t as attractive as the coming venture-backed voracious tech tenant.

Back up to line 1: The stats (our source is CoStar, the de-facto market research database for virtually every major commercial real estate firm) show that 53 million square feet remain on the market in the SF Bay Area…and have been on the market for over two years.

The fact that little vacancy is in the form of sublease space indicates that deep-pocketed landlords (with Other People’s Money, of course) will let good space sit fallow for years rather than doing the correct economic thing.

Consider direct space (direct lease with the landlord): since 1Q 2008 San Francisco has seen negative absorption in 10 quarters and positive absorption in only 6 quarters. So, the last half of 2011’s demand set landlords on fire. However, two quarters is not a trend and one would be wise to doubt that the speed of transactions will continue at its record pace. Put another way, our industry—for the past 30 years, at least—gets failing grades predicting tenant demand.

Not to be ignored, here’s the amount of new space that came on the market during the last 45 days of 4Q 2011:

San Francisco 810,000 square feet
San Mateo County 880,000 square feet
East Bay Counties 520,000 square feet
South Bay (Santa Clara County) 785,000 square feet

The markets are talking to you, tenants, telling you what to do. You’ll need to burn the extra hours (and we’d be happy to lead you through this process) to figure out your next move, but you’ll likely have to vote with your feet. If it looks like a bubble and your landlord acts like he could care less, it’s a bubble.

Protect your bottom line. We’re getting our clients into deals where they spend no more than 8-9% of their gross revenue on rent.

Venture Funding Drives Growth & Revenue, Not Profits

We’re not here to offer securities advice. But like any office market aficionado, we’re trying to make sense of the demand in the marketplace.

By nature, venture funds are speculative funds. And the billions of dollars breathing life into young companies are producing sustained, growing revenues. But where and when are the net profits?

Landlords, wringing their hands in anticipation of yet higher rents from the next tenant to step forward, could care less. Why? The tenant is VC backed by [fill in the blank…Kleiner Perkins, etc]; the tenant put up a huge letter of credit (a la Dot Com heydays); and the financial statements confirm heavy cash balances to hire scores of new employees.

The investment question for fund participants is one of timing: When do I kick out of this deal if there’s no “event”—IPO or sale?

Like during the Dot Com, revenues must be leveraged through advertising. It’s all about monetizing eyeballs/traffic. But the devil’s in the soaring cost of the work force. In order to sell your ads, software, apps, games, devices—especially in the San Francisco/Silicon Valley areas—you’re going to pay $60,000-$80,000/year (including benefits) plus per employee.

Has anyone perfected the science of calculating returns on advertising on the web? We certainly have a massive body of young companies selling the sizzle. But one also recalls the end game when the burn rate buries the financials.

Landlords should re-think the fundamentals of companies leveraged on advertising. How many hundreds or thousands of ways do we need to be connected? How many travel or review companies do we need? How many games can we play…and who’s paying for these games?

Do your own securities analysis. If you really enjoy a gamble, see our friends at SharesPost and try trading in pre-IPO stock.

Historically, landlords have been more conservative. They acted more like hedgers than speculators. Landlords banked on tenants with longevity and great credit. Not anymore. Today, it’s all about the big bang. In a market like this, and considering our global economy, watch your step and be ready to run for cover. Everything is for sale….and you’ll likely have a new landlord before you know it.

53 Million square feet of office space remains on the market, and, most notably, it’s been on the market for two years or longer! Our markets were crushed under the weight of less supply during the Dot Bomb when only 42 million square feet were available for lease.

How many alternative spaces are available to you to suit your requirement? Isn’t this part of the core litmus test of how soft or tight the market really is?

See our chart below where we track the changes for all size ranges of tenants in these reports every quarter. If you want real-time data, please call me.

If you’re in search of intelligent life in the brokerage community, please enjoy this Editorial with my compliments. For more historical perspective, feel free to peruse the last 10 years of pearls of wisdom.

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

53 Million Square Feet On The Market

Q4, 2011 in the San Francisco Bay Area wrapped up as follows:

square feet available (millions) average time on market (months)
San Francisco 15.4 27.3
San Mateo County 6.5 23.8
Santa Clara County 14.2 29
Contra Costa &
Alameda Counties
16.8 26.3

Top Five Leasing Transactions by County for 4Q 2011

San Francisco

1 Pac-12
(370 3rd St)
114,214 sq. ft.
2 Covington & Burling LLP
(1 Front St)
108,815 sq. ft.
3 Pillsbury Winthrop Shaw Pittman
(4 Embarcadero Ctr)
107,447 sq. ft.
4 Morgan Stanley Smith Barney LLC
(555 California St)
90,000 sq. ft.
5 First Republic Bank
(1 Front St)
63,097 sq. ft.

San Mateo County

1 Sony
(2207 Bridgepointe Pky Bldg 1-Bridgepointe Corporate)
167,505 sq. ft.
(2211 Bridgepointe Pky Bldg 2-Bridgepointe Corporate) 141,500 sq. ft.
(2215 Bridgepointe Pky Bldg 3-Bridgepointe Corporate) 141,496 sq. ft.
2 Guidewire Software, Inc.
(1001-1051 E Hillsdale Blvd Parkside Towers, Foster City)
97,674 sq. ft.
3 NetSuite, Inc.
(2955 Campus Dr)
79,589 sq. ft.
4 Responsys, Inc.
(1100 Grundy Ln Bayhill VI)
58,000 sq. ft.
5 Actuate Corporation
(951 Mariners Island Blvd San Mateo BayCenter 1)
53,832 sq. ft.

East Bay Counties (Alameda and Contra Costa)

1 General Electric
(2623 Camino Ramon Bldg GG-Bishop Ranch 3)
233,674 sq. ft.
2 BevMo
(1401 Willow Pass Rd Tower 1-Metroplex Office Center)
33,963 sq. ft.
3 Chevron Federal Credit Union
(500 12th St City Square Building B-Oakland City Center)
33,000 sq. ft.
4 American Baptist Homes of the West
(6120 Stoneridge Mall Rd Bldg 5-Stoneridge Corporate Plz)
24,801 sq. ft.
5 -unknown-
(4000 Dublin Blvd Bldg 1-Dublin Gateway Medical Center SWC Tassajara Rd)
22,848 sq. ft.

Santa Clara County (South Bay)

1 Avaya Communications
(4655 Great America Pky Towers at Great America)
275,156 sq. ft.
2 Flextronics
(6201 America Center Dr America Center Phase I-Bldg 2-America Center)
106,757 sq. ft.
3 Rovi Corporation
(2830 De La Cruz Blvd Airport Technology Park Santa Clara)
90,000 sq. ft.
4 Financial Engines, Inc.
(1050 Enterprise Way Bldg C-Moffett Towers 94089)
80,995 sq. ft.
5 eBay, Inc.
(2535 N 1st St Bldg 1-Lincoln Technology Park)
62,280 sq. ft.

Total Number of Leasing Transactions (2005–2011; Direct + Sublease)

2011 2010 2009 2008 2007 2006 2005
San Francisco 1709 1785 1555 1391 1201 1211 1311
San Mateo County 729 708 591 640 500 657 613
Santa Clara County 1892 1774 1341 1296 731 964 732
Contra Costa &
Alameda Counties
1667 1749 1647 1321 679 750 1325

Vacancy Rates: Are Your Options Fading?

Tenants should watch carefully to detect how and to what extent your field of options changes. Which size blocks of space are getting leased?

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 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

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 400 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 Tishman Speyer, Shorenstein, RREEF, Boston Properties and Hines. 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 *Jones Lang LaSalle 12.0% 2,434,830 44
2 *The CAC Group 11.4% 2,323,219 73
3 *Cornish & Carey Commercial Newmark Knight Frank 10.1% 2,064,958 42
4 *Cushman & Wakefield of California 8.2% 1,673,390 59
5 *Colliers International 6.4% 1,305,695 83
6 *Kidder Mathews 6.3% 1,283,143 44
7 *CBRE 5.2% 1,062,424 27
8 *Grubb & Ellis 5.1% 1,032,361 52
9 Shorenstein Properties, LLC 4.2% 848,157 7
10 Tishman Speyer 2.5% 505,425 4
11 Beacon Capital Partners, LLC 1.5% 307,000 1
12 Stockbridge Capital Group, LLC 1.4% 281,982 1
13 Hines 1.3% 260,431 6
14 Boston Properties Limited Partnership 0.9% 185,097 4
15 *Cassidy Turley 0.9% 174,791 21
16 *TRI Commercial / CORFAC International 0.8% 161,771 48
17 The Presidio Trust 0.8% 157,260 40
18 *Starboard TCN Worldwide Real Estate 0.7% 133,100 43
19 *Terranomics Retail Services 0.6% 118,754
20 *Sansome Street Advisors 0.5% 99,283 9
21 *Colton Commercial & Partners 0.4% 89,199 21
22 *The Hawthorne Group 0.4% 83,077 22
23 *UGL Services 0.4% 76,676
24 *McLellan Commercial Real Estate, Inc 0.4% 75,528 4
25 *Cresa 0.4% 72,740
  Total   20,349,318  

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