REAL ESTATE NEWS & EDITORIAL
SECOND QUARTER 2016

From Dan Mihalovich, Principal of Mihalovich Partners and Founder of The Space Place

If you're in search of intelligent life in the brokerage community... please enjoy this Editorial with my compliments.

In this Issue:

The last 10 years of our pearls of wisdom:

MIHALOVICH PARTNERS
655 Montgomery Street, Suite 1490
San Francisco, CA 94111
License # 01376000
Office: 415-434-2820
Cell: 415-999-9244
Email: dan@TheSpacePlace.net
Web: www.TheSpacePlace.net
Twitter: @MihalovichCRE
Skype: danmihalovich

Thank You to Our Clients & Friends

We believe that representing tenants – and only tenants – is a noble cause, our specialty for over thirty years. We greatly appreciate our clients’ confidence and kind words about us, our level of advocacy and enthusiasm to negotiate aggressively ….. and mind the details while guiding the leasing process. Here’s to a spectacularly successful 2016.

Death by Office Lease: How to Avoid It.

Office tenants, this is for you. And it’s personal. If you don’t have your act in order in this overheated, over-priced and treacherous office market, you’re going to jeopardize your business and future. As a 30-year veteran advising tenants in this territory, I also have a piece of advice to other tenant-rep brokers: Do your flipping job. Outside of the tech sector, which has entirely fueled the frenzied space-grabbing in the San Francisco area, non-venture-backed tenants have been compelled to sign leases north of $60/$70/$80 per square foot per year – absolutely unsustainable levels. Tenants, if you’re devoting more than 8-10% of your gross revenue to rent, you’re in trouble. Office leasing isn’t gambling. Your lease should be an *asset*. Odds are stacked heavily against you, at the moment, some of the reasons for which (see below) may surprise you. Dodging bullets -- avoiding death by office lease -- is possible. Critical thinking... and planning are required. CEOs have limited time for either.

• Market conditions ARE changing, slowly but surely – “taking” rental rates are easing in a few places….but primarily in the sublease market. Direct space rental rates – in particular view space – is always the last to decline in value. The weakest offerers of space are tenants, who’re leading the decline in rates. In San Francisco, in every size range of space, the number of choices increased by 11% - 37% since last quarter! (See our chart below.) Brokers (especially the landlord-brokers mentioned below) will have you focus on the “vacancy” rate rather than the “availability” rate. The City has over 14 million square feet available, ~12%....and climbing. San Francisco’s (aka Camelot) leasing activity led the explosive absorption of space in surrounding suburban markets; it will lead the decline as well.
• We are undoubtedly in a bubble -- meaning local conditions are clearly not sustainable for tenants. Even, if not especially, angel/venture-backed tech tenants….90% of whose Hail-Mary, non-sensical pledges to stratospheric rent will end badly. Whether the air leaks out slowly or quickly is a matter for tenants to decide. New-construction  supplies of space haven't caused any of our downturns since 16 million square feet came out of the ground in San Francisco in '82. Tenants (read *demand*) are the key. No one -- take your pick -- JLL/CBRE/CW/Newmark/Colliers is any good at predicting demand. And neither is the landlord community or the press. So, drink the Kool-Aid you hear from listing brokers and landlords or not….with your eyes wide open.
• Q2 national economic data shows the third consecutive quarter of less than 2% growth – the weakest stretch in four years, in spite of improved consumer spending. The growth rate was less than half of what economists predicted. Outside of tech, business spending is weak. The unemployment rate declined, yet millions of Americans still sense recession – not recovery. The Fed doesn’t dare raise interest rates for fear of havoc. To landlord-bulls I say, why are rates so low if the economy is allegedly so terrific? We see deflation, stagnation and the flight of capital from outside our borders to the U.S. – where at least we can offer capital preservation. And why did the U.S. print $80 Billion per month for many years, if not to artificially stimulate the economy? Long-lasting results are negative real interest rates; effectively free money (if you can qualify) everywhere; continuing record funding given to VCs (but much lower levels of actual investment); and a growing chasm between what building owners pay for and expect to yield from office buildings – versus what tenants can afford to pay in rent. What is good for the goose (buyers of office buildings) is not good for the gander.
• Speaking of [JLL/CBRE/CW/Newmark/Colliers], the landlord-brokers who control 75% of the listings on the market: Here’s the big question for those of you tenants who swear you’re getting great advice from them:
  • When they have their weekly leasing meetings and compare asking rental rates and deals in all of their listings….does this serve your interests when they’re doing their best to pump up rates and drive down concessions for their landlord clients? Of course not. Are there implicit agreements to keep rental rates high? Is this a form of collusion or conscious parallelism?
  • Isn’t doing business with and for the landlord a much better business than representing you, tenants? After all, they earn property and project management fees managing those buildings; they can earn fees appraising them, packaging and selling them; and the long-term listing assignments far outweigh what they can earn by representing you. These brokerage firms are sales organizations. Close your deal and move on to the next one.
  • Tenants large and small try to make “safe” decisions when hiring a broker to represent their interests. You rely on your tenant-rep broker to advocate for you and advise you of market conditions and opportunities. What is “safe”, tenants, about the conflicted environments described above? If you’re wondering how and why market conditions are moving slowly to the downside, in spite of economic forces at play, look no further than the market prognostications and advice given to the landlord clients of [JLL/CBRE/CW/Newmark/Colliers]. In many respects, they are the Wall Street of the commercial real estate markets. Rarely will you hear bearish sentiments. And what happens behind closed doors between the brokers is none of your business. In the meantime, isn’t it a coincidence that [The Herd] voices the same advice to tenants: Markets will continue on track; demand is solid; rates may flatten but remain strong, perhaps stronger; tour activity and appetite for space at current rent levels persists.
• Your Team should use the latest innovative tech to avoid making mistakes in the deal-making process: griddig. We’re using griddig's live marketplace platform and (pre-populated) tools for all of our tenant-rep assignments. We collaborate – with transparency throughout the leasing process – with our client (and all necessary decision makers), architect, contractor, real estate lawyer….from calculating your space needs, through search, comparison of your total occupancy costs in buildings of your choice, and fully execute your Letter of Intent ONLINE. Listings of space are publicly viewable; we push landlords/listing brokers to upload details if they haven’t already. Using smart tech like griddig is the most expedient route to deal closure.

Tenants, please: Choose your brokers carefully and compel them to do their flipping job. Tenants need not suffer death-by-office-lease. Hire a team of advocates (ALL who specialize and are devoted to serving tenants: Broker, Architect, General Contractor, RE Counsel). Think about our representing your interests in your next office leasing negotiation. Thanks.

Checking Vital Signs: Do You Want to BUY Tech, or Short it? What Impact on Office Markets? (Part 4 of our series)

Tenants – Here’s Round 4 in this discussion. Tech, clearly the driving demand factor in office markets around the country, gets its lifeblood from venture capital. So, where are we in the VC cycle NOW? If the flow of VC slows, crawls or evaporates, will the office markets collapse --- and if such a scenario is even likely in the foreseeable future, WHEN might this occur? Do you want to be “long” tech, or “short” it? We asked for an update (from last quarter) from a local brainbox – a venture capitalist whose tenured company has more than $1B invested in public and private tech. We agreed not to disclose the VC’s name, but here’s a direct quote:

His bottom line (full length version below): “…Things will be much slower than it’s been but not catastrophic unless the economy really turns, perhaps triggered by global deflation or a failure of the European banking system.”

“While there have been numerous global macro developments since our last check-in, my overall view of the market has not changed—cautious but not outright bearish. As I have noted before, I am not a macro guy. I invest in good businesses with a long term horizon and short bad businesses with near term catalysts

My macro view instead informs my portfolio construction and net exposure. As such, I do not try to time the market, and believe trying to do so is foolish. With that disclosure out of the way, we are at an increasingly interesting juncture. I do not “trust” the tail end of this central bank driven bull market, but I also believe we will remain range bound as long as the fed remains accommodating and US data remains ok.

Stock buybacks have likely peaked, as evidenced by the slowing rate of corporates taking up leverage with debt fueled buybacks. I think this will continue, removing one of the drivers of the up market and earnings growth.

To that point, corporate earnings have been ok to soft, with 2016 S&P 500 revisions consistently biased to the downside into the current 2Q earnings season.

Globally, I am concerned with deflation and the negative rate picture. 37% of global sovereign debt has negative yields (25% being JGBs and the remainder from the Eurozone). While Brexit is still largely an unknown, it clearly will not help the mosaic.

On the more bullish side of things, the US consumer appears ok, with some wage growth at the lower end, energy prices staying soft, and jobless claims and unemployment still solid. This stable consumer should preserve the housing market, particularly if the rates-lower-longer paradigm continues. The housing market should be further bolstered by positive demographic trends driving household formation. The biggest issue with the current housing market is tight inventory.

The VC environment is clearly still in a slowdown vs 2015 levels, but has stabilized sequentially and funding is still robust in absolute dollars (following VC related data is courtesy of CB Insights). Global VC financing is at a -18% y/y run rate through 2Q’16. 2Q was -21% vs 2Q’15, but ticked up slightly sequentially from 1Q’16.

North American VC financing is at a -13.5% y/y run rate through 2Q. 2Q North American financing was -16% y/y at $17.1B (but +10% sequentially from 1Q). It is important to note that the Uber and Snapchat deals contributed $4.5B to this number—further evidence of the “concentration of leadership” thesis I presented in my last update.

The IPO market is tepid at best, with few new deals. 2/3 of the 10 biggest 2015 IPOs are trading below their issue price. The one recent bright spot was the Twilio (TWLO) deal, which continues to trade well +178% from its issue price. This should hopefully help spur the 2H IPO market, the point being that there will be capital available for some of the VC backed companies with solid fundamentals.

To summarize, the global macro picture is shaky but US leading indicators remain ok and the fed remains dovish, keeping me from adopting an outright bearish stance. I believe eventually there will be a price to pay for central bank intervention and negative rates. However, until US leading indicators turn I do not think there is a more attractive asset class than US equities—best house in a bad neighborhood—and multiples can likely be sustained or even go slightly higher. I am attempting to manage the reality that we are in a tenuous and likely volatile market by keeping net exposure low and sticking to simple clean stories that we know well on the long side, and shorts with identifiable catalysts and low takeout risk.”

2Q 2016 Top Leasing Transactions

SAN FRANCISCO
Tenant	Address	Sq Ft
FitBit	215 Fremont	208,000
Stripe	185 Berry	102,000
--	600 Townsend	41,000
Chart Boost	85 Second	41,000
Paul Hastings LLP	101 California	40,000
SAN MATEO COUNTY
Tenant	Address	Sq Ft
Medallia	450 Concar, San Mateo	107,000
Fan Addict Sports	1 Franklin, San Mateo	48,000
--	2001 Junipero Serra, Daly City	45,000
Bridge Edge	989 E. Hillsdale	37,000
EAST BAY COUNTIES (Alameda/Contra Costa)
Tenant	Address	Sq Ft
Wells Fargo	1755 Grant	185,000
Wells Fargo	1655 Grant	98,000
--	2100 Powell	48,000
Captricity	1999 Harrison	21,000
--	1814 Franklin	20,000

If Your Lease Will Expire Within The Next Three Years…

or if there is another compelling reason to discuss your firm's office leasing situation, please call us. For qualified tenants, we offer the following pre-contract services:

• Free preliminary office lease and operating expense review;
• Free consultation to discuss project management, Team formation and project schedule;
• Market surveys and our specific tenant-driven leasing recommendations ; and
• Assistance in selection and coordination of all Team members throughout planning and negotiation phases.

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.

HOW MANY BLOCKS OF SPACE ARE AVAILABLE FOR YOU?	San Francisco County		San Mateo County		East Bay Counties
	Q1’16	Q2’16
5,000–9,999 sq. ft.	274	303	Call us for more info
	▲ 11%
10,000–19,999	151	172
	▲ 14%
20,000–29,999	45	54
	▲ 20%
30,000–39,999	19	26
	▲ 37%
40,000–49,999	14	18
	▲ 29%
50,000+	35	48
	▲ 37%

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. To discuss your space needs in person, call 415-434-2820 or email dan@TheSpacePlace.net.

Five Brokerage Firms / 12M SqFt of Space / 420 Buildings Listed: How Do You Spell “Conflict of Interest”?

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 75% of the space in San Francisco?

The top companies controlling the most space available are NOT landlords….Rather, they are office leasing brokerage firms acting with the landlord’s interest in mind. They are:

CBRE
JLL
Cushman & Wakefield
Colliers
Newmark, Cornish & Carey

These brokerage firms control over 75% of all listings and 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?