News Clipping Vacancies soar, troubles loom
Battered real estate market may face more grim news as high vacancy rates could increase foreclosures Lynn Graebner []
Silicon Valley Business Ink []
June 14, 2002

With Bay Area office vacancy rates well into double digits and no slowing of the bleeding in sight, some real estate attorneys and brokers expect to see increased foreclosures on properties by year end.

“If it doesn’t come back in six to nine months, that’s when we’ll start to see foreclosures,” says real estate specialist Paul Stewart, a partner and chairman of the California business law department at Foley & Lardner’s San Francisco office.

“And my guess is that will happen,” he says.

Real estate attorneys say they have not seen many foreclosures to date and, given the dismal state of the real estate industry, that surprises Stewart.

Dan Mihalovich, principle of Mihalovich Partners, a San Francisco commercial brokerage firm that represents tenants in office leases, expects to see landlords handing building keys to the banks soon.

“I think we’re probably already in the process in a number of areas around the Bay Area,” he says, adding that folks are reluctant to talk about those situations.

Office vacancies have soared to 21.3 percent in Silicon Valley, reports Cornish & Carey Commercial Oncor International in its first quarter report. Colliers International also reports 21.3 percent of the valley office space is available. That’s a far cry from the dot-com mania of 1999 when less than 2 percent of Bay Area office space was vacant.

Why it hasn’t happened sooner

One of the major differences between this commercial real estate slump and the one in 1989-1991 is that not a lot of space was built on speculation in the last six to seven years, says Brad O’Brien, head of the real estate department for Palo Alto law firm Wilson Sonsini Goodrich & Rosati.

Much of the space on the market today was more conservatively appraised and underwritten than in the ’80s, meaning lenders loaned less money for the buildings and developers were required to put in more equity, O’Brien says.

“We have a lot of buildings that were better conceived with more equity and more holding power,” he says. Although he’s also surprised not to have seen more foreclosures by now.

And corporations who built space for their own use won’t jettison it until they absolutely have to, he says. Space that is in the right location, the right size and built to the company’s specifications is too valuable an asset to let go, he says. And lenders aren’t anxious to get saddled with a lot of empty real estate in a market with no takers.

Bankers are going to great lengths to avoid foreclosure, but at the same time, they have federal banking regulators making sure they are not carrying too many problem loans on their books without adequate capital. So bankers are going back to developers to obtain additional collateral and negotiate other restructuring techniques to shore up problem loans. It’s either that or foreclosure, says Brad Smith, CEO of Heritage Commerce Corp. of San Jose.

“And no banker wants to own a building,” Smith says.

Landlords and lenders have big incentives to work with struggling tenants and borrowers. If those businesses end up in bankruptcy, there’s little chance the landlord or lender will end up with much compensation at all, Mihalovich reasons.

In that kind of scenario, where the lease is breaking the tenant’s back, the landlord is coerced to negotiate, he says.

Back to the table

While real estate brokers aren’t busy these days, real estate lawyers are.

“We’ve seen more lease workouts this year than I’ve ever seen in my career,” says O’Brien, who has worked in Silicon Valley real estate for the past 26 years.

Landlords are making numerous concessions to help tenants keep their leases and to attract new ones. Rents have dropped in half in many Bay Area markets and some areas more than that.

One source, who asked not to be named, says he’s heard space at Stanford Research Park on Sand Hill Road is going for $3 per square foot down from $12 at the height of the market.

Cornish & Carey reports Silicon Valley/South Bay office rents fell to an average $2.26 per square foot last quarter, down to 1998 levels.

Today landlords are offering free rent for a period of time, free tenant improvements, paid moving expenses or are moving tenants to less costly space owned by the same landlord.

“And we’re going to see a lot more of it,” Mihalovich says.

For many landlords that will mean money-losing leases for a couple of years.

“We’ve had years when every deal a landlord did was a negative deal,” Mihalovich says. “We’re in that kind of market again.”

Landlords are desperate to secure tenants that will potentially start paying a higher rent when the economy turns around.

Some leases are constructed so that the tenant pays a lower lease rate in the near term and makes that up on the back end of the lease with interest, O’Brien says. Landlords also are lowering rents but extending the term of the lease or simply reducing the amount of space leased.

Bob Herr, head of the real estate group for Pillsbury, Madison, & Sutro LLP in San Francisco says some of his clients are allowing tenants to terminate leases in exchange for a lump sum, which eliminates some of the risk for the landlord.

And it looks like more tough times ahead since there is more vacant space coming onto the market than is being leased and occupied.

“The problem is getting worse rather than better,” O’Brien says.

The only silver lining is it’s getting worse more slowly than in recent months.

© 2002 Silicon Valley Business Ink.

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