Market Insight Editorial & Advice to Tenants: 4Q2001

Welcome! Now Celebrating a 20th Anniversary.

From Dan Mihalovich, Principal of Mihalovich Partners; Founder of The Space Place®:

Thank you for dropping by our website. I’m very pleased to be celebrating my 20th anniversary representing tenants in office leasing negotiations in the San Francisco Bay Area. This website, an integral part of our resources, serves as an example of the quality you can expect from our representation services—but also as a tenant community builder. We offer, for free, educational articles in our Guest Articles written by many of the community’s most talented professionals. (eg. How will the terrorist acts of 9/11 potentially affect your lease?) The articles are written by real estate lawyers, architects, contractors, tax consultants and others, all whom I have come to know through direct experience over the years. After 20 years representing tenants, I recognize invaluable advice when I hear it, and do everything possible to encourage contributions to this site for your benefit. Please, enjoy, and participate.

Last year was a challenging year for all of us, but nevertheless a very productive one for us at Mihalovich Partners. I would like to recognize and thank all of our clients who contributed to our successes in 2001, and wish all of you an all-encompassing and mighty turnaround in 2002!

Wilson, Sonsini, Goodrich & Rosati
Internet Capital Group
Addwater, Inc.
Majestic, Parsons, Siebert & Hsue
RiverSoft, Inc.
Green, Fauth & Jigarjian
Dr. Gil Amelio
Commerce One

The Wall of Worry. Crawling into 2002

Few of us will look back longingly to 2001. If the weak economy hadn’t already done its damage by 9/11, the ensuing atrocities crippled the San Francisco Bay Area business community. By year end, Wall Street reported the weakest corporate earnings since World War ll. The pace of job layoffs, which has been devastating in this area, has slowed to the point of encouragement—although the proverbial “recovery” seems far off. Challenger, Gray & Christmas reported that 2001 witnessed the largest total number of layoffs in the past 8 years. At least we can look elsewhere around the country and notice that we have been harder hit here, in California. In our office markets, all signs confirmed the worst—that leasing activity and net absorption of space were abysmal; rental rates plummeted, and continue to do so; and vacancies—both in the near term and projected throughout the year—are soaring. Please see our summary of leasing activity, vacancy rates and projections in our San Francisco Bay Area Stats. When will we climb over this wall of worry? Dan Mihalovich, Principal of Mihalovich Partners, is available to meet and discuss our view of the marketplace, where it’s heading and how we may serve your interests as tenant representation specialists.

Silver Lining: 50 Million Square Feet of Vacancy Can’t be Wrong

The Bay Area closed out 2001, as expected, on an awful note. Absorption of space for the Bay was negative 1.34 million square feet (landlords and tenants together put 1.34 million square feet more on the market than was absorbed through all leasing activity). Only San Mateo and Santa Clara Counties showed miniscule positive absorption, offset entirely by San Francisco’s continued poor performance, at negative 1.44 million square feet. Has the pace of new vacancies slowed? NO. Read on.

All the pundits, soothsayers and prognosticators are out their stumps, all trying to predict “the turnaround”. Since we are all in favor of a healthier economy and try to be eternally optimistic, should we allow ourselves to be clouded by our hopes? In the past 45 days, the markets have seen enormous new vacancies offered for lease:

San Francisco: 1,600,000 square feet
San Mateo County: 300,000 square feet
Santa Clara County: 710,000 square feet
East Bay Counties: 1,400,000 square feet

This is enough space to accommodate 20,000 employees! Bay Area current vacancies have now risen to over 40 million square feet, but well over 50 million vacant considering space now on the market for occupancy later in the year. SO, ARE THE MARKETS “WORKING”, and what should we do about it?

  1. The markets are working, and how. The function of the markets, at this point, continues to be to price in new demand; whether from its existing tenant base (musical chairs for tenants), new start-ups, demand from tenants outside the Bay Area or demand from tenants whose leases don’t expire until late 2002, 2003 or later. Rental rates in San Francisco have plummeted over $10 per square foot per year—just in the last 3 months (this, in additional to the free fall of more than 50% from a year ago). Demand, as we’ve already reported, remains negligible in the City, so we should expect rates to continue to slide, landlord concessions should continue to rise, and broker fees and bonuses to climb (see a more detailed explanation below, in “Raining Space, More Business Failures Coming”. Whatever it takes—the free market will do. The tighter landlords and sublessors try to grip pre-existing rental rates, the freer the fall in rates will be, since demand must be heavily courted in this type of economic downturn.
  2. The economy outside of lease rates and concessions is working, too. Much of the space available (Request a free space survey.) is offered on a “plug and play” basis, meaning that the space is completely built out, ready for occupancy, including furniture and Internet and networking cabling in place. Tenants who can take advantage of these opportunities will save enormously versus building anew and purchasing all the infrastructure.
  3. “Used” furniture supplies, much of it brand new, are a glut on that market. Telecom equipment; computerware; many retail goods; salaries and benefit packages; cheap interest rates; much reduced security deposits; cheaper housing markets—are all factors far cheaper for employers and new companies than in recent history. These now lesser expensive overhead categories will add fuel, and a silver lining, to a recovery—when it comes.
  4. Slowly, the markets are removing barriers to doing more business…expanding businesses, jump-starting hiring, boosting confidences and, finally, more leasing activity will result from the economic forces currently hard at work. When it’s time to enter the marketplace for office space, be prepared—as we do for our clients—to surround yourselves with experts across the board…those resourceful people who can help you to source and tap into the great deals available in the marketplace, with the proper negotiating skills to make it all worthwhile for your company or firm. Those of you who know us know that we treat our client’s money as though it was ours. After 20 years representing tenants, we take great pride in negotiating more aggressively for our clients than do our friendly competitors. Our 25 letters of recommendation speak to the quality of our advocacy. Please call us to discuss how we may assist you.

“Raining” Space. More Business Failures Coming.

For all the veterans of this marketplace, the pace of new vacancies has been overwhelming. To help make the point, consider the sheer number of options available to a 10,000 square foot tenant, shopping for space in the Bay Area for occupancy within the next six months:

San Francisco: 674 parcels of 10,000 square feet, in 232 buildings.
San Mateo County: 282 parcels in 138 buildings.
Santa Clara County: 407 parcels in 242 buildings.
East Bay Counties: 369 parcels in 223 buildings.

The abundance of choices in San Francisco has driven rental rates to the point where Bay view space is now leasing—on a direct basis—in the low-mid $30s/sf/year, fully serviced. Sublease space, which in the City comprises more than a third of the total vacancy, continues to drive rates lower at an alarming pace. Again, the markets are working. We should start to see an overall increase in the level of activity, as the market tries—difficult as it may be—to seek equilibrium. Bear in mind that the strongest market in the City is the view space market, and pricing for the balance of the inventory will be adjusted accordingly. View space priced in the $30s—quite reminiscent of the markets of the late 80s when vacancies in the City hit 20%. What a coincidence. Our experience tells us to never say “never”; it is possible that the top end of our markets could fall into the $20s.

More business failures are coming, without a doubt, hopefully not of the Enron variety. Rather, we continue to speak to struggling companies, law and other professional firms, all seeking ways to reduce costs, trim personnel and close unproductive offices. There is an indeterminate amount of space forthcoming to the market, in no small numbers, we anticipate. Of interest is that many landlords in the community are competing head to head with their own tenants’ marketing efforts, to shed excess space. Oftentimes these owners, publicly traded REITs and other large institutions, refuse to negotiate with struggling tenants for fear of interrupting the cash flows promised to their shareholders.

In 1999 and 2000, when we witnessed record leasing activity in San Francisco, some 5 million square feet of long term deals were struck with the once quite arrogant landlord community. All of these deals, with rental rates streaming from the $50s into the $100s per square foot per year, present troubled situations which will at some point soon return to haunt the market. Few of these businesses, in the current economy, can withstand the overhead for the duration of their 5 to 10 year lease terms. The deals made little sense then; they make less sense now. Landlords will be forced to renegotiate most of these deals, or face a reletting of those spaces left behind by bankrupt entities. Two of our Guest Columnists, Jess Bressi and Scott Brooks, law partners at Cox, Castle & Nicholson, wrote an informative article about landlord’s rights under tenant bankruptcies.

Warming up to the Market. A Time to Deal.

In any kind of market, it’s impossible, and oftentimes unimportant, to pick the proverbial “bottom”. Most businesses, and the executive teams who manage them, are not so speculative that they would effectively gamble their way through a lease negotiation in an attempt to perfectly time the trade. On the other hand, like us, tenants want to vigorously negotiate the most aggressive terms possible. So, let’s focus on the big picture for a moment. The markets have made a major move in the tenant’s direction. Rental rates and terms have finally landed in a range where many businesses can afford to operate profitably, and that IS significantly new in this market. With continued pressure on rates, tenants who slowly and methodically negotiate in this economy will be the beneficiaries of terms better than we’ve seen in several years—and should be better than was negotiated last week! Moving allowances, beefier tenant improvement allowances, fees to pay for your architect to perform speculative analyses—are readily available throughout the City. If you have a lease coming due in 2002, the market is ripe for the picking.

For those with lease expirations into 2003 and beyond, bear in mind that many of today’s most compelling opportunities are those offered for delayed vacancy—buildings under construction or renovation; and large blocks of space which will be left behind by other major tenants who have already made forward commitments. Pricing for these spaces has plummeted along with the rest of the inventory. If you are in a position to make a forward commitment, and can benefit from today’s pricing without sacrificing flexibility in the future—let’s talk.

It’s time to make hay. We can take you there.

San Francisco Bay Area Market Stats:

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.

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