Professional Documents
Culture Documents
OR SIDEWAYS?
Real Estate Roundtable presented by Sedgwick, Detert, Moran & Arnold LLP
January 14, 2010
At great expense and with historic blood-loss, our local and national economy has
been through a multi-procedure, exceptionally difficult 15 month surgery and I’m
here to tell you that THE BLEEDING HAS STOPPED! … for now anyway. This is
evidenced by the past two consecutive quarters of positive net absorption in the CBD,
a less than 1% asking rental rate decline in the 4th quarter and San Francisco metro’s
November unemployment rate was 9.2%, down from 9.4% in October. Nonetheless,
the patient, our economy, remains in critical condition and the length of recovery is
uncertain.
In many ways, real estate brokers and attorneys are the surgeons within the real estate
industry. We may have suffered our own personal financial or business set-backs, but
really, we are middle-men and women who are charged with solving or repairing
some difficult problems that face owners of real estate and companies involved with
real estate – which is a big and generally unhappy lot. The good news for us is, there
is no shortage of folks that need good advice and a realistic strategy to create the best
possible outcome, given a grim set of circumstances.
If we think too much about our nation and the multitude of problems our country
faces, economic and otherwise, we might all feel like climbing back under the covers
and sleeping it off. Instead, today, I want to focus on our local San Francisco
economy and office real state markets where we are involved on a daily basis and
where we have some control over the situation. We’ll take a quick look at where
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we’ve been, painful as it may be, where we stand, and yes, where we are heading,
painful as this also will be. But the good news is, against significant odds, we have
emerged from 2009 alive and with some indications that the worst is behind us and
our long-awaited recovery has begun.
We all know, and reassure ourselves, that San Francisco and the Bay Area is a
dynamic economy that is more resilient than most major U.S. metro areas because of
our diverse industry base including: banking and finance, legal services, advertising,
construction, retail, manufacturing, shipping and government … and then of course
TECHNOLOGY, which includes, internet search, internet media, social networking,
computer hardware, chips, software, mobile devices, gaming, bio-tech and clean-tech
industries.
Our entire local economy, to a great degree, depends on TECHNOLOGY as its driver
and this is not going to change. In fact, technology will play an increasingly
important role in the overall health and welfare of our local economy. All of the
previously mentioned non-tech industries, in some way, shape, or form, will derive
direct or ancillary benefit (or sufferance) based on the overall well-being of these
“tech” industries.
The health of the technology sector depends on innovation. Innovation, in large part
begins with people and companies who put significant resources at risk to develop
new ideas and new technologies that feed into the greater technology juggernaut.
These are the seeds of technology and they start with the universities, venture
funding, private equity, government grants and the like. For a long time, well into
2008, we here in the Bay Area felt insulated from the dark clouds and economic
indicators on the horizon that said we were heading for a recession, primarily because
the tech sector still felt healthy. We can look back to September 15, 2008 and say
that the day Lehman Brothers died, we in the Bay Area realized that nothing was
sacred or safe and cash is king.
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This point was really driven-home in a widely circulated presentation given by
Sequoia Capital on October 7, 2008 to the leaders of its portfolio group of companies
– now known as the “Rest In Peace – Good Times” presentation. This presentation
was a dire, but accurate and sobering look at exactly where the economy was heading
and what technology companies needed to do to survive. Their advice: “Spend every
dollar as if it were your last.” Fiscally, this wisdom instantly shut the spigot off,
relative to the way technology start-ups and even well-established companies would
choose to spend precious cash over the following 15 months. Needless to say, hiring
was frozen, headcounts reduced, comp plans revised, office leases put on hold and
budgets of all kinds were revised and reduced.
Since the Great Recession officially began in October of 2007 everything went
downhill fast…
Everyone has had to adjust dramatically and the necessary fiscal behavior
modifications have resulted in companies, of all types, painfully weathering the storm
and emerging leaner and wiser, but still hyper-vigilant about how every dollar spent
will affect their bottom line.
Unfortunately, for real estate owners, leverage created the inability to react quickly to
the new rules. Debt coverage is stifling and the ability to work out near-term loan
maturities feels next to impossible. The misfortunes of many who purchased
commercial real estate from 2005 – 2008 were been pre-determined by the type of
loan or ownership structure that was placed on a property in a lending and economic
climate that no longer exists. While the “Rest In Peace - Good Times” wisdom could
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have been great advice for real estate owners too, by that time it was already too late.
And then came the double-whammy…As companies have resolved to spend less on
non-core business functions like real estate transaction costs (including TI’s, moving
costs, brokerage commissions and legal fees), these costs still have to be paid by
someone, and the tab increasingly falls squarely in the hands of building owners and
NOT the tenants.
Reduced headcounts means decreased demand, which leads to lower rents and
increased concessions and minimal, if any returns for owners after debt coverage.
Those few who had the discipline to adhere to the once-shunned practice of extreme
conservatism have been rewarded. It’s the old saying: “The best deals you ever make
are often the one’s you don’t.” These are the Shorensteins, the Boston Properties and
others who have, at least locally, sat on the sidelines and did not participate in the
frenzy from 2005 - 2008.
Then there are others who have had to go back to the well (if it is not already dry) and
recapitalize and spend more money, just to be able to make lease deals at lower
market rents. The REITS and publicly traded entities whose performance is tied to
occupancy levels are increasingly more willing to do whatever it takes to boost
occupancy and sign new leases. This makes it increasingly difficult for property
owners who have big debt hurdles and are cash constrained to compete for new
leases.
So this leads to demand profile. Are there “new deals” out there? According to our
Cushman & Wakefield statistics, there are 3.9 million square feet of active tenant
requirements in San Francisco today. This sounds good and may sound like a lot, but
nearly 40% of these can be qualified as passive demand, meaning those tenants who
have a net neutral or lesser space requirement relative to their existing lease.
Furthermore, if you look at the CBD as a whole, 8.5% of CBD leases expired in 2008
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and 8.2 % rolled in 2009, but a whopping 14.6 % will roll in 2010 and 12.1% in
2011. This will mean a significant increase in leasing activity in 2010 and 2011, but
don’t confuse activity with results. These are really 5 and 7-year leases that were
signed between 2004 and 2006, when the last recovery began to take hold.
In 2008, we tracked 6.3 million square feet of leasing activity in San Francisco and
then 5.3 million square feet in 2009. While it is particularly hard to track all renewal
leases, of all leasing activity in 2008 16% were renewal leases versus 24% in 2009.
This indicates a trend towards renewal that will continue for the next couple of years.
This trend towards renewal leases is the result of a couple of factors. As mentioned,
with limited ability to borrow, tenants are focused on cash preservation and they
WILL NOT come out-of-pocket to pay for non-core business functions related to real
estate, like moving costs and tenant improvements, unless there is a compelling
business reason to do so. So if headcount has stabilized, and given the choice of
spending any up-front capital and enduring the disruption of relocating, even if it
results in modest long-term savings, businesses are inevitably choosing the path of
least resistance: RENEWAL. Landlords with well-occupied buildings also have the
ability to be more competitive and retain tenants by offering immediate rent reduction
on leases expiring within the next 12 – 24 months.
Though some more quickly than others, landlords have come to terms with the
realities of today’s market and with the fact that the recovery will take time. While
supply constrained San Francisco has always benefited from big spikes in an upward
trending market, a “spike” in rents and job growth is probably several years off.
Realizing this, landlords are quick to take every competitive advantage they can to
retain their good tenants and keep their buildings full.
On the opposite side of the coin, those landlords who face some or significant
vacancy, tend to fall into 2 categories: either a) dead in the water, due to prohibitive
debt obligations or lame-duck control in the capital stack, or b) more competitive due
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to a lower reset basis. The reset basis may be due to erosion of priority in a capital
stack – like Apollo with the MesRef portfolio, purchase out of foreclosure like 250
Montgomery and 188 Spear, or simply acquiring assets at new base values that are 30
– 40% below peak values like 49 Stevenson Street. In any event, we have seen and
will continue to see more of this value resetting, which feels bad if you bought real
estate in the past few years, but is ultimately healthy for the market to clear itself and
establish a stable foundation from which fundamentals can improve.
It is very true that traditional commercial real estate statistics mirror greater economic
indicators like the stock market and more importantly, employment and job growth
statistics, though commercial real estate statistics lag greater economic indicators by 2
– 3 quarters.
Many have talked about our “Jobless Recovery”… well there is no such thing. Our
greater economy and our local real estate economy will not improve without the
creation of new jobs. The jobless recovery phenomenon only tells us that companies
have been doing relatively more with fewer resources and by spending less. Most
companies’ human resources are tapped out and worker productivity in 2009 reached
a 5-year high. However, we have started to see an increase in temporary and part-
time hiring, which ultimately should lead to full-time employment growth. And in
fact, Ken Rosen predicts that the San Francisco metro area, consisting of San
Francisco, San Mateo and Marin counties, will add 5,000 new jobs in 2010. It’s the
chicken or the egg… most companies need to demonstrate revenue to warrant new
hiring, but they need to hire to increase revenue.
When the outlook is still grim and the economy is flat, everyone wonders what will
drive our recovery and generate real new jobs and increased demand for office
space? Well here in San Francisco, you can count on one thing… you guessed it…
TECHNOLOGY! If you look at the largest office space requirements (aside from the
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larger law firms with lease expirations in 2011 and 2012), the immediate, organic
demand includes Salesforce.com with 200,000 sf of net new demand, Zynga with
150,000 sf of growth and consolidation, and then dozens of smaller tech firms in the
10,000 to 30,000 sf size category, which are still considered good-sized deals by San
Francisco standards.
Since the advent of the iPhone in 2007, it has become apparent that mobile computing
is here to stay and it is POWERFUL. New entrants into the market, including
Google’s recent announcement of the Nexus One Smartphone, indicate proof of
concept is in place and major stakeholders are moving in. Developers have flocked in
droves to what is being coined as the new “Mobile Computing Gold Rush”, and it has
all the DNA of the last tech boom…except this time companies are actually making
money! Playfish for example, a company founded in October of 2007, who makes
social games on platforms such as Facebook and the iPhone was acquired by
Electronic Arts this November for an astonishing $400 Million based on estimated
2009 revenues of $75 Million. Computing is evolving, just as it did in the past from
large HAL-sized goliaths, to small desktops, and now to handhelds, and the
background infrastructure for mobile computing is on the verge of exploding right
here in our own backyard.
So assuming technology and mobile computing is the impetus for recovery, how long
and how much will it take? In San Francisco alone, 2009 dealt us approximately 1.3
million square feet of negative net absorption in San Francisco’s CBD. The overall
Citywide vacancy rate for all classes of office space currently stands at 14.8% and
13.6% in the CBD. However, the worst appears to be behind us as we experienced
two consecutive quarters of positive net absorption in Q3 and Q4 2009 totaling
approximately 240,000 sf in the CBD and nearly 200,000 sf of positive net absorption
Citywide in the 4th quarter.
To put this in perspective though, we would need to create approximately 11,500 new
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jobs to fill the new space that was placed on the market in 2009 alone. Assuming we
continue at a moderate positive absorption rate of 200,000 square feet per quarter, it
will take the better part of three years to get back to a healthier market for building
owners. In the meantime, and particularly in 2010 and 2011, tenants will enjoy
significant leverage and lots of good space options. Most tenants will use this
leverage to benefit renewal terms, though we will see some flight to quality as tenants
seek to realize exceptional value in higher quality space. Well-priced, quality class A
and high-end class B, or “creative” space – which appeals to the tech companies - will
remain the most active and sough-after space categories, though there will be plenty
of pure bargain hunters as well.
Thank you for your time today. Are there any questions from the group?