The Space Between
Choppy markets lack data that point to a trendline which all participants understand and accept. The San Francisco office market is now in the choppy phase of a broad decline that has yet to fully materialize. The data is lacking both in terms of sustained tenant demand and completed transactions.
During this phase, completed transactions often seem too high or too low; whereas, once the market trend is clear, pricing becomes more unified. Resistance is a real factor. Landlords do not want to lower rent and increase concessions. But the market trend is, ultimately, fed by the supply/demand dynamic. It cares not what an investor paid for the asset, just as the impact of higher rent on the tenant’s bottom line is not a factor in determining how much rent a landlord can charge in a tight market. In the end, everyone has to play in the same sandbox.
We’ve often talked about how markets fall unevenly. This is true until the decline gains momentum, gathering the aforementioned data. Tenants face unique challenges during the choppy phase of a market decline. On the one hand, the cause for decline is always obvious (e.g., the pandemic), but the underlying fundamentals of the market (and perhaps the rental economics being proposed by the landlord) seem to defy gravity. This is precisely why it’s so important to use time wisely and identify a short list of sites with which to negotiate. This activity is also a bit more nuanced than just finding a handful of acceptable buildings. It’s vital to understand the specific circumstances of each landlord. What is the current vacancy at the asset? What recent transactions have been completed? What is the owner’s cost basis? How much debt is held and when does it come due? What is the ownership’s motivation profile (Cash Flow, Future Value, REIT)? It’s possible to select a short list of sites that all have the same dynamic. When this happens to be a group of assets that are attempting to defy gravity, the occupier fails to capture market leverage. The concept of leverage in the context of office leasing is often misunderstood by tenants. They think of it as a noun, as something that exists independent of their activities. However, leverage is actually a verb. A skilled negotiator will leverage the market for client benefit. Yes, ultimately a market will capitulate to cumulative leverage, creating some degree of passive benefit for all to enjoy (the later phase, unified market). But leverage is the essential action that enables smart tenants to successfully navigate the choppy phase of a declining market, the phase where 2 tenants can pay substantially different amounts for the same quality of space.
In choppy markets, there is a lot of space between where the market is obviously heading and where it may be at a moment in time. Sophisticated occupiers use time wisely, select target sites carefully and employ leverage to move the market in their favor, despite significant resistance. Getting it right means eliminating the space between bad and good, unleveraged and fully leveraged.