Tenant Perspective
We're beginning to see some common themes emerge in terms of the nature of demand for San Francisco office space. These include:
Flight to Quality: Occupiers who relocate to new space tend to seek better, more compelling space to fuel RTO
Aggregate Downsize: Occupiers, in the aggregate, are reducing the amount of space leased
Uncertainty: Occupiers remain mostly uncertain about the workplace and are still struggling to determine the best solutions
At a macro level, these themes can have the effect of creating somewhat confusing datapoints from one quarter to the next. Take, for example, the metric of average asking rents across the whole of the market. This datapoint shows year over year rent growth. Taken in the absence of a broader market perspective, it can be misleading. What is actually happening, is there is limited transaction velocity, but many of the transactions that have occurred are indicative of the flight to quality phenomenon wherein companies downsize but move to nicer, premium space. In the premium space market, rents are on the rise. Hence this view of the market paints the wrong picture. By the way, even when companies are choosing nicer office space at higher prices per square foot, they're typically achieving savings over what that were paying pre-pandemic because they're taking less space. Less but nicer space.
More indicative to the true market narrative is what is happening with demand, overall. It's down. How much? We had 7.4M sf of active demand in March of 2020. Today we have 3.1M sf. And the trend from 01 of 2022 to 02 of 2022 is also not good, with demand decreasing by 36.7%. In fact, we're experiencing a net downsizing to office demand like we've never seen before. As noted in our prior repot (Q1), it's not just that companies are reducing the amount of space they lease; it's that, in some cases, they're not leasing any space at all as they hire outside the region and/or adopt virtual first workplace solutions.
Landlord capitulation, the point at which the landlord side of the market begins to accept its fate and negotiate to optimize outcomes on the basis of actual and realistically projected market conditions instead of overly optimistic perspectives which are untethered from reality, is now in full swing. Of course, there are limits and not all landlords have the capacity to meet the market in the same way. But there's more sobriety. This will accelerate as conditions continue to erode. Vacancy remained flat from Q1 to 02 of 2022 at approximately 21.7%, but we expect this number to increase in the coming quarters as tenants continue to downsize and net absorption remains either negative or marginally positive. It will take a long time to bring the vacancy factor down to 10%, widely considered to be market equilibrium.
Occupier uncertainty is translating to shorter term leasing that is not being done to promote optimal workplace solutions, but instead to buy more time so companies can monitor their sector in search of better ques around how competitors plan to reestablish their work places. No one wants to be wrong.