How Remote Work is Changing Small Town Residential Markets

For many years my family has been coming to Vermont for summer vacation.  We love the change of scenery from our urban life in San Francisco.  Every morning at about 5 am the birds begin singing outside our windows, serving as a natural alarm clock.  As they gently nudge you awake with their beautiful songs, the sun begins to rise.  Our place is located in a town called Quechee, VT, home to a long running hot air balloon festival.  It’s pretty common to hear the gentle hiss of a balloon passing overhead early in the morning.  When this happens, it’s such a beautiful sight that we usually jump out of bed and run to the deck to watch.  It’s a peaceful experience. 
 
As I dropped my kids off at summer camp this morning, my ears were automatically drawn to a different sound, that of parents chatting about how much they love working remotely and living in Vermont.  It got me thinking about this small town and how much it’s changed in the past few years.  The proximity of small New England towns like ours to big cities like Boston and New York is a big draw for would be remote workers.  We bought our modest condo here in 2012.  Having grown up in the area and having family in the residential real estate business, I knew the market had been flat for many years.  In fact, residential pricing throughout the region was not historically prone to significant swings in value.  But that all changed in 2020.  We rent our condo most of year.  Historically, renters would stay for a few nights or maybe a week at a time.  Suddenly, in 2020, we had renters seeking multi-month occupancies.  This continued through 2021.  Additionally, we began to get unsolicited offers to purchase the condo.  And these offers were 4X what we paid for it. 
 
Visiting with my sister-in-law, a residential agent in the region, I learned that the same phenomenon we’d become accustomed to in San Francisco, homes selling over asking price in a period of hours with multiple bidders, was in fact playing out here.  After 2 years of this trend, supply is extremely limited.  The presence of wealthy buyers coming from the big cities to the south, coupled with investors (including institutions) buying up single family homes as rentals, has put extreme pressure on many of the would be local buyers who live and work in the region.  Their incomes no longer support the cost of buying a home.
 
The ongoing disruption in how and where we work is having far reaching impact on many aspects of society.  Sometimes it’s hard to see the bigger picture.  Cities like San Francisco, for example, where office going population is still <40% (and much less on many days of the week), are experiencing business failures as merchants who formerly served this population struggle for survival.  In addition, city government is bracing for significant reductions in tax revenue as corporations reduce their office footprint, reducing the value of office buildings and the taxes they pay.  Not surprisingly, the office economy is a huge engine for most major cities.  At the same time, small towns are struggling with an opposite problem; an influx of urban wealth, rapidly changing the socio-economic landscape.  Those choosing to live in a city like San Francisco mostly do so knowing it will be expensive.  They come there to participate in an economy that at least provides the possibility of earning sufficient income to make it affordable.  But for the working class families that have made small towns throughout the US home for generations, this changing dynamic is not wanted.  But it’s happening.  The implications of remote work will continue to have far reaching impacts on society, disrupting not just big cities, but also small towns throughout the US.

Ice Cream on a Hot Summer Day

It’s not difficult to sell ice cream on a hot summer day.  People want it because it tastes good, it’s full of sugar,  it’s cold, etc.  It has intrinsic appeal.   
 
Office space is not ice cream.  The consumer does not universally crave the product.  It’s mostly a necessary adjunct to the work we do.  When given the choice between ice cream or no ice cream, many will readily choose the former.  However, when given the choice between office and no office, many will choose no office (or, at least, less office).
 
Landlords have a product problem.  They must think carefully about how to make their product more like ice cream.  The consumer has to want it.  They can no longer rely on the product being consumed simply because it is forced upon employees.  This new era, call it the “ice-creamization” of the office, will be the catalyst for significant change that will render the historical construct of the office unrecognizable.  It’s a dynamic and exciting time; one that will ultimately lead to better solutions for all.

The Questions

We’re having the same important conversation with nearly all our clients.  It stems from 2 basic questions; 1) What if we don’t have an office, and 2) Can we structure the lease so that if the market declines over the coming years, the rent for our space will similarly decline? 

We believe these are very important questions as they relate to broader issues about the value of an office lease to your specific organization.  This is the most useful dynamic to evolve from the pandemic, a thoughtful analysis of how leasing office space supports, indeed promotes, employee engagement and productivity.  And, it’s important to contemplate this value against the backdrop of the market in which occupiers and landlords alike must accept fixed cost/return outcomes despite ongoing fluidity that may result in a given space being worth more or less over time.

Starting at why.  It’s a valid consideration.  For many companies, the posture of the past couple of years has been de facto no office.  Has it worked?  Have the employees been more or less productive, happy, engaged?  What contribution does the office make?  How can it better serve the organization?  What many are now realizing is the office is less essential as a place to do work.  It’s more vital as a place to gather, to connect at the human to human level, without the interface of technology.  If this is true, perhaps the office should be designed specifically to facilitate such connections.  Or, maybe the conclusion is these connections can be achieved in other ways that don’t necessitate an office.  While it’s tempting to make this assessment with a bias toward cost reduction, it’s important to avoid being swayed simply by how much can be saved without an office.  Yes, office space is an expensive investment.  But what is the return on the investment?  It’s this ROI that gets to the heart of its value.  Occupiers should be focused on increasing ROI by creating more targeted outcomes from the employee gathering spaces they provide.

Assuming an organization concludes it needs an office (by the way, the term “office”, itself, seems due for rebranding), it’s important to talk about the market, to understand how it functions and what’s likely to occur over the coming quarters.  Of course, no one has a crystal ball, no one can predict the future.  However, real estate firms that have a deep market presence and quality research can make reasonably good projections of market scenarios over a 12 – 36 month window.  For example, the current market dynamic in San Francisco is interesting.  Over the last 2 years, while occupiers effectively abandoned their office space and are now using it at a rate of about 35%, rents in San Francisco have fallen only 10%.  This is because the true impact of the pandemic on landlords is only now beginning to play out.  The market is 23% vacant and climbing.  Landlords are in varying states of readiness to meet the demands of this market, based on the specific economics of their ownership.  It’s undoubtedly an excellent time to negotiate, but occupiers who sign a lease now will not achieve bottom pricing.  The bottom is likely ~3 years out.  So, yes, while you may get a good deal now, you stand to get a better deal in 18 – 24 months.  So what strategy should you employ?  Your current space is likely too big.  You have a lease expiring in less than a year.  You could attempt a short term extension with the intent of negotiating a better outcome in 18 - 36 months.  This is a common approach, yet it’s not without limitations.  Firstly, the space may not be compelling in the sense that it serves the new purpose you’ve identified.  In other words, the old space may be ill-suited to attracting your employees back to the office.  Secondly, in many cases the existing space is too big and the cost, even at a steep discount, ends up being more expensive than a new solution.  Another approach we’ve seen clients contemplate is to let the existing lease lapse and endeavor to reengage with the market at some point downstream, when conditions seem most optimal.  This scenario may work if the organization is comfortable not having an office for a period of time.  It should be noted, too, that the importance of having an office may translate in more ways than just its impact on employees.  Consideration should also be given, for example, to branding and client engagement activities.  One thing we have not seen in the markets, nor do we anticipate seeing it, is the ability to structure leases that provide downward rent adjustment mechanisms.  If such a structure were to be accepted by a landlord, it would stand to reason that this landlord would also want an upside mechanism in case rents increase.  For better or worse, domestic office leases in major metros are mostly fixed cost during the term based upon the rental economics negotiated at the time the lease is signed. 

This is certainly a time to ask the right questions.  While it may seem counterintuitive to engage your real estate advisor in conversations that include doing nothing, your advisor is a critical source of knowledge and input on this topic.  The best of us are ready to help, to provide non-biased feedback, regardless of the near-term fee implications.

Who Stole My Narrative

Historically, the narrative within the commercial office markets in big cities has been controlled by institutions. Institutions who own the buildings and institutions who “own” the employees. The markets fluctuated between “tight” or “soft” and leverage shifted back and forth from landlord to tenant. These 2 market participants, landlord and tenant, supply and demand, called the shots. Sure, there were other variables, the economy, other market influences and influencers. But the narrative was defined within a fairly narrow range.

What’s fascinating (and confounding to some) about the state of the current office market narrative is that it’s not being driven by the institutions. We’re not listening to the voice of the landlords that own the buildings, or the corporations that employ the masses. No. We’re listening to the voices of the employees, the individuals that are speaking up, sharing their views on what makes them productive, healthy and happy. Those ensconced in the comfortable leather chairs around the board room table aren’t quite sure how to deal with this rebellious new member who cares not for their traditions and norms.

This new voice is controlling the narrative and making the institutions increasingly uncomfortable. After all, the institutions and historical market participants have a lot invested in the outcome. Owners have massive investments in the assets. Companies have massive investments in their office space and they believe it’s essential to control where the employees work. Brokers want the market to return to normalcy so their income can do the same. It’s these “vested” parties whose voices sound increasingly shrill as they seek to regain control of the narrative. It is they who demand that all employees return to the office 5 days a week. And they who will tell you that within 2 years the office markets will be just like they were in 2019. They’re the ones with limited patience for the concept of remote or flexible work.

But the voice of the employee continues to dictate. They talk about how much they hate commuting. They’re talking about how they can be productive from anywhere - - - more so than when they’re forced to come to an office. They’re asking why they need to come to an office to do the same things they can do from anywhere. They want to be compensated for the work they do, not where they do it. These employees have had more than just a taste of a different reality, they’ve lived it for over 2 years now.

Personally, I think it’s time to acknowledge a new narrative, even embrace it. The office market is changing with or without the blessing of those who used to be in control. As with all times of great change, some will adapt early and be rewarded; whereas, others will hold steadfastly to the past and be punished.

Why You Need to Spend More on Design

Architecture, interior design and furniture design each impact how we feel. If you’re someone who is not particularly aware of this connection, take a moment over the coming days to note your feelings upon entering different buildings, different spaces. Notice the volume. Contemplate the impact of day light and other light sources. Consider the way the rooms are designed, the flow. What about the furnishings? Is it comfortable? Does it look interesting? Is there artwork? If so, how does it affect you? Does the space inspire you? Does it make you feel content? Does it make you anxious? Does it make you feel gloomy?

In the context of the modern office, design is having an important moment. Both occupiers and landlords are searching for ways to curate environments that drive engagement by making employees feel better. The tricky thing about design is you have to start by identifying the feelings you seek to create. It has to be intentional. This exercise is often uncomfortable for those charged with making such decisions. The default construct is about cost, not feelings. For many, it’s easier to choose a design that costs less because they remain largely unaware of how design compromises will end up costing more by muting the effect the space has on employees, clients and partners. Also, it feels risky for stakeholders to argue a more expensive design in the absence of proof of its positive impact. Choosing option A, which is cheaper than option B, yields the simplistic yet immediate result of cost savings, which is easier to understand than cost avoidance. Most organizations still reward near term cost savings.

The future of the office is as a place for employees, clients and partners to feel. Smart landlords will find ways to lean into design, to maximize the design impact their specific asset can have to ensure their building makes people feel good. Obvious steps they may take include designing pre-built spaces which incorporate strong design elements and showcase placement of high quality furnishings. This is not unlike the staging wave that hit the residential real estate markets over the past decade+. Why would a seller stage the home? Because there is always a positive ROI in terms of sale velocity and price. It’s worth it. It turns out the feelings a buyer gets upon entering a carefully curated room, filled with beautiful furniture and thoughtfully placed artwork is different than those one gets when entering the average home, which depicts a less thoughtful approach to design and offers a less aspirational image of everyday life. I’m sure you’ve noticed the strategic photography used to market homes that may otherwise be less than compelling. Artistic shots of objects, for example– objects that have nothing to do with the room, which is cramped and lacks good light. This is not by accident. It’s a marketing “sleight of hand”. The seller’s agent is smart enough to realize the emotions created by the space itself are not consistent with the price being sought. They need a more compelling visual. Many office landlords face a similar challenge. I’d strongly suggest adoption of the residential and hospitality playbooks which seek to impact feelings and experience.

We’ve written and spoken at length about how we believe the office is in an existential battle with technology (like the bookstore before it). How can the office reassert its importance? By great design. Great design makes us feel good, it draws us in. It connects us to place and to people in ways that cannot be achieved in the virtual.

When Workplace Isn't a Place

Technology used to compliment space. It was an adjunct to the physical office. However, today’s workplace is really not a place at all; rather, it’s a hub of technology resources that travel with the employee wherever she may go, which may or may not include a corporate office. Tech has jumped ahead of space as the more important element in defining the total workplace.

Technology and office space are two of the fundamental areas in which companies spend money to enhance the employee experience, to create more engagement and increase productivity. Until recently, the nature of this spending was mostly formulaic and dictated by sector norms. Yet, today, the workplace landscape is in flux and organizations are crafting their own individual solutions that are not necessarily tethered to industry standards. There’s a lot more experimentation, a lot more sensitivity to the needs and demands of their employees. Defining this modern workplace requires a completely different approach. A different conversation. It doesn’t begin with space. It might begin with demographics and geography, as in, where is the greatest concentration of key talent we seek to hire? But since nearly all workplaces will have at least some degree of hybrid, employees will need to be positioned for success with the right tech, so they can be productive regardless of where they’re working. Hence tech is at or near the top of the list of variables to be considered, ahead of real estate. Once you’ve identified the right markets and technology, you can then establish a supportive role for physical space, should it be part of the overall strategy. In this way, the balance has shifted. Space now compliments tech.

‍Interestingly, the advisory market has not yet evolved enough to properly address the new conversation occupiers are having. Workplace tech is the Wild West, with new products coming to market all the time. It’s difficult to find good advice as to which tech products are best suited to your specific needs. Furthermore, it’s counter-productive to have multiple conversations with multiple consultants, each of whom is expert in one facet of the total workplace (but whom may be biased toward driving specific outcomes in that segment which would not otherwise be optimal given complete knowledge of the total landscape). Occupiers need competent, agnostic and holistic guidance.

Several years ago we started down a path of bringing together technology and the full scope of occupier services being offered at C&W in order to develop a better approach to occupier real estate. We call this TenantSee. Of course, at that time, we were still thinking about this in a pretty traditional way. Yet despite the fact the world has changed far more and far more quickly than we anticipated, our simple shift toward full scope services that use technology to aggregate and analyze data has made all the difference. We’re not stuck in 2019, or desperately wishing the office market would revert to its former state. We’re looking straight ahead to what’s next. Our upcoming Café TenantSee event (being held on June 15, 2022 at our office at 425 Market Street at 9 am) is a great example. We’re hosting Impec Group, the leading workplace technology consultancy. We know that getting the tech right is vital to your success and we are pleased to have partnerships and resources available to help our community meet these objectives. We hope to see you on the 15th!

Got Leverage?

With the exception of premium view space, which is leasing at rates above pre-pandemic highs, many office owners in San Francisco are heading into a prolonged period when competition for tenants will be intense. There are several reasons, but let’s start with a few stats:

• Total San Francisco Office Market: 85M sf

• Currently Available: 23%, or ~19.5M sf

• 2020 Net Absorption: (10.6%) or (~9M sf)

• 2021 Net Absorption: (5.1%) or (~4.3M sf)

• Q1 2022 Net Absorption: (1.8%) or (~1.5M sf)

• Expiring Leases 2022, 2023 and 2024: 11.8% or 10M sf

• Assume 70% expiry extension rate: Add 3M sf, or 3.5% to vacancy

• Assume 60% expiry extension rate: Add 4M sf, or 4.7% to vacancy

• Assume 50% expiry extension rate: Add 5M sf, or 5.9% to vacancy

Prolonged vacancy of 20% or higher will put considerable downward pressure on rental rates and result in greater concessions as landlords compete to fill vacancies. I believe vacancy will remain >20% for at least 3 more years.

Here's why: Firstly, the trend in net new occupiers coming to San Francisco is not positive. In fact, despite record payrolls, the workers aren't here. They either live in the region but don't work in an office, or they live in a different part of the country or world. Given the strong employee bias against being forced back to the office and the significant economic benefits of leaving San Francisco for a lower cost of living, it's hard to forecast a reversal in this trend. Secondly, as a byproduct of job migration outside the region and of remote and virtual-first workplace strategies, San Francisco office demand relating to expiring leases is closer to the 50% level. Lastly, we’re heading into a potential recession; or, at best, a period of economic headwind that is already resulting in reduced hiring.

The data tells a story. Market participants often endeavor to spin it, one way or the other, to protect or enhance their position. I think the facts speak for themselves. Of course, the future is unknown. But it's clear that mitigating the mounting supply of vacant space will require wholesale changes to the trends presently characterizing demand, changes that aren't easy to effectuate. For these reasons, we are seeing a rapid shift in the landlord/tenant leverage dynamic. We anticipate material gains in tenant leverage to accelerate over the coming months.

Lease Security: How Landlords Underwrite Risk

Ever wonder how landlords underwrite the financial risk of your lease transaction? Or, why many landlords prefer a letter of credit instead of a cash security deposit? The security deposit was originally conceived as a mechanism to help the landlord cover ancillary costs that come up during the term and/or upon lease expiration. Typically equal to 1 or 2 months of rent, it did not cover much. Then, somewhere along the way, an enterprising landlord with leverage got clever and decided to negotiate for more value in order to better cover what really happens when a tenant defaults.

What is the landlord’s cost exposure with default? Here’s a hypothetical example: Tenant defaults 2 years into a 5 year lease on 10,000 sf. To make the original transaction, the landlord provided $60/sf in tenant improvements and paid leasing fees equal to $22/sf. The rent is $75/sf. The potential loss to the landlord includes the unamortized value of the initial costs, for sake of this example, we’ll simply straight line them over the term $82/5, or $16.40/sf/year. The 3 years of unamortized costs equates to $492,000. The monthly rent is $62,500. It will likely take ~3 months before the default is official and the landlord has taken legal action against the tenant. So let’s say we have $187,500 in unpaid rent. Then, depending upon the market, it will take a period of time to find a new tenant and the landlord will incur new expenses (tenant improvements and leasing fees). Even without accounting for new costs to secure a replacement tenant, the landlord is out $680,000, or 10.8 months of rent. That’s the realistic math behind default.

So why do landlords favor the letter of credit? Because it enables them to access the security, regardless of whether the tenant has filed for bankruptcy protection. In bankruptcy a cash security deposit is treated as an asset and is under the control of the bankruptcy court. The landlord gets to stand in line along with all other creditors.

Different landlords underwrite tenant credit differently. Some institutional owners have formulas and systematic ways of evaluating credit (sometimes provided by 3rd party analysts) and prescribing lease security. Others are less rigorous. All will look at the tenant’s basic financials for a period of at least 3 years (assuming there is 3 years of operating history). The requested financials typically include balance sheet, income statement and statement of cash flows. When dealing with technology companies, which often operate at a loss in order to continue to grow market share, owners will scrutinize the “burn rate”, which is a calculation of how long the company can survive given static expenses, no revenue growth and/or new funding. These days, there is a lot of emphasis on private market valuations – especially true with tech unicorns. However, it’s difficult for a landlord to make credit decisions based on private valuations. So while having a $2B valuation is great on paper, it is not something a creditor can take to the bank.

Given these variables, it’s not uncommon for landlords whom are underwriting a transaction with a young, money losing business, to propose a lease security equal to 6 – 12 months of rent. It’s vital to promote dialogue between the CFO and the landlord so the financial picture can be properly explained. It’s also important to note that these instruments are negotiable. For example, it is fairly common for the value of the L/C to “burn down” over the term. This means that as the tenant performs in good standing, the amount of lease security is reduced. The logic behind this is the landlord’s exposure is reduced with each year of fully paid rent. Another mechanism for burn down can be the meeting of certain financial benchmarks; for example, a profitability benchmark.

Negotiating lease security can also be challenging even when the tenant is a large, profitable company. Such companies often look to execute the lease using a “pass-through” corporation which does not hold assets. As a legal document, the lease is tied to a legal entity. Absent explicit agreements (e.g., guarantees), landlord recourse is tied directly to the legal entity on the lease. If this entity has no assets, irrespective of the scale and profitability of the company, the landlord is exposed. I have seen instances in which a strong credit tenant has ended up providing far more lease security than it otherwise should because it endeavored to hold the lease with an assetless entity.

While this may be strategic, it can also be costly. I’ve also seen instances in which occupiers have sought to negotiate the terms of the lease security in a vacuum, without the guidance of their real estate advisor. This nearly always ends up worse than it should because the finance executives don’t understand the market nuance around lease security. It’s a negotiated outcome, tied to market norms like most other facets of the lease negotiation. It’s important for the real estate advisor to be “in the tent” when it comes to presenting the tenant’s financials and developing the approach to lease security.

Essential Math

Office markets are big boats. They don’t turn quickly. There’s always a delay between negative macro-economic events and declines in rental economics. After all, it’s not as if landlords see the negative event and decide it’s time to lower rents. No, they resist. As long as possible. This creates a gap between where everyone knows the market is heading and where it is otherwise defined by comparable lease data. We’ve written in the past about how eventually a declining market reaches a point of broad capitulation when landlords are more unified at the bottom – this is when nearly all tenants benefit from the down market simply by showing up. The challenge facing occupiers whom are negotiating at the front end of the downturn is how to capture the full benefit of a decline that has yet to fully mature.

The key lies in using data to educate the landlord counter party as to its alternative outcomes in the event the tenant vacates the space. Comparison math is always a vital aspect of any good negotiation. But we need more than just the tenant’s view. We must also understand the landlord’s view, especially when the targeted outcome is pushing beyond the limits of where the landlord would otherwise transact. In the early-stages of a declining market, a successful negotiation will always push such boundaries.

The essential math is often referred to as “indifference math”. It’s about solving for the economic variables associated with a discounted lease extension that are low enough to reach the point at which the landlord is effectively indifferent to whether the tenant stays or vacates. Considerations include:

• Projected market rent for a new lease to a new tenant

• Projected landlord cost to provide market tenant improvements necessary to achieve the market rent

• Projected market term

• Projected free rent

• Projected downtime associated with the procurement of the new tenant

  • (e.g., the period of time vacancy of former tenant and rent commencement of new tenant)

• Potentially some calculus for credit differential between the former and new tenant

  • (this is relevant when the vacating tenant is strong credit such that the likely replacement tenant may present a downgrade in credit)

In modeling hypothetical landlord outcomes, we invite dialogue about our assumptions. If we can engage at that level (e.g., focus on what’s likely to happen if we vacate), we have a much better chance of capturing more of the downturn vs. transacting based on the most recent comps. In general, our clients whom are looking to extend leases require substantially less tenant improvements than new tenants and when extending the lease they enable the landlord to avoid downtime.

These 2 factors, alone, translate to big swings in value for the landlord. We find that we don’t often have much disagreement with the landlord about what we call the “full retail” value of their space (it’s just that we want our renewing client to pay wholesale). For example, let’s say they believe the space is worth $70/sf. We “agree” to that assumption, but we clarify that it’s the value a new tenant might be willing to pay for the space, including all the ancillary costs necessary to procure the new tenant (TI and downtime). Ultimately, a lease transaction is a basket of economic variables (term, tenant improvements, rent, concessions, downtime, etc.) which yield a total return. In today’s market, it’s entirely possible for a landlord to achieve a better return by offering an existing tenant a 10% to 20%+ discount to the value it otherwise believes it can achieve from a new tenant (full retail). If extending the existing tenant at a 20% discount to market creates a better yield and de-risks the future, why would the landlord not choose this option?

Landlords don’t want to see this math - - - sophisticated landlords have already done it. But still, what matters most is they know you know. To be sure, knowing the math doesn’t guarantee a favorable outcome. Both parties in a negotiation ultimately make their own calculations of risk and reward. Yet failure to negotiate with the benefit of this perspective often results in a less favorable outcome. When markets are declining, it’s tempting for occupiers to simply make lowball offers. Sometimes this approach succeeds, but it’s accidental. We’re all about creating the surest path to positive results, one that leverages our considerable data and knowledge of how landlords evaluate transactions to do the essential math.

Following the Money: A Tenant Advisor's Compensation

Ever wonder how and/or how much a tenant advisor is paid? It’s an obscure compensation model. In the interest of transparency, we thought it might be useful to provide a more detailed view.

Tenant advisors (in most cases) are not paid a salary. Their compensation is usually 100% commission-based. This is among the reasons why the industry lacks diversity, both racial and socio-economic…it’s nearly impossible for someone without a measure of financial support to get started. The path to compensation begins with being retained by a client. Yet being selected to advise a client is not easy. It is typically the culmination of a long period of marketing, knowledge sharing and relationship building. Developing a meaningful relationship may take several years (and probably should). Hence a lot of the activities in which a tenant advisor is engaged are non-compensatory…they’re speculative.

Once retained, there is a spectrum of outcomes that are determined by the complexity of the project, the scope of the services and the overall nature of the engagement. It is not uncommon for a lease project to span 12 – 18 months. During this period, the tenant advisor is actively serving the client but is also not compensated. Compensation occurs only after a transaction is completed.

So we’ve got a situation in which the tenant advisor has worked hard to build a good relationship for 18 months, convinced the client that she is the best advisor for the project, been retained and then worked on the transaction for 18 months. At this point, she is 36 months into the journey and has yet to receive any compensation. The typical commission structure calls for her to be paid ½ the fee on lease execution and ½ on lease commencement. Commencement is typically 6 – 12 months after lease execution.

Let’s look at a typical San Francisco lease as an example. The client is leasing 10,000 sf of space for a 5 year lease term. The total leasing commission is $150,000. Most tenant advisors work for firms that share in the fees. The firm provides administrative support, a network of resources, brand/marketing and other services to the advisor in exchange for a portion of the fee. A typical “split” is 50%. So upon lease execution, the firm would be paid $75,000, of which the tenant advisor would receive $37,500. The second ½ payment would come at commencement, maybe 9 months later. As you can imagine, tenant advisors need to store cash in order to pay themselves throughout the year. They also need to set aside funds for taxes which are not usually withheld from the payment (brokers pay quarterly taxes). There’s a lot of cash flow management necessary to make it work.

Tenant advisors have 2 basic ways to grow revenue. They can either do more transactions or they can do larger transactions. The volume approach usually relegates the advisor to smaller transactions which are completed more quickly; whereas larger transaction are usually more complex and time consuming. Interestingly, the 2 markets end up being mutually exclusive in the sense that working the small transaction, high volume approach precludes the advisor from relevance in the larger, more complex market where competition is stronger and clients are making hiring choices based, in part, on relevant large transaction experience. It’s thus a delicate balance to determine how to advance one’s career and grow the business.

We’ve written often about the importance of understanding how tenant advisors are paid, of aligning compensation to services. To be sure, it’s an unusual model, one in which all market participants would benefit from greater transparency and closer alignment of interests. Despite the challenges of the compensation model, the inherent risk, most tenant advisors serve their clients with integrity, upholding their fiduciary responsibilities. It’s always important to know how (and how much) your advisor is being compensated.

Culture and the Modern Workplace

Culture: noun: the customs, arts, social institutions, and achievements of a particular nation, people, or other social group.

We all want to be part of something great. We want our workplace culture to be worthy of its “Best Places to Work” status. But in many cases, the corporate “cultural persona” does not fully reflect the cultural reality.

Why? Firstly, leadership. Leaders tend to focus on the desired culture as opposed to the existing culture. It’s easier (and more uplifting) to identify the cultural characteristics you want, as opposed to sifting through the complexities of the culture you have. But when the aspirational culture fails to align with the existing culture, it results in an authenticity problem. However, you can’t fully blame leaders. Most companies lack the right incentives for leadership to invest in the hard work and difficult decisions necessary to bridge the gap between existing and aspirational culture. For example, achieving cultural alignment might necessitate terminating individuals who are financially productive but culturally cancerous. There could be entire groups within the company who behave in a manner that is inconsistent with the aspirational culture.

Establishing a culture that is intentional and truly reflective of specific corporate goals requires years of practice. It’s hard work. A good example is Goldman Sachs. David Solomon, Goldman’s CEO, has been outspoken about the need to have Goldman employees back in the office. He has very specific reasons for this, which tie directly to Goldman’s culture. If you listen to him speak on the subject, you will quickly realize that his views are not reactionary or based on this moment in time. He is speaking about the office in the context of how it fits into Goldman’s long established (and cherished) culture. For Goldman, having employees work remotely is antithetical to its culture. It’s an existential threat to how it develops its employees and creates the powerful networks vital to its success.

Contrast Goldman’s unflinching views on the office with the wishy washy uncertainty that is so pervasive today. The reason so many are unsure about how to define future workplace is because they are unsure about the underlying culture they seek to promote. When culture is known, the workplace strategy is less mysterious. This is because the workplace is not the defining element of corporate culture, it is a part of the whole. What happens when workplace strategy is disconnected from actual behavior? Culture suffers. A timely example would be the promotion of a virtual-first workplace when the actual workplace is biased toward in person participation because leadership is in office and (despite the messaging) regards those who work virtually as less committed.

In the end, corporate culture is determined by the intentional acts of leaders who consistently promote and support the foundational elements of a specific cultural objective; or, it is determined by the lack of such leadership, by the gap between what a company says and what it does. There is risk when companies thoughtlessly identify cultural initiatives without understanding how they fit the existing culture, without assessing the change necessary to integrate them into the existing culture. It’s become clear these past couple of years that many companies are not maximizing the benefits of the workplace, they’re not engaging the employee as fully as they otherwise could. The workplace is a cultural opportunity, but one that must be approached thoughtfully.

Stupid is Easy (and expensive)

In tenant-favorable market environments, landlords often provide more concessions to compete for tenants. Concessions come in many forms, the most obvious being, landlord funding for tenant improvements, free rent, reduced rent and more flexible lease terms. But understanding the value of the concession is not always easy, especially relating to tenant improvements, one of the biggest economic variables in leasing.

The cost of tenant improvements is less straight forward than rental rate because it’s usually not directly correlated to the actual cost to build the space. In most cases, it is expressed as a landlord funded tenant improvement allowance, or “TIA”. Understanding the real value of a TIA necessitates knowledge of the actual cost to design and build your specific space. Remarkably, occupiers often lack this critical knowledge before signing a lease. This creates risk and cost exposure. Today, design and construction of standard office space costs ~$200/sf, or $2M on a 10,000 sf space. Landlords are keen to negotiate this aspect of the transaction while the tenant is still ignorant of the actual costs. In the current San Francisco market, a standard TIA for a longer term deal would be ~$100/sf. Note this leaves the occupier with a $100/sf exposure in funding the full cost to build new space.

How can occupiers negotiate a more favorable outcome? The first step is to prioritize understanding cost and schedule relating to the design and construction of tenant improvements. This requires engagement of an architect and general contractor at the onset of the project. These experts should work “hand and glove” with the real estate advisor to test fit and develop basic space plans for target sites. Thought should be given to the construction and level of finishes necessary to build the optimal office. Test fit, planning and ROM budgeting should be undertaken for all serious site options. Yes, there is a cost to this effort in the form of programming, test fits and space planning. However, these are all costs you will incur, in any case. Our approach simply moves them to the front of the schedule, where the knowledge acquired can be leveraged for a better outcome.

You might be wondering why understanding the cost of construction remains largely outside the realm of the typical broker-led tenant advisory service? The reason is because acquiring this knowledge adds complexity and time to the transaction process, creating more risk and less profitability for the broker. This ties back to the misalignment of interests we’ve written about in the past. Stupid is easy, smart is not. If the leasing process seems simple, centered on finding a building and negotiating a “market” transaction, including a “market” TIA, maybe it’s time to consider a new approach?

Thinking vs. Doing

Much of what we “do” every day is driven by long established norms, norms that most of us rarely give much thought. Societies always have outliers who think about things a little differently. Often, these thinkers are entrepreneurs. Their journey usually begins with “why” or “what if”. Why are most people seemingly happy to exist within the status quo? I believe it’s the discomfort created by stepping outside the normalcy bubble to think for oneself. Just spend one day asking yourself why you do the things you do and you’ll see how easy it is to imagine different solutions. Of course, you have to accept that your solutions might be worse. And should you wish to advocate for your new solutions, be prepared for resistance. People resist out of fear of the unknown, or because they have a vested interest in keeping things the same. But resistance is a powerful force against change.

I believe this dynamic is now playing out in the context of the office. For generations we’ve conceived of the office in the same way. The peripheral voices of the thinkers who put forth data and arguments in favor of remote work, or shorter work weeks, or the virtual workplace have been there for some time, but they were difficult to hear amidst the steady drumbeat of a massive industry (the office market). Companies thought they needed the office to be productive. Employees thought they needed the office to be connected. Investors and developers thought their office buildings were susceptible to market change, but only change within a relatively narrow band of supply/demand economic outcomes driven by traditional macro-economic stimuli – not existential threats.

From my small window I see enduring changes taking place that will have meaningful impact on cities, on office markets and on how companies and employees work. It’s not too soon, in my opinion, to identify some clear trends. These include reduced demand for space based on new workplace strategies. For evidence, look no further than San Francisco, where current office jobs are greater than the pre-pandemic peak when office vacancy was 4%, yet today the office market is 20% vacant. Many in the office market speculate there will be a reversion back to the norm (pre-pandemic). Maybe. But only if hybrid, remote and virtual-first workplaces begin to fail. They have not done so yet. In fact, many companies have enjoyed increased productivity during the pandemic. What will failure look like? Inability to retain talent will be one indicator. Reduced productivity is another. Challenges managing the distributed workforce would contribute. We must also consider that once a previously accepted norm is turned upside down and the questioning begins, the answers aren’t necessarily binary. In fact, future outcomes are unlikely look like the pre-pandemic norm or the current state, they’ll be something different. One “for example” would be the conversion of an otherwise obsolete office building into a vertical corporate community in which employees work and live. Talk about a way to retain talent - - - housing, onsite daycare and the office experience, all in the same building. Whatever the future holds, the current moment is more about thinking than doing. This will be uncomfortable for some, and there will be winners and losers. Progress is always measured in this way.

Equity and the Hybrid Workplace

Workplace equity is a big, important topic. The pandemic has helped advance a better discussion about how to create workplaces that are more inclusive, that support the specific and differing needs of the employee base. It’s not so much that we’ve learned our offices don’t serve all equally well, we already knew this. Instead, companies have been forced to address this reality head on because the concept of the office has been turned on its head. The act of creating equity when everyone was remote has (hopefully) built some institutional “muscle memory” that will serve us well as we embark on what’s next.

But it’s what’s next that concerns us (somewhat). Why? Because the reality of supporting and promoting an equitable workplace in the hybrid context is complex. It requires the right technology, clear intentions, consistent training and strong support from leadership. Let’s start with technology. This is perhaps the easiest piece of the puzzle. Many companies (my own office included) don’t have the right technology in place to support an equitable experience. For example, I recently endeavored to remotely attend a meeting that was otherwise mostly in person. My participation was via call in, facilitated by one speaker at the center of the conference table. I had no visual connection to those in the room, nor they to me. The sound was terrible, when all were chatting before the meeting began, it was unintelligible, and when individuals were speaking, it cut in and out such that I heard every other word.

After 5 minutes, I disconnected. In fairness, the company I work for is not (necessarily) intent on supporting or promoting a hybrid workplace (the disappearance of the office is an existential threat to the business). So our workplace solution strongly encourages all to be in office. But the world has changed and even at companies that favor having all in the office, there will increasingly be a need for virtual participation and such participation must be equitable. What does the right tech look like? Well, at a minimum, it gives the remote/virtual participant an equal experience as those attending in person. It must put the person in the room, with an equal visual and audio experience.

The elements of success which depend upon human behavior are more challenging. Starting with intent. We are finding that a lot of companies are using language to describe their future workplace that while seemingly in step with the current trend, is often not fully understood. For example, “hybrid”. Hybrid is a catch all for workplace solutions that support both in person and virtual participation. Simply labelling your workplace as hybrid and giving employees the choice of being there, or not, is not a quality solution. Your particular brand of hybrid must be carefully developed. Thought must be given to all aspects of the employee experience. The steps you take must be intentional, chosen based on the extent to which they fit with the overall objective.

On the subject of training, we can’t say enough. None of this will work if a large or otherwise powerful contingent within the workforce ignores the new protocols essential to promoting an equitable experience. For example, if the workplace is described as hybrid, theoretically equal to both in office and virtual employees, but the balance of power sits in the office and favors those who are also in office, you have a problem. The solution is training around hybrid workplace etiquette and use of the technologies that promote equality.

Of course, massive changes to the workplace will be doomed to failure when they lack vital support from leadership. Leadership must actively demonstrate the desired behavior, must be the first to adopt new technologies and practices that support an equitable hybrid workplace and must diligently tamp down resistance, the inevitable tendency by some to revert to old, familiar ways.

If this suddenly seems very complicated, it’s because it is. If we look to the best examples of companies that are actively advancing hybrid workplace, or remote-first workplace or any new strategy that is other than “we expect you in the office 5 days a week”, we will see many months of work by leadership across all facets of the organization and ongoing policies and procedures to ensure success. We believe the modern workplace can be better for all, but getting there will likely require more time and effort than most realize. This is a moment when the workplace can change in ways that truly support a more equitable experience for all, creating lasting value for both employer and employee.

Where Else Can You Go?

One of the more interesting outcomes from the pandemic has been the advent of a new competitive factor for landlords to contemplate when negotiating with existing tenants; namely, the possibility of no office, either as a permanent or temporary solution. When a company is willing to let the lease expire without having secured an alternative office solution, it takes one of the landlord’s most effective “levers” out of play. As we’ve written about in prior posts, landlords are very good at using time to their advantage. Historically the closer the tenant gets to lease expiration without having fully negotiated new deal terms, the more leverage the landlord has to command better terms.

Prior to the pandemic, negotiations followed a fairly typical timeline. The lease expiration date always served as a hard line by which something had to be done. This is no longer the case, especially as we work through the first phase of post pandemic occupancy. Even for occupiers who have every intention of returning to the office, the fact most employees have been working remotely for a couple of years now makes it possible to extend remote work for some period of time while working on the right office solution. A lot of landlords will underestimate this variable. We’ve already seen instances when the tenant has established a price point at which it would consider a short term lease extension and the landlord has countered with terms that imply they perceive more leverage than they actually have. When the tenant simply walks away from the negotiations, the landlord is often surprised.

Instead of negotiating to avoid the possibility their tenant may relocate to another building, today landlords must realize they are solving for a broader spectrum of places the tenant may go, including home. The next couple of years should bring a steady uptick in leasing activity as companies recommit to the office. But that commitment will look different than it did in the past. The pathways taken to formulate the new office may also be different, possibly undertaken with less pressure attributed to the expiring lease.

3 Reasons Why Demand for San Francisco Office Space May Remain Low

With overall market vacancy north of 20%, the San Francisco office market has more available supply than at any time in the past 20 years. But with its tech sector engine, many believe the market will rebound swiftly as the pandemic eases.  However there is mounting evidence San Francisco may be in for a prolonged period of reduced demand and high supply. 

The first reason is the broad adoption of hybrid work solutions that look to change the way the office is used and (often) result in the leasing of less space.  While it’s too soon to know the exact level of impact these new approaches may have, early data would suggest a 10% to 15% reduction in demand.    

The second driver is remote work.  When San Francisco-based employees relocate and the company follows and/or the company actively pursues a distributed workforce by hiring in other regions, it has the effect of reducing demand for San Francisco office space.  We are seeing a shift in the location of job postings for many San Francisco tech companies. They’re hiring, just not here.

Third is the commute.  San Francisco was built around the idea of public transit.  But people aren’t eager to ride packed trains and buses.  The presence of Uber and Lyft, coupled with the increased level of drivers trying to access the urban center via car, has already made city streets seem overly congested despite <30% of the downtown working population having returned to the office.  The challenges of commuting into the city will, in part, fuel greater demand for remote work and drive employees out of the region.

The combination of these factors has begun to erode the powerful pull of the City’s business ecosystem, a place where startups and mature companies alike begrudgingly signed expensive leases because they felt they had to.  To be sure, the City remains compelling due to the  venture community, educational institutions like Stanford and Cal and the aggregated presence of so many technology companies and their employee talent.  But it’s also a time when office building owners should keep a close eye on trends in demand and be nimble in adapting to a changing market.

Underwriting Tax Increases (Before You Lease)

Over the past decade, many office buildings in San Francisco have been sold, some multiple times.  For tenants, these sales translate to material increases in the cost of the lease.  Why?  Primarily because of taxes. 

California  has Prop 13, which limits annual increases in real estate taxes to 2%, excepting at the time of a sale or financing of the asset, at which point the tax base is adjusted to market, often causing a big spike in taxes.  It’s in these latter scenarios, a sale or financing, when tenants are exposed to potentially large cost increases.  This is true because the tax attributable to a sale or financing is passed on to the tenant. 
 
For every $100/sf in increased asset value, the rent increases by $1.50/sf.  So if a company leases space in a building that has a tax base value of $400/sf and the building subsequently sells for $800/sf, there is a $6.00/sf/year increase in the lease cost.  For a 10,000 sf lease, the added annual cost is $60,000.    
 
Yet for all but the largest tenants (e.g., leasing a large portion of a building), tax increases are unavoidable since landlords will not readily negotiate what is known as “Prop 13 Protection”.  The most advantageous form of such protection would simply be to prohibit tax increases due to a sale or financing.  However, the tax doesn’t go away.  If a landlord agrees to such a provision (and it almost never would) the effect would be to lower the value of the building.  When Prop 13 Protection is given, it is typically in a phased context, offering limited protection.
 
So what are most tenants to do, understanding that protection is not available?  The answer is to underwrite the potential for such an increase while evaluating leasing options.  To do so, when dealing with buildings which have a low tax basis, we run 2 iterations of the financials, one that shows the rental economics as negotiated, and one that shows the potential impact of a sale or financing.  This creates visibility for a key issue and helps the tenant make a fully informed decision.  This is particularly relevant because a building that has been owned for long period of time have will have a lower tax basis and typically offer more compelling rental economics (e.g., less expensive to lease).  Hence it’s possible for a tenant to think it has chosen to lease the lowest cost scenario only to have a sale occur mid-lease which spikes the cost, making it the most expensive.  As with most things relating to good tenant leasing outcomes, acquiring key knowledge early and understanding risk, makes all the difference.

Sucking More, Not Less: A Modern History of the Office Lease Document

Ever wonder why the office lease is 60+ pages of single spaced madness? The answer is simple. The “selling” of protection from crafty attorneys and incident-driven drafting. With the former, lawyers craft language and sell it to institutional clients as creative mechanisms for protecting landlord value. Over the years, I’ve seen “gotcha language” buried deep in all sorts of poetic BS. Firms have incentive to create these documents because protection sells. In the latter, incident-driven drafting is what happens when a tenant and landlord have a dispute and the landlord says, “…let’s draft language so that never happens again.” As you can imagine, throughout the decades, there have been many disputes and issues between landlords and tenants, greatly adding to the heft of your lease document.

But despite being a terrible read, there’s a lot to pay attention to in a lease document. You see, these documents are created first and foremost to protect the landlord’s interests. That’s not wrong, it’s just a fact. After all, the landlord arguably has more skin in the leasing game than the tenant since they put up the money and took the risk to buy or develop the building.

To be sure, the quality of the lease document is a key determinant in the overall quality of the lease. Getting a great deal on the rental economics is important, but failure to capture the best possible legal outcomes will ultimately reduce the value of the tenant’s lease. In most cases, the letter of intent fails to cover a broad swath of very important details that, when poorly negotiated, can cost tenants dearly. For example, the operating expense and tax provisions, wherein lies a Pandora’s Box of issues. And then there’s what I call flex factors, like the assignment and sublease provision. Getting those wrong can prohibit or reduce a tenant’s ability to exit the lease.

Hiring a competent attorney whom specializes in leasing is the only way for tenants to fully protect themselves. Absent such representation, tenants are often exposed to language that is designed to benefit the landlord. A good lease is not a matter of what’s fair…it’s a matter of what’s negotiated. That’s how you make the lease suck a little less.

Intent, Policy, and Behavior

It’s not uncommon to see discrepancies between corporate policy, the intent of the policy and the actual behavior of the leaders who are charged with implementing the policy. Jan Johnson and Jeff Leitner have studied this phenomenon in their work on the power of unwritten rules in shaping human behavior. I was thinking about their work as I recently participated in a panel discussion titled, “The New Geography of Work”, hosted by the Northern California Chapter of CoreNet. The discussion was fascinating, mostly thanks to the contributions of our moderator, Robert Teed of Integri Group, and the smart panel members, Kate Lister of Global Workplace, Chandler Bonnie of Dropbox and Irene Thomas Johnson of JLL.

A couple of the key takeaways: 1) it’s not easy to design and implement a new workplace strategy, especially one that is radically different, and 2) it’s incredibly important for leadership to “walk the walk” in support of the new approach. A great example of this is Dropbox. Here, we have a company that in 2019 was office-first with nearly a million square feet of office space (in San Francisco, alone). Now, just 3 years later, the company is what Chandler calls “virtual first”. You get the picture - - - a physical office is not the first place the employees show up to work. But getting here was not as easy as making the decision and sending a memo. Instead, it involved a deliberate, years long, discovery process that engaged all facets of the organization. And once they settled on the approach, the real work of training and implementation began and remains ongoing. Dropbox employees continue to learn about their new workplace every single day. Without sponsorship at the highest level, this type of radical shift has the potential to create far more harm than good.

Another striking aspect to our conversation was the mostly hopeful and optimistic expectations for the distributed workplace to deliver better results in the context of DEI. Panelists spoke about how greater flexibility in how employees work is opening up the field of candidates to include individuals who would have otherwise been unable to compete. More access, more competition, more flexibility…what’s not to like? As we continue down the path of defining the future workplace, I’ve no doubt mistakes will be made. But when intention, policy and behavior are aligned, when the organization goes all in on making it happen (however “it” may look to them), new solutions will have a positive ROI. In contrast, the worst outcomes will reflect a gaping chasm between what the company states as its workplace strategy and how its leadership actually works.

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.