Swimming Naked: The Risk of Non-Performing Vacancy

Over the past decade the San Francisco office market was among the most desirable global markets for institutional office investment.  Valuations increased by 100%+, and many assets traded…some multiple times.  Even those that didn’t trade were often refinanced at substantially higher values, enabling the equity partners to take out significant amounts of capital.  Today values are dropping as demand for office space in San Francisco is at historical lows, causing rental economics to decline rapidly.  This presents unique challenges that are (typically) not entirely obvious to occupiers; namely, a full understanding of the debt and equity stack and the landlord’s ability to perform. 
 
We’ve always believed it’s important to understand the landlord’s financial structure.  But today it’s critical, as many ownership structures (debt and equity) are broken.  There’s simply no way to generate a positive return by doing market transactions, and there is no reasonable future exit scenario which would otherwise compel the landlord to deepen the losses it’s already experienced. When this happens, it creates what we call “Non-Performing Vacancy”.  Non-Performing Vacancy presents a risk to occupiers.  The risk is in not knowing the landlord can’t perform.  You see, landlords won’t hang a sign on the building that says, “closed for business”.  Risk of Non-Performing Vacancy is at its peak at the onset of a major market downturn (right now) because none of broken financial structures have been fixed.  The original equity and some portion of the debt may be under water.  But the lender may not be interested in taking back the keys, leading the parties to negotiate a short term “extend and pretend” arrangement that keeps the lights on but does not allow for market-based performance, for deal making.  Non-Performing Vacancy will continue to be marketed for lease and these landlords will continue to negotiate with prospective tenants.  In many cases, their inability to meet market will become clear through the negotiation process, however, in some cases, a proposed lease may get all the way to letter of intent only to be rejected by a 3rd party, usually a lender.  At this point, the occupier may have squandered a good portion of its timeline, necessitating that it resets its process under significant time constraints which can impact leverage.
 
Counterintuitively, as Non-Performing Vacancy is identified, the assets are effectively removed from the supply brokers will otherwise consider in selecting options for their occupier clients, having the effect of temporarily making the market a little tighter (less supply).  Non-Performing Vacancy becomes Performing Vacancy (is fixed) when one of two things happens: 1) the existing financial partners elect to double down on their original investment and take more losses now by meeting the market in order to possibly recoup their investment downstream, or 2) the asset is recapitalized with new equity and new debt at a new, lower valuation that facilitates productive performance in the market, such as it is (meaning they can make money based on existing rental economics).  Of course, the latter scenario requires the original landlord (and quite possible the lender(s)) to take a loss.  We’re always reminded of Warren Buffet’s great quote about swimming naked:  “…when the tide lets out you see who has been swimming naked”.  The tide is letting out.