The Great Reset and Rent
The so called “capital stack”, the money investors and lenders have put into an office building investment, has recently been the subject of much discussion in markets like San Francisco. In many cases, the stack is broken, meaning the investor has lost all its equity and the value of the lender’s position is compromised, as well. We’ve reached a point at which these financial partners have concluded there is no path forward for the investment, leaving only one option: sell. This is how the Great Reset begins. It’s exemplified in the sale of buildings like 350 California Street, an asset that would have traded in the $800/sf+ range prior to the pandemic, but which traded in the $250/sf range this year.
The question is, how will these resets impact rental economics? Intuitively, it makes sense to conclude the new financial partners will lower rents to compete more effectively, thereby adding velocity to the pace at which rents fall. After all, the reason the prior investors we unable to transact was they had no capacity to generate a positive return in doing so. In fact, transacting would have required the parties to invest more capital on an already failing investment with a very uncertain pathway to gaining any positive future ROI. Surely these new investors can achieve a positive return by leasing at lower rents. While this seems logical, they face some major hurdles.
Firstly, investing in office today is risky at a time when investors can otherwise achieve comparatively high returns through investing in very safe investments. Office investors need to achieve strong, positive IRRs on their investment to justify the risk (otherwise, why do it?). This means the deals they make need to have a positive yield now, as opposed to generating the potential for positive returns years from now via sale. Also, while debt is expensive and hard to get, it remains essential for most investors to hedge the investment risk with debt. While the value of the debt is lower, commensurate with the value of the asset, interest rates are 2X pre-pandemic levels. Debt in this market, as a component part of the investment thesis, can thus be a larger factor than in prior cycles as it has a greater impact on the landlord’s ability to achieve positive net rent outcomes when margins are thin.
Next, despite the overall acquisition cost going down, the cost of construction has remained at all-time highs. In fact, as we’ve noted in the past, it’s possible today for the cost of the tenant improvements within the building to cost more than the cost to acquire the building. For example, the investor buys at $225/sf and the tenant improvements cost $250/sf. This is a highly relevant matter as making a building compelling in a 35% vacant market requires heavy spending on improvements and amenities.
These variables combine to create an effective floor on rental economics, a point below which few will go because there is simply no economic incentive to do so. Hence, despite the The Great Reset (and, yes, this is going to happen), we won’t see the kind of decline in rental rates we would otherwise assume. Assets that trade will be acquired by “risk-on” investors, but they will still have a challenging path to profit. The building which trades at a 70% discount to its prior value will not be able to offer rents which are 70% below the prior value. The new capital stack will proceed cautiously to achieve positive returns. They’ll be able to do more than the prior capital partners, but they won’t be able to do it all (e.g., lower rent AND spend large amounts of capital).