Unpleasant to Existential
When the pandemic hit in 2020, emptying San Francisco office buildings, landlords were mostly unfazed given high levels of occupancy and income. As the pandemic gained momentum, some owners began to quietly wonder if this could be bad enough to render their buildings empty for a prolonged period. Yet it wasn’t until late 2021/early 2022 that investors began to fully grasp that appetite for their product had changed in significant ways.
The underlying economic fundamentals of the office market are, of course, a product of the supply/demand dynamic. For decades, San Francisco office investors enjoyed a market characterized by surging demand and limited supply, resulting in ever-more favorable leasing fundamentals. Occupiers were forced to navigate a market that at times bordered on ridiculous. While the pandemic initially caused many landlords to brace for a difficult period in which some “unpleasant” deal making would be necessary to ride through the cycle; now, some 3 years on from the first utterances of COVID-19, the situation has shifted from unpleasant to existential.
Office buildings are an expensive investment. They cost a lot to build, to buy and to run. They require ongoing investment to ensure successful leasing. To generate better returns, they’re usually financed with debt. These days most large office assets are owned in a financially engineered partnership consisting of equity and debt. These partnerships are designed to maximize returns. Like any investment, they’re a bet on the future. The investment is mostly conceived to generate profit. Less attention is given to preserving the investment if the bet goes wrong. Investors can weather some amount of downturn, but there is a point at which the structure breaks down. Many San Francisco landlords are there now. This is not as much the result of bad bets, as it is a “black swan” event. The current state of the market was not reasonably predictable.
But here we are. It’s important for occupiers to understand what is happening as we enter a period of significant dislocation. In simple terms, think of the San Francisco office market as having an underlying cost basis in the range of $800/SF, a value that requires rents of about $80/SF across about 85% of the asset to generate adequate NOI to maintain valuation. So those would be the basic characteristics of an investment that was performing adequately well. Yet with demand off by as much as 50%, supply steadily increasing and now standing at about 30% available and rents on the decline, now standing in the low $70s for all but the most premium view spaces, the $800/SF investment structure is untenable. It must either be broken in favor of a totally new investment (one with a much lower cost basis), or the original parties must elect to invest more in the asset and incur even greater losses to hopefully ride through the cycle to a future in which the asset can regain its lost value. This latter scenario is unlikely given the severity of the downturn and the lack of visibility into future of office occupancy.
It takes time for a dislocated market to find its equilibrium. During this phase, occupiers must be aware of which assets are “broken”. Make no mistake, we’re now in the existential phase and while the losses are on the landlord side of the table, the impact can have negative repercussions on occupiers, as well.