A Few Thoughts on the State of San Francisco Office Market
We normally reserve discussion of market fundamentals for our Quarterly market updated, “The Tenant’s Perspective” (which we release just after the close of the quarter). However, as we near the close of Q1 2023, there are several narratives playing out which we deem significant in shaping the near and mid-term market dynamic. We think it’s important to share these now.
By early 2022, demand for office had begun to recover, albeit at considerably lower levels than pre-pandemic. However, by Q3 of 2022, regional demand was once again stalled. Transactions begun in 2021 and 2022 are limping across the finish line, but new demand is muted as companies continue to downsize and/or look to sublease space. The tech sector has experienced significant layoffs and new sublease space has continued to come to market. We are on pace to close Q1 2023 with about 500,000 sf of gross leasing activity, the lowest on record other than Q2 of 2020, when the pandemic froze the market.
Speaking of sublease space, the sublease market is capitulating. Many would be sublessors have been unable to attract a deal for well over 18 months. Available terms are getting shorter, impacting value and sublessors are simply giving up, willing to accept even a modest recovery. Beginning in Q1 2023, sublease rates have begun to drop precipitously. Quality space can now be sublet in the $30s. This is noteworthy for a couple of reasons; 1) most sublessor’s are paying north of $80/sf for their space, so the sublease rents represent a mere 20% to 30% of the existing obligation and 2) sublease values do impact direct space values. When quality sublets that have 3 years or more of term are leasing at such low rents, direct landlords are forced to lower their rents to compete. Expect to see more aggressive downward movement in direct rental rates.
The inevitable outcomes one would expect in a market that is >30% available and which is characterized by decelerating levels of demand are now showing up. Dislocated ownership structures are seeking solutions and there are no easy answers. Equity is lost and, in many cases, debt levels may also be “out of the money”. Special servicers, entities that get involved when owners default on debt and there is not a clear path forward, are increasingly busy. We’ve written recently about non-performing assets, the phenomenon when a building’s capital structure is out of whack with the underlying market such that the building cannot lease space. San Francisco is now seeing a growing number of assets in this category, making the market less transparent and navigable for occupiers.
The San Francisco office market is the most distressed major office market in the US. The market was already a laggard in terms of RTO and was struggling to recover from the profound effects of the pandemic. The impact of macroeconomic events on the tech sector, big and small, has hit the region hard. Occupiers looking to lease space in this environment will have generational opportunities, but achieving such outcomes requires thoughtful strategy informed by a broad base of knowledge inputs, including a full understanding of capital market implications.