It's Tricky

Despite being awash in available space, the San Francisco office market can be tricky to navigate.  By now, everyone knows the market is distressed.   When companies explore leasing options, they do so with the expectation they will be able to trade up for better quality space at substantially reduced pricing; or, they expect to significantly decrease the cost of their existing space with a lease extension.  These are reasonable expectations, yet they can be elusive for several reasons.
 
Firstly, there is the issue of scarcity in the premium space market segment.  Over the past couple of years, when tenants have chosen to relocate in San Francisco, it has often been to premium view space.  Landlords, experiencing steep declines in the value of commodity space, have made a last stand, holding firm or increasing rents for the best space in the building.  And occupiers have shown a willingness to pay.  There are few bargains in the premium space market.
 
Another surprising and unanticipated factor is the cost of building new space.  While rental economics have fallen, construction costs have continued to rise (don’t ask me how this makes sense, I can’t tell you).  These days, when tenants choose to relocate, they’re mostly focused on creating custom designed space that better solves for return to office.  But it’s very expensive to build new space and landlord allowances typically cover about one-half the cost, leaving the occupier with a very large cap ex to manage, often making the transaction non-viable.   
 
Then there’s the non-performing asset issue.  We’ve expanded on this previously, but the short version is some landlords and their lenders are simply not in a position to make deals right now.  The capital structure of the asset needs to change and has yet to do so.  These non-performing assets can be tricky to identify, as absent good advisory, you only know when you know.  This same issue can impact the values a tenant might achieve in a lease renewal where the landlord is simply unable to meet the market.   
 
All these variables combined make for a more challenging market than would otherwise be expected given the circumstance.  The one place where occupiers are near certain to see value commensurate to the distress in the market is in the commodity space segment.  When a company is willing to lease space in the lower half of the building, where the view is typically obstructed and the light constrained, landlords not struggling with capital stack issues will offer great value to secure the deal.  Yet as noted earlier, most tenants who are otherwise looking to relocate have a strong interest in upgraded space options… they’re not really focused on the commodity supply.  It can be tricky out there. Our simple advice?  Retain a qualified, experienced advisor from a firm that is sufficiently resourced to understand the full landscape (capital markets, etc.), give yourself plenty of time and be sure to look carefully at not just the asset, but also the capital stack to avoid non-performing assets.