The Artificial Floor
Currently, there’s a lot of downward pressure on rental rates in the San Francisco office market. This is caused by a massive uptick in available space (4% to over 30+%), the proliferation of subleases in which the sublandlord is motivated to mitigate cost, not achieve target NOI, and the presence of owners having a materially lower cost basis, either through a long-term hold strategy, or a recent acquisition at steeply discounted pricing, both of whom can compete at much lower rental economics. Indeed, the economics being offered by these parties stands in stark contrast to those offered by landlords who bought or refinanced in the years running up to the pandemic. This latter category, by the way, encompasses a large swath of the market. These investors are struggling against a confluence of factors, including rising interest rates, maturing debt, rising insurance costs, decreased demand, lack of capital, and valuation outcomes that put equity and debt underwater.
To the untrained eye, office buildings may seem to be valued like houses, where location, size and quality of design play a key role in determining value. While these factors do matter, the leading indicators of an office building’s value are its net operating income (“NOI”) and weighted average lease term (“WALT”). Location, size, and quality of design are more associated with the building’s value floor. From the occupier perspective, when 2 buildings offer comparable space, but one is priced at half the value of the other, the choice is easy. Those owners struggling against cost basis will often propose terms that are more aligned with the 2019 office market than that of 2023. This is not because they don’t get it. It’s because the structure of their investment simply can’t support going where they otherwise need to go to compete. This is precisely why we’ll see more assets become available for trade with owners/lenders that have fully capitulated to a sell posture, regardless of outcome. In turn, this will fuel buy side demand from speculators intent on taking a long-term approach to the market.
While occupiers rightfully expect strong leverage and rental rates that align with those being offered in the sublease and cost advantaged owner market (essentially half of 2019 values), a big percentage of the market can’t get there (not won’t, can’t). Indeed, the macro data shows a comparatively slow decline in rents given the extreme circumstances of the market downturn (e.g., 4% to 30+% vacancy). Yet this year has marked the beginning of the reset. We’ve had 4 assets trade and we’re poised to see at least 2 more do so prior to yearend. Sure enough, there’s ample buy side demand at values not seen in San Francisco for over 30 years. These low values will continue as buyers know that even when buying at a steep discount, it’s difficult to underwrite the market’s recovery. Most will assume demand is going to be sluggish as companies continue to wrestle with their workplace policies, and all will assume the pace of decline in rental economics will accelerate as more assets trade, giving more owners the ability to compete for tenants with low rent.
We’re nearing the point at which we’ll soon break the artificial floor on rents, that being held up by failed capital stacks. This is the moment we’ll begin to see substantial declines in rent across a broader spectrum of the market. As noted, we’ve already seen cost advantaged owners go low. The opportunity for occupiers over the next 3 years in San Francisco will be nothing short of “generational”.