Translating the Lease

Recently, we completed a lease for a client in a small San Francisco building. The transaction was negotiated to provide our client with a tenant improvement allowance, and the right to manage their construction. Because the client is a design firm, this approach suited them well. They understand design and construction and can leverage relationships to mitigate cost. The ownership of this building is not an institution, its management team lacks the sophistication you would otherwise see with professionals working for larger institutional owners. The lease provided the landlord with the right to approve the plans prior to construction, but it notably lacked a specific mechanism for communicating such approval. Our client provided detailed plans. They received a few minor comments/questions to which they responded promptly. Otherwise, the landlord agreed to the project schedule and let them commence their construction – implicit approval. During the construction, the client invited the management team to attend weekly meetings, to walk the space and generally sought to keep them informed (under no obligation to do so). Despite a few bumps along the way (the building had non-compliance in a few areas and a small amount of hazmat was discovered), the project was successfully completed. However, after moving into the space, the landlord sent a letter stating numerous elements of the construction had been completed without its approval, and the space must be restored at the end of the lease term (an undertaking which would cost hundreds of thousands of dollars). Naturally, our client was concerned. Thankfully, they sent us the letter and asked for our guidance.

The landlords letter referenced numerous sections of the lease which, in the aggregate, they claimed, entitled them to demand restoration. Here’s where it gets interesting. Either the landlord and its management team didn’t understand their own lease document, or they were attempting to make it look like they had rights they did not have, hoping the tenant would not understand the flawed ways in which they referenced the lease. In nearly every case, the sections of the lease to which they attributed their rights was incorrect. For example, they referenced the “Alterations” section of the lease despite this section explicitly governing the defined term Alterations, which relates to work done in the Premises after lease commencement and which may (with notice), at landlord’s election, require restoration. This section specifically excluded the initial tenant improvements, the governing of which was detailed in the Work Letter. The Work Letter itself included language that noted the initial tenant improvements were not subject to restoration.

To the average person, a commercial office lease, with its 60+ pages of legalese, can be confusing, difficult to translate. As experienced tenant advisors, to us the lease is more like a playbook we’ve studied for years, with which we are intimately familiar. We understand which clauses define which behaviors. Since we are deeply involved in negotiating the document, we know how these clauses have been formed. As with rental economics, there’s a “market” for lease clauses, a spectrum ranging from good to bad in terms of how any given clause is negotiated. While a landlord and/or its management team may send an official looking letter referencing the document, don’t assume they’ve got it right. Rely on your advisor(s), those who negotiated the document, to guide you in assessing the veracity of the landlord’s claims. For our part, we’re always available to our clients, not just when engaged in transaction-related work, but throughout the life cycle of the lease. In this capacity, translating the document is a common request.

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).

Wayne Gretzky and the Young Generation

Wayne Gretzky attributed his success, in part, to his ability to “…skate to where the puck is going, not where it’s been”. This was among the skills that made him a great hockey player. This same skill can help companies and individuals be more successful in business. Yet it’s not what comes natural to us. Have you seen young children play hockey, soccer, or similar sports? A child’s first instinct is to go where the puck or the ball is, resulting in a highly ineffective throng of players. In business, it can also be hard to go where others are not. It requires instinct, thorough analysis and understanding of a market; and, most importantly, confidence to stay the course.

With all the chatter about Gen Z and Millennial workers being “different” (often translated as “lazy”) we’ve recently experienced the opposite in searching for a junior member to join our San Francisco-based team. Firstly, joining the commercial real estate business to focus on office leasing is not the most obvious career choice these days. It’s no layup. No get rich quick scheme. Also, the startup phase of our business, in the best of markets, is challenging. We describe it as a 3-year journey during which (assuming a good team, excellent training and mentorship, resources, etc.) one can learn the business and begin to build a career. This journey will be many things, but lucrative is not typically one of them.

We think of Gretzky’s famous words because the young people we’ve met have metaphorically skated where the puck is going to be. Yes, where and when we work is changing. Yes, the office markets will transform and there will be significant losses. But we believe the office product will continue to matter. Somehow, despite a decidedly different generational narrative, these young people also share this view. They realize it’s going to be tough to build their career, but they’ve concluded it’s better to do so now because they’ll be able to learn more in a hyper-competitive environment. They want to use the downturn to learn so they can be more effective when the market comes back, figuring they won’t be making much money during the early days anyway.

We’re inspired by these young people, by their confidence and willingness to embrace risk. They’re smart and ambitious. Most importantly, they’ve given a lot of thought to who they are as individuals, to how they “fit” in this industry. Indeed, they’re making the decision to join this industry with far more intention and clarity than I had when I joined some 30 years ago. We seem to have an enduring need to label generations. But it’s quite possible we’re getting it wrong, choosing our labels poorly. If our recent experience is any indicator, there’s some amazingly talented young professionals out there ready to play like Gretzky.

Reconnecting Work to Place

Lately I’ve been contemplating Enrico Morreti’s 2012 book “The New Geography of Jobs”. In it, Morreti makes the case that urban winners and losers are determined, in large part, based on the extent of geographic concentrations of high-tech employment. San Francisco was perhaps the most prominent example of the thriving economic ecosystems that can emerge when tech employment is aggregated in one region. I believe Morreti’s core thesis remains correct. But his ecosystems are more fragile than we may have anticipated. In fact, it seems they can unravel in much less time than they took to build.

Having lived in the Bay Area, working in commercial real estate (office sector) for over 30 years, I’ve seen the region’s transformation, firsthand. I’ve witnessed the exact effects Moretti details in his book. San Francisco, in the late 1980s, was a stable, if not sexy, regional headquarters market. Most regional tech was concentrated with hardware companies in the Silicon Valley (Cisco, Apple, etc.). The Dotcom era ushered in a new generation of software tech innovation, activating the internet. This new economy was centered in San Francisco. While many of the companies driving growth in that era failed, San Francisco nonetheless became the place tech workers wanted to live and work. From the mid-1990s to early 2020, San Francisco’s appeal continued to grow. Yes, it became increasingly expensive, but the jobs were here, as were the best salaries, the best opportunities.

The pandemic separated worker from place. First from their offices, then, in some cases, from specific geographic centers, altogether. Initially, tech workers seemed unaware of the broader implications of remote work on their local economy. Many still can’t connect the health of their city with where they choose to work. Workers don’t believe a thriving city has anything to do with where they choose to work. They see such suggestions as little more than pandering to the interests of office investors and corporate leaders. To them, these interests look to profit at the expense of the worker. It’s not the worker’s fault the health of modern cities relies on their presence. No one asked them.

Downtown financial districts (like San Francisco’s) were built on the premise that workers aggregate there to work. Today, we have a new class of so-called experts who’re quick to point out the obvious strategic flaws in the planning of cities this way. They say, San Francisco planners were short-sighted in creating a downtown centered around the presence of daytime workers in offices, the vast majority of whom commute into the downtown market from other parts of the region. Planners obviously should have created a more diverse downtown, with more housing and related uses. They argue the city’s concentration on the tech sector was a strategic blunder. Planners should have promoted diverse industry. Where have these experts been the past 2 decades? If the San Francisco playbook was so wrong, why did government officials across the US (many likely clutching Moretti’s book) race to replicate it? No, it wasn’t wrong. It worked and would still be thriving today if not for the separation of work from place.

Cities all over America (not just San Francisco) are searching for new ways to thrive without concentrations of workers. So far, none have devised a winning strategy. Like American factories before them, modern office markets were purpose-built. Indeed, the transformation of manufacturing jobs in America is an apt proxy for the ways in which distributed work may play out. Those pro-distributed work argue it creates a more equitable economy by spreading the wealth of highly paid workers more evenly across the US. But they fail to see that when employers are not limited to local, regional, or even domestic labor markets, when they’re hiring from a global labor market, competition increases while compensation decreases. The US worker, let alone the Bay Area worker, is substantially devalued. Negative impacts on the workers themselves is thus the next phase in the deconstruction of the economy caused by dislocating worker from place.

It’s imperative that corporations reestablish connection between work and place. This connection is vital to the welfare of our cities, and workers alike. Yes, workers should have more flexibility and agency in how and where they work. But we need guardrails. Leaders, both corporate and government, seem to be increasingly aware of the urgency of this situation, and we’re seeing an evolution of better thinking, of better strategies. Hopefully, this trend will continue.

Social Facilitation

Here’s how ChatGPT defines social facilitation: “Social facilitation is a psychological phenomenon that refers to the influence of the presence of others on an individual's performance of a task. It describes how the mere presence of other people, whether they are spectators, colleagues, or competitors, can affect an individual's behavior and performance.” In 1898, Indiana University’s Norman Triplett studied cyclists to determine differences in performance when racing other humans vs. the clock. He found, “…bodily presence of another contestant participating simultaneously in the race serves to liberate latent energy not ordinarily available…” I’ve experienced my own version of this in training for and running marathons. Without fail, I was always able to run faster and farther when in the presence of others. It turns out we have the capacity to do better, to do more, but reaching that next level is not easily accomplished alone.

I believe the same concept is relevant in work. Not all work, but in the kind of work that involves the performance of tasks for which we have demonstrated proficiency, at which we are skilled. Especially when we’re performing these tasks in the presence of colleagues doing the same type of work. This creates a dynamic which is both supportive and competitive. We want to perform well, ideally better than the rest, but we also know to learn from those better than us. This explains why, in all walks of professional life, individuals who shift from being the best in a “small pond” to being average in a “big pond”, always improve. We need the inspiration of others to get better.

What does this have to do with the office, you ask? I know, you probably didn’t ask - - - and these days, with all the noise about the office, it may be the last place you want me to go here. But go I must. You see, I’m one of those who believes social facilitation is relevant in the context of work. I believe it’s a reason for the office (maybe the reason for the office), that bringing people together makes them better. Yes, I’ve also experienced the benefits of social facilitation in my work life. My professional growth has come from witnessing the greatness of others and from striving to be as great as others.

Let’s be clear. Good enough is good enough. But many of the things we do in life can be improved by more effort. And that’s not a bad thing. It’s not bad to try hard, to want to be better (or even the best). Most of us, if we’re being honest, will admit we can find another gear when under pressure to perform to higher standards set by others. Doing hard things can be, well, hard. But our minds and bodies play tricks on us, telling us we must stop when we have more to give. As we continue to evolve through changes in work, my bet is a new class of super achiever will develop, a group which actively seeks the benefits of social facilitation and significantly outperforms all others. For ambitious young workers, this may be the most opportunistic moment in recent history to stand apart from the pack. Indeed, it’s a time when those who strive for more will gain disproportionately against the backdrop of a general worker population more consumed with redefining the boundaries of work. I say, go!

Timing the Downturn

Since the pandemic, the cost to lease San Francisco office space, but for the most premium segment of the market, has steadily declined. The pace of decline is beginning to accelerate as more landlords capitulate to unprecedented vacancy and reduced demand, just as more companies are (finally) taking a longer-range approach to workplace. For occupiers, this provides a welcome respite from the relentless effects of a decades-long dynamic in which the office market was both too tight and too expensive.

But just as landlords couldn’t perfectly time the top, it’s important for occupiers to realize they also cannot perfectly time the bottom. Leasing decisions are generally made better through predictive analytics which look to inform the benefits of acting at different times. For example, in the San Francisco market, tenants seeking non-premium view space will fare some order of magnitude better by addressing the lease in say 2025 than in 2024, as the market dynamic will have become even more tenant favorable. Our research and analysis allow us to confidently predict another 10% to 20% drop in rental economics over the next 24 months. Along with declining rental rates, landlords will find it increasingly necessary to bolster concessions. So, yes, the narrative for tenants will continue to improve. Does this mean tenants should delay negotiations? Not necessarily.

The bigger picture matters. One of the most important post-pandemic changes in how we think about workplace is a keener focus on how the space serves the organization. Corporations are now designing physical spaces which best promote outcomes not easily facilitated through technology. That’s the modern purpose of the office. This has resulted in a shift away from commodity type offices which are leased with strong emphasis on cost containment toward custom designed spaces which offer employees unique experiences designed to foster important behaviors (where the ROI of the space is a more relevant driver than its cost). Delaying the creation of such an office solution to capture more savings in a future market may thus be a flawed strategy in that the impact of the delay on ROI outweighs the benefit of the cost savings. To be sure, we’ve entered a “generational” market moment where the leasing dynamic is (already) materially better than it has been in decades. What’s more, a good advisor can capture some portion of the future market decline today, as the market’s downward trajectory is (also) not a mystery to the landlord. Today, risk avoidance is the landlords most important objective. The biggest risk is what happens if they don’t make the deal…what comes next.

Given current and near-term future market conditions and the new imperative of the office, this is not the time to let cost drive strategy. Yes, cost is a factor. But it should be given proportionate consideration along-side the achievement of key employee engagement and productivity goals (ROI). You may not be able to time the bottom perfectly, but the value of such an accomplishment is dubious, in any case.

Can We Talk About Work?

Can We Talk About Work?

Have you noticed that people are very passionate about work?  Not necessarily about what they do as much as how and where they do it.  These days, talking about work has become a bit like talking about politics or religion.  This is especially true in the world of social media, even in the tamer waters of LinkedIn, where if you post about the benefits of working in an office, or you appear curious about the longer-range impacts of remote work, you will most certainly be attacked.  The attack comes from people vehemently opposed to return to office mandates, really to any concept of work that does not permit the employee a wide range of freedom in deciding where and when to work.  Some of them have financial interests in shifting work patterns, for example as purveyors of coworking solutions.  Others are anti-establishment, with echoes of the Occupy movement.  The more reasonable voices in favor of remote work are academics like Nick Bloom.  They conduct research and study work patterns, adding valuable balance to the discussion.

Work is far reaching in how it impacts society.  It translates to how we spend our time, where we live, the viability of cities and broader societal trends.  Work and all its related facets (i.e., commuting, etc.), is among the most significant of social constructs.  It makes sense we would approach large scale changes with caution, implementing big changes only after careful consideration.  But this has not been the way in which we’ve muddled through the past few years.  I think most employers have been as thoughtful as possible about work, initially by doing all they could to protect employees and later by perpetuating remote and hybrid workplace strategies even when they preferred that employees return to the pre-pandemic workplace posture.   Of course, much of their decision making occurred against the backdrop of historically high employment, causing them to perceive risk in advocating unpopular workplace strategies.  The net effect has been perpetuation of remote work at a level that many employers find uncomfortable.  It’s been the relative normalization of measures that were hastily enforced to protect people, never intended to be permanent - - - the keeping of these practices absent careful consideration of their broader impact.

Recently, I posted on LinkedIn about a New York Times article I found thought provoking.  I was curious to learn what others thought.  To be sure, I received some insightful comments.  Yet I also received a range of comments that could loosely be characterized as attacking.  Some of these had elements of perspectives I would like to have unpacked, but the sender’s “you’re wrong, I’m right and I’ll fight you to the death with my arsenal of word salad talking points” posture made productive dialogue seem improbable.  Some offered sweeping views, like: “People have disliked office life, politics and culture forever, it just wasn’t thinkable before the pandemic to oppose it or choose a different way of life without a private office.”  Umm…ok?  Have we now entered a new realm in which companies no longer have politics and culture?  That seems very non-human.  Then there’s the guy who immediately labeled me for my obvious bias: “Says "Executive Managing Director”.   I give him high points for being snarky, a skill not lost on me.  Finally, one pleaded:   “Why do we need to hang on to the old ways of working?”  I, for one, am not convinced we do.  But I think we should compare the pros and cons of the “old ways” vs. whatever is being held out as the ideal new ways.  In any case, the NYT article wasn’t necessarily suggesting we go back to the old ways.  Nor was I.  But since we’re asking questions, why do we need to make permanent, temporary changes in how we work which were made in response to a global pandemic without the benefit of careful consideration?  

It’s understandable that workers want more freedom, more flexibility to determine where, when, and how they work.  The idea that companies engage their employees more fully in developing workplace strategies is a big positive.  It’s the bigger, long-term implications of changes in how we define work that we’re most concerned about.  The act of deconstruction can be destabilizing.  Maybe workers are being influenced too much by the perceived benefits of not having to commute, or work in a synchronous context?   Maybe the short-term benefits are preventing them from thinking a few steps ahead about what could happen if this becomes the new normal?  For example, are workers considering the longer-range impacts of being distributed and having considerably less physical connection to their colleagues and management?  Is there a future state in which employees lose with distributed work?  I suspect, yes.  Why?  Because when companies are fully distributed, they can source labor based on cost and you can hire an engineer in India for way less than the same talent would cost in San Francisco.  For employers, a workforce that is more mobile, less sticky, creates more churn and makes it harder to build culture.  The broader effects of making the internet the global office include the erosion of cities, a dynamic that is taking shape right now.  Does that matter?  As with other social constructs that we’ve moved digital, like our use of social media to replace aspects of in person communication, are we destined to see similarly disappointing results?  Are we sure the new digital office is going to be better for society than the old in-person office?  Devoid of politics and awkward attempts at culture?  We have our doubts. 

It's About Trust

Getting More for Less.

Companies aren’t families.  The employer/employee relationship is governed more by economics (math) than trust.  This is at the heart of the ongoing struggle between employers and employees over return to office and asynchronous work.  Let us explain.
 
The employer wants the employee working in the office at times of its choosing and the employee wants to work wherever and whenever she chooses, so long as she gets her work done.  In fact, surveys reveal employees are willing to take a material reduction in compensation to preserve flexibility.  Academics and research organizations have begun to study the impact of remote work on productivity.  Studies show workers are generally as productive when working from anywhere and/or asynchronously as they are when working from the office.  In some cases, these studies argue employees are more productive and in others they show a slight decrease in productivity.  Stanford economist, Nick Bloom, a foremost expert on remote work, points out that while there may be some modest level of decreased productivity (especially when fully remote), overall profitability may increase due to savings in real estate costs (e.g., the enterprise may be more profitable).  He also, correctly, points out the substantial benefits to the climate by reducing the carbon footprint associated with commuting.  There’s also an argument to be made that employees are healthier, both physically and mentally, when given more flexibility.
 
Given the benefits of a providing employees with more agency over their work, why are so many employers working to undo pandemic freedoms?  It’s about trust and economics.  Specifically, the employer simply does not trust that its employees are doing their best work when working remotely and/or asynchronously.  It gets back to the transactional nature of the economic relationship.  It relates to the disconnect between executive and employee compensation and economic motivations.  Executive compensation is largely tied to measures of productivity.  It is widely regarded as beneficial to the enterprise and its shareholders to have leaders’ comp so aligned.  This gives leaders a variety of levers to pull in achieving their compensation objectives, in showing increases in productivity.  One such lever is to drive more production from employees while not increasing the cost of labor.  The employees are assets, yes, but they’re also a unit cost in the production of goods or services.  How is employee compensation disconnected from that of corporate leadership?  Well, aside from the fact in most companies’ executive comp is wildly higher than that of the average employee, employees also have far less control over their compensation.  They have fewer levers to exercise in acquiring economic advantage.  But the idea of creating leverage, of discovering value, is not lost on the employee.  One way to view the newfound freedom employees have enjoyed since the pandemic is in terms of the agency it created for employees to exercise economic advantage.  Take the employee who kept her high-paying San Francisco job but sold her small bay area home and moved to Boise, ID.  She likely made a very attractive trade.  And the employee who is now free to do other things during the day and work at night has made similar gains that would not have been possible prior to the pandemic.  When considered in the context of the compensation interests of the parties, executive and employee, the struggle makes more sense. 
 
Shifting the employer/employee relationship from economic to trust-based is not easy (maybe impossible).  In fact, we’re starting to see employers pull purely economic levers to compel employees back to the office, including increased compensation and more opportunity for growth.  Indeed, these actions portend a step backward, away from a place in which employers give employees more agency.  Many have hoped for a new future state of work in which the employee enjoys much more flexibility.  Maybe we’re moving in the direction of an entirely new model of work, one that embraces remote and asynchronous work over the traditional model.  Maybe we’re close to a time when all workers are trusted to do their best work, no matter where they may live or if they show up to a physical place.  Maybe the four-day work week will become standard.  Maybe.  But this would require a huge shift in trust, in addition to changes in corporate transparency and compensation models such that executive and employee compensation are truly aligned (not talking about the nominal levels of stock/upside participation that allow a company to promote alignment when not really providing any material benefit to most employees).  People often talk about how the new generation of leaders will embrace hybrid and remote work, how they’re less committed to the office.  This may be true.  Yet I confess to being a bit skeptical that young leaders, upon gaining their seat at the boardroom table, will abandon the historical practices which enable the few at the top to maintain outsized compensation which is derived the old fashioned way.  Sure, there will be outliers, already are.  But the fundamental trade in the transactional relationship of employment will always be about getting more for less.

The Lingering Fog of a Bull Market

The Lingering Fog of a Bull Market.
 
Advisors on the right side of a bull market end up looking good, no matter what they do.  This was certainly the case for landlord advisors in the San Francisco office market for the ~10 years leading up to the pandemic, a time when you could win for losing, as the deal you failed to make was often (quickly) replaced by a new deal at better rental economics due to rapidly appreciating rents.  Today, both landlord advisors and the investors they advise are, in some cases, suffering from the lingering effects of the bull market.
 
The landlord advisor’s work has become significantly more challenging with less margin for error.  The best advice can be hard to deliver, as the new version of “success” looks dramatically different than it did in 2019, and in many cases requires landlords to do things they don’t want (or can’t afford) to do.  For example, take the landlord struggling against a challenging capital stack in which equity is lost and the loan is both under water and coming due. This reality may play out at the very time when the asset requires a significant capital spend and decrease in target rental economics to ensure its relevance.  It’s understandable that investors will try to preserve as much of their original value thesis as possible.  Occasionally, instead of taking sound guidance, they seek advisors who support their false narrative.  But this is not a market in which magical thinking wins.  
 
Indeed, the role of the landlord advisor today is to align outcomes with data, to show the investor client where its asset sits in the vast sea of available supply, and how best to position if for success; including clarification of what success will look like.  In many cases, the best guidance will aid investors in making tough decisions, existential decisions about the viability of their investment.  When the client is unable to meet the market where it’s at, there is nothing to be done.  This is the point in time when the asset must trade at a discount, the moment when a new investor can enter with a new thesis that is better aligned to the current and projected market.  These “resets” are beginning to play out in San Francisco. 
 
Of course, old habits, especially those borne of a bull market, die hard.  It can be difficult for owners and their advisors to adjust to being on the wrong side of leverage.  This is the fog of a bull market.  Here, they react in shock when asked about the financial health of the asset.  The idea of funding all or a large portion of the cost to build new space seems wildly unreasonable.  The practice of competing for a tenant against the backdrop of multiple rounds of negotiation in which competitive landlords are seemingly willing to do more than they should to secure the deal is frustrating, at best.  This often results in the common phenomenon in which a landlord will “chase the market down”, being unwilling to accept current market realities, only to succumb to worse conditions downstream.  During the fog of a bull market phase, one common “solution” to under performance is to fire the advisor.  This is the easiest way to redirect blame away from the asset management team and/or the acquisition team.  Yes, the market is challenging, but fundamentally the under-performance has been the result of bad advisory.  A fresh start with a new broker is what is needed.  In some cases, aspiring landlord advisors, seeking to aggregate a portfolio of assets to lease will take on opportunities in which the investor client has unrealistic expectations, hoping the client will “get religion” in short order, allowing them to be successful.  But there’s no role quite so lonely as that of advisor to a broken capital stack (investor/lender) that can’t/won’t accept reality and adjust its expectations, accordingly. 
 
No, this is not a time when landlord advisors will gain from telling the client what they want to hear.  It’s a time when sober, credible, data-backed analysis and strategy wins.  The San Francisco office market is not going to rebound quickly.  We’re living through a structural shift in where and how people do white collar work, resulting in reductions in the amount of office space being leased.  Even if it turns out employer and employee decide they want to revert to pre-pandemic norms (I doubt it), the time it will take to lease our way back to a healthy market, and the rental values associated with such leasing will be a bridge too far for many landlords.  The most successful investor advisors of the next decade will be those who can cut through the fog of the long bull market to focus clients on the new normal.

It's Not Really About the Office

It’s Not Really About the Office
 
We’re experiencing a behavioral shift which is changing one of the most pervasive social institutions of our time; namely, how, and where white-collar workers work.  Few societal constructs impact individuals, or society, as much as where and how we work.  The collective dialogue about this change, especially between employer and employee, has at times been challenging.  However, we’re now entering a more hopeful phase of the conversation, one which promises to finally move us to a new place, letting go of the idea that we must revert to pre-pandemic norms.
 
When the pandemic hit the US in March of 2020, many cities put in place measures which prevented office workers from going to the office.  By the summer of 2021, we had the hope of a vaccine.  By winter of 2021, the swift emergence of new COVID variants brought renewed concern about returning to the office.  By then, some 2 years in, the behavioral shift had already begun to change the concept of work from something which was temporarily upended by the pandemic (which would without question revert to its prior state once it was safe to do so) to an entirely new construct.  Throughout 2022 and into 2023, despite employees having made significant changes in how and where they live and work, many employers continued to push for a reversion to the pre-pandemic construct in which most employees were expected to work in an office.  The dialogue has been somewhat mind-numbing in its failure to delve into the issues at a deeper level, being relegated mostly to a figurative shouting match where flexibility is pitted against productivity.  This has mostly been driven by the employer being uncertain how to move forward with the hard business of defining its version of the workplace.
 
But as we approach the close of 2023, we’re finally seeing a (better) conversation emerge in which companies are qualifying and quantifying why they want (or don’t want) to have an office.  It’s a fact that a company can exist today without an office, with no office space whatsoever.  It’s a fact that employees have refined their views on where, when, and why they work.  It’s quite possible new employee habits yield less corporate productivity than their pre-pandemic equivalent.  It’s also possible, the enterprise is equally, or even more productive.  Productivity is extremely hard to measure.  The emerging dialogue is more sensitive to these facts, more centered and rationale.  It is based more on the honest and direct assessments of all parties.  Employers must take a stand.  They must decide how they feel about their workplace.  Do they want their employees in the office full time, sometime, or never.  Importantly, why?  Employers must clearly communicate the “why” behind their thinking.   Goldman Sachs has done a really good job (in our opinion) of making its case to employees.  Leadership talks about the importance of building professional networks in their offices which cannot be replicated in any other context.  They view these networks as the secret sauce to their success.  It’s that simple.  Some Goldman employees may disagree.  They’re entitled to their view, but they may need to find a new place to work.  This is a productive exchange between 2 parties that have thoughtfully formed their views and are willing to stand by them. 
 
To be sure, employees have a new degree of agency, a new space in which to exercise individual freedom of choice in how and where they work.  Technology has made this possible and it will continue to evolve.  Unless and until the new ways of working result in the destruction of corporations, meaning structural harm to the economy and a great loss of employment, workers will be disinclined to give back their new freedoms.  Sure, faced with a mandate to return to the office or lose their job, some will begrudgingly return, but they’re likely to begin searching for alternative work immediately.  Employees must thus also be clear headed in prioritizing what matters.  Are you willing to leave your company to maintain flexibility in how you work?  Willing to take a cut in pay?  To assume greater risk?
 
Work in the information economy has fundamentally changed.  There’s very little to suggest it will return to its pre-pandemic state.  Some companies will determine their best path to success is to work exactly as they did in 2019.  But many will forge a new path, leaning into hybrid or remote strategies.  At the same time, we’re on the precipice of big changes from AI, which stand to, yet again, transform how we work.  In the end, we must move away from the false narrative about the office toward a more productive dialogue about work.  As much as the office markets have suffered from diminished demand, this is no longer as simple as determining in or out.  It’s encouraging to see more companies doing the hard work to define their position, to take a stand.  These companies will create competitive advantage by creating a culture in which employer and employee are aligned.  Let’s continue to talk about work.

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”.

Meet WALT

WALT, or weighted average lease term, is an essential metric in the valuation of office buildings as it forecasts the stability of future cash flow.  WALT was less important back when office markets like San Francisco were seeing aggressive year over year rent growth.  Back then vacancy was worth more than leased space, the theory being a buyer could take advantage of vacant space to capture higher rent (necessary to justify inflated pricing which baked in aggressive rent growth assumptions).  However, in the broader historical context of valuation, the idea that vacancy is worth more than occupancy is antithetical to defining value.  Indeed, the more prevalent (and logical) approach to value hinges on the quality and duration of the net operating income.  Of course, this approach is less sexy as it disables a seller’s capacity to “sell the dream”.  The buyer is buying stability and yield, both of which are measurable going in.   
 
Occupancy being more valuable than vacancy is good news for occupiers.  To be sure, WALT is the catalyst that makes the early restructure transaction viable.  It’s the reason a landlord will (and in many cases should) accept a near-term reduction in rent (despite remaining term on the lease) in exchange for additional term commitment on the back end.  For example, let’s say an owner had a loan maturing in 3 years, the building is 30% vacant and the balance of the leases expire within 2.5 years.  The anchor tenant’s lease (40% of the total space) is up in 2.5 years.  Add to this a market that is over 30% vacant with rental economics trending down.  This is a bad dynamic for the capital partners (landlord).  Regardless of what they choose to do at loan maturation (sell or refinance), having more WALT will be valuable.  Consider that existing tenants may be paying 30% or more above the current market value of their space.  Adjusting the lease to market immediately and extending the term may be a winning scenario for both landlord and tenant. 
 
While the near-term impact to the landlord’s cash flow can be significant, it is often less onerous than the outcome it would otherwise face if the occupier chose to vacate its space on expiration of the term.   Understanding this risk is central to navigating the early restructure negotiation.  When space goes vacant in a market like San Francisco, the first variable to consider is what we commonly refer to as down time.  Down time is the period between when one tenant vacates, and another occupies.  In San Francisco, it is now common for space to sit vacant for upwards of 24 months.  On top of down time, landlords must also consider the capital required to secure a new lease.  Typically, a new tenant will need to improve the space to suit its needs.  The cost to build new space can easily exceed $200/sf.  Finally, there is risk.  This is a tough time to bet on positive future outcomes, a time when the bird in hand is truly worth 2 in the bush.  The biggest risk is market trajectory, meaning what is going to happen to rental economics over the course of the remaining in place term.  While adjusting to current market will feel lousy to the landlord, the future state may be significantly worse.
 
At the end of the day, occupier leverage creation necessitates a keen understanding of counter-party vulnerabilities.  Understanding the value of WALT and its specific implications for your current landlord is a good place to begin to assess your opportunity for a favorable early restructure.

What Could Go Right?

Mass psychology is literally contagious (that’s how it becomes “mass”).  This is especially true in times of change, when a significant event has precipitated such change (e.g., the pandemic).  These events can be positive or negative.  In our current state, the catalyst was negative, and, in many ways, has resulted in a decidedly negative outlook.  When things turn negative, there will always be market casualties (just as a rising tide lifts all boats in the positive context).  For example, the impact to investors in the domestic office sector has been mostly negative.  As change unfolds, it can have knock-on impacts that weren’t necessarily anticipated.  For example, the demise of urban downtowns due to shifts in daily worker population.  Collective sentiment tends to aggregate around a view and stay there until some brave souls dare to take the contrarian view.  As these contrarians see success, it spurs others to jump on board and the collective sentiment begins to shift, once again, in the other direction.
 
The office market is primed for contrarian bets, both from investors and occupiers.  In San Francisco, 2023 has marked the beginning of what is sure to be a substantial wave of office asset sales, with contrarian investors placing bets at values that are 60%+ below pre-pandemic highs.  Event with steep discounts, these investments aren’t a slam dunk.  But in our view, when the real estate is good (bad buildings will remain a problem), investors who buy San Francisco office now will be well positioned to see out-sized returns as the market recovers (and, yes, we believe it will recover). 
 
Similarly, companies looking to lease office space in San Francisco have an opportunity to do so against the backdrop of what is likely the most favorable occupier market dynamic of at least the past 50 years.  Options are plentiful and the cost of space (but for the most premium view spaces) is 30%+ lower than it was pre-pandemic.  Whereas a 10,000-sf space in a decent building would have cost $850,000/year in 2019, today the same space can be leased for $550,000.  Saving $300,000/year on a 5-year lease is real money companies can use to invest in other facets of their business.  Adding to this is the flexibility occupiers can achieve today, and the fact most are leasing ~30% less space than they would have leased pre-pandemic.  For those who continue to believe in the value of the office, this is a generational moment to capture sizable savings.
 
Maybe it’s just us, but we’re starting to feel contrarian.  While the debate over RTO rages on, we’re seeing companies become more thoughtful about why they want to have an office.  While this may yield an office need that is less than it was in 2019, that’s not the point.  The point is more companies are beginning to take a position on the office.  This, alone, will bring more demand and begin to stabilize what has otherwise been a very unsteady market.  Other indicators point toward greater stability, as well, including a recent Cushman & Wakefield analysis of in and out migration in major US cities which showed the patterns have largely returned to the pre-pandemic norms.  To be sure, domestic office markets still face strong headwinds, including reduced tenant demand, dislocated capital stacks and an expensive and limited financing environment.  Yet we’ve entered the contrarian bet phase in which more will ask, “what could go right?”

How to Protect From Landlord Default?

Office building owners are facing the most challenging environment of the past 50 years due to substantial reductions in demand for space.  The shift in demand is not cyclical; it’s a systemic shift caused by changes in how work is done in the information economy.  In other words, investors can’t count on a swift reversion to the norm.  This dynamic is playing out globally.  There are geographic differences, but the fundamental trend is the same.  The impact on office investors has been swift and brutal, leaving many in a precarious financial position.
 
From the occupier perspective, understanding the landlord’s capital stack is now of vital importance.  It’s also imperative that transactions are appropriately secured against landlord default.  While landlords are skilled at protecting against tenant default, requiring large lease security, parent guarantees and other mechanisms to secure the lease, it’s less common for tenants to properly secure the deal.  Indeed, landlords have historically rebuffed attempts to assess their position and capacity to fulfill transactional obligations.  No landlord, regardless of scale, is immune to financial distress at the asset level.  Landlords can and will walk away from obligations.  Today many large-scale office owners are carefully evaluating their portfolio to determine which investments are worth keeping and which should be terminated.  While terminating an investment doesn’t necessarily mean default, it is an option.  In such a case, the lender’s recourse is the asset.  Yet given the scale of declines in value, the lender(s) position may also be “under water”.  However, unlike the investor, the lender can’t simply walk away.  Its options are either to sell or to step into the landlord’s shoes and run the building.
 
What are some of the ways landlord default can impact the tenant?  One example is a failure to fund capital obligations related to the lease.  Depending upon the scale of the lease, these obligations can run into the millions of dollars.  When the landlord entity defaults, it’s not a given the lender will step into their shoes to fulfill the obligation, even when the tenant has a subordination, non-disturbance and attornment (“SNDA”) agreement from the lender.  The implications for the tenant can present many challenges.  Work stops, the schedule is disrupted, and the target relocation date is delayed.  This may put the tenant in a holdover scenario, typically at a prohibitive cost; or, worse, expose the tenant to consequential damages because in holding over it has delayed the existing landlord in accommodating a new lease it has structured for the space with a third-party tenant (a domino effect).
 
How does a tenant protect itself?  Firstly, self-help.  Self-help is exactly what it sounds like.  It’s a mechanism in the lease that enables the tenant to step into the landlord’s shoes and fulfill its obligations, for example, funding the unfinished tenant improvement project.  Funds so allocated are recouped by the occupier through deduction from future rent.  Another important protection is to have the lender explicitly guarantee aspects of the landlord’s obligations – like funding tenant improvements – in the event the landlord defaults. 
 
Landlords won’t enjoy a conversation about their ability to perform.  But it’s a conversation that must be had.  Tenants must be careful to put this topic on the table early, while they still have time and options, because not all landlords and lenders will agree to protective measures.

The Disconnected Worker

I read an article recently about layoffs in the tech sector.  In it, one worker shared her story of being laid off by 3 companies in less than a year.  The first was a startup where she had worked for several years.  She questioned why she had been selected – it clearly felt personal.  The next 2 employments were each of short duration, the last being merely a month long.  In the end, she was left questioning whether she wanted to continue working in tech.  The tech sector, especially the startup segment of the tech sector, has never been a great place to seek job security because of its inherent volatility.  Yet it has long been a place in which employers seek to espouse winning and attractive cultures that are all about “the people”.  This got me thinking about job security in the post-pandemic workplace.  Has employment in the information economy become more unstable because there is less connection between employer and employee?  Is the relationship between employer and employee becoming more transactional? 
 
These days all the headlines are about the battle over return to office.  Workers have voted with their feet, it’s clear they prefer to work remotely.    But a more permanent state of remote work seems destined to bring a “gig-economy” effect to many jobs.  Gig workers are independent.  They have a narrowly defined and fully aligned relationship between their work and compensation.  I don’t think your average Uber driver is there for the company culture.  Many workers seem to want this type of relationship with their employer, one in which the production expectations are clearly defined, and they have the flexibility to meet these expectations on their own schedule.  Yet workers may be unaware how this shift will impact their value to the organization.
 
This is, fundamentally, a transition from people-centric to data-centric.  Specifically, data that defines what is (and is not) productive.  Certain industries, like ours (commercial real estate brokerage) have long been about production.  Brokers are the original gig workers.  We come to our industry accepting, even desiring, a construct in which our compensation is 100% aligned with our effort.  It’s not a comfortable place.  There is a constant pressure to perform against the backdrop of a pervasive awareness of your value.  Is the average employee ready for this?  Will they thrive in a transactional workplace in which one’s value is narrowly defined by specific production targets?  I’m not sure.  I think people mostly want the best of both worlds.  They want their employer to value soft qualities that make the workplace feel safe and comfortable, more like a family.  A place in which, yes, production matters but so does the person.  They want the freedom that is normally associated with total accountability for one’s income (e.g., the entrepreneur) without being totally accountable for their income.  We get it.  But is this a realistic outcome?
 
This is not a prediction of a dystopian future.  It’s a commentary on the possible impact of decreasing the human connection between employer and employee.  As companies struggle to figure out what to do about the office, how much to force employees back, etc., it's possible the worst outcome for employees is the one they seemingly want the most:  fully remote work, largely disconnected from people and physical places that embody corporate culture.  The disconnected worker. 

Sublease, Terminate, or Restructure

Subleasing is the most common approach occupiers take in mitigating the cost of underutilized space.  Yet in San Francisco, it has become increasingly difficult to sublease office space.  With recoveries ranging from 0 to 25%, companies must consider the full spectrum of options.  Remember, too, sublease recoveries can be expensive to execute (fees and concessions); and, in subleasing, the occupier takes on a variety of risks that can prove costly (e.g., subtenant default). 
 
An alternative to subleasing is terminating the lease early.  But when sublease markets are challenging, the viability of an early termination diminishes (if it’s hard for the tenant to find a subtenant it’s also likely difficult for the landlord to find a new tenant).  These days, occupiers are often surprised to learn their landlord is unwilling to accept an early termination even when they agree to pay most of the remaining lease obligation.  Landlords may be facing a vacancy dynamic that is so unfavorable as to discourage any level of risk taking.  Even where a landlord may otherwise be inclined toward a more entrepreneurial posture, when there is a lender involved, the lender may prohibit the termination.  Tenants still have the option of taking a full impairment loss by abandoning the lease and paying in full.  But why would a company do such a thing?  Several reasons.  Firstly, if there is no utilization of the space, it has no sublease value, and the company is otherwise booking losses, it may wish to package the lease impairment with other losses to get it out of the way.  Another reason is this action can free the occupier to take a totally new approach to its real estate.  These days the future occupancy scenario usually looks vastly different than the pre-pandemic use case.  A fresh start can be powerful in creating a workplace that is compelling in the context of earning the commute.
 
Restructuring the lease is something we’ve written a lot about previously.  This is most relevant for occupiers who are paying above market rent, have between 2 and 4 years of remaining lease term, and are willing to offer between 3 and 10 years of additional term beyond the in-place expiration.  The basic trade here is one of landlord-funded concessions which may include reduced space, reduced rent, and/or landlord contributions toward tenant improvements in exchange for more term. 
 
Vetting the options requires good underwriting and engagement with the finance team, especially when assessing the timing of impairment charges.  Today, despite shifts in office usage and dramatic changes in the market dynamic, most companies still have mechanisms for enhancing their space and reducing their cost now, even when they have remaining lease term.  But it’s become more challenging to know which approach will yield the best result.  A competent real estate advisory partner can help navigate and vet all options.

Knowledge, Leverage, and Opaque Markets

An office lease is a unique financial transaction.  While supply data is widely available, the values associated with completed leases are not so readily available, nor is the financial position of the landlord and its partners.  In effect, despite the preponderance of available data in residential markets (e.g., Zillow, etc.), office markets remain opaque.  The educated occupier can certainly access more information today than in decades past. But it’s not enough to merely know available spaces. Achieving a complete understanding of the markets can only be accomplished by partnering with a firm which is engaged in the market in a variety of very specific contexts.  You need an intimate understanding of landlord motivations, capital structures, and even the intricate dynamics of tenants within a building. Yet many real estate service firms don’t have this information because they lack the practice groups. 

Let's break this down. Why should you, an occupier, care about the landlord's capital market strategy? In one word: leverage. By understanding a landlord's motivations, strengths, and weaknesses, an occupier gains an upper hand in negotiations.  Such knowledge which can only be gained by being active in the markets – by having access to offering memorandums (“OMs”) and other data-rich sources that reveal the landlord’s investment thesis, its capital structure (debt and equity) and the unique tenant dynamic within the building (lease rollover, transaction values, etc.). 
 
Similarly, you might wonder how investor (landlord) advisory helps the tenant advisor achieve better results.  It’s because a robust landlord advisory practice creates a trove of data that is otherwise not available to firms who lack such a practice.  Included in this data are “lease comparable” showing the complete details of transactions completed.
 
Securing the right office space isn't just about the art of the deal. It's about aligning the property with specific business goals. From fostering employee well-being to ensuring optimum productivity, the right office can be a catalyst for achieving broader organizational objectives. Knowing what you want—be it a certain location, design, or cost—is paramount before even setting foot in the market. Only after defining the target outcomes should companies embark on identifying site options.  Importantly, prospective sites must also be evaluated based on landlord motivation (debt and equity), leverage dynamic (lease roll, etc.), cost basis, quality of amenities, quality of management (tenant experience) and many other factors. 
 
The gap between a landlord's initial offer and the final deal can be vast. This gap is where occupiers can harness the power of competition. When multiple landlords compete for a tenant, businesses have the advantage. The more landlords compete, the more an occupier can flex its leverage to meet their leasing goals at an attractive price.
 
Our role as the tenant advisor is to structure this competition in a manner which maximizes the extent to which landlords compete, thereby enabling our occupier client to meet its leasing objectives at the lowest possible cost. And this dance of negotiation isn't random; it's a choreographed performance, managed meticulously with requests for proposals (RFPs), comparative analyses, and subsequent structured negotiations. Proper time must be given to allow this process to be fully realized (often providing for several rounds of negotiation), including protecting back-end schedule which is reserved for planning and construction. 
 
This is how we “leverage” the market.  Leverage, however, is only as strong as the knowledge and timing that backs it. When properly deployed, leverage has a massive effect on quality and cost.  With office markets under intense pressure from hybrid and remote work setups, this is a uniquely favorable time for occupiers to negotiate office leases.  But tread with caution: going solo without an advisor can prove costly. With so much fluidity in the markets, we are seeing a broad range of leasing outcomes, from good to bad. The worst results evolve when occupiers choose to negotiate without an advisor. This is often done with the assumption the leasing fee the landlord would otherwise pay will be available as an additional concession, applied for the benefit of the tenant.  However, this is highly flawed logic.  Firstly, many general partners keep the entire fee for themselves when they avoid having to pay a 3rd party broker – the fee is not eliminated or redistributed to the tenant, it’s kept by the landlord operating entity.  Secondly, the value of a leasing fee should represent a small percentage of the value created by a good tenant advisor.  For example, the fee on a 5-year lease of 10,000 sf in San Francisco would be $150,000.  Yet a good advisor, by accessing critical data (e.g., lease comps, investor data, etc.) and running a strategic process to access leverage, can easily facilitate an extra $20/sf in landlord-funded concessions, and reduce rental economics by 15% (say from $75/sf to $64/sf).  The value of the concessions is $200,000 and the value of the lower rent is $550,000.  Hence the fee is just 20% of the added value derived by engaging the tenant advisor.  Most importantly, in San Francisco, the tenant advisor’s fee is paid by the landlord, in any case.  In the end, when occupiers negotiate without proper advisory, they fail to access critical leverage and pay significantly more.
 
Office markets will continue to be largely opaque to occupiers.  A well-chosen advisor will bring knowledge to bear and create leverage which will drive value.  This is a great time for occupiers to achieve long-term savings, but good advisory will make all the difference.

I Digress...

A little AI distraction to cheer your day (and relieve us of yet another discussion about workplace). Ever wandered through the streets and felt like you've stepped into the future? With their undeniable presence here in San Francisco, the driverless car is quickly becoming the most prominent representation of AI in our daily lives. If you spend any time in San Francisco neighborhoods, you can’t miss them. The other day, as I chatted with a neighbor, I counted 6 autonomous vehicles casually cruise by our front door within a span of 10 minutes. Intriguing, right? And today, in a twist of irony, I was held up by one. Blocked by a double-parked UPS truck, the driverless car hesitated, unsure about navigating into the lane of oncoming traffic. Of course, all the drivers in the opposing lane weren’t too keen to make space for the driverless car, as one normally would (or at least the more decent among us would) for a human-driven vehicle. Hence, we waited.
 
While sitting there contemplating my driverless future, I began thinking about other applications for these information gathering machines. Picture this: police using them to spot minor traffic offenses and dispatching e-tickets seamlessly, in the same way we now go through toll booths and simply get a bill. More severe violations, like excessive speeding, could prompt these vehicles to alert human officers nearby. Could they also serve as eyes on the streets, spotting potential crimes in progress?
 
What about redefining delivery? Imagine compact, driverless vehicles that ping you upon arrival, so that you can go to them and retrieve your goods via an app, eliminating the all-too-familiar sight of double-parked delivery trucks. Of course, this poses potential challenge for delivery jobs (a big hit to the gig economy). One summer when I was in college, I worked for a bakery loading trucks at night so the drivers could show up to a fully loaded truck and make their deliveries the next day. It was hard work, made harder by the fact I worked with one other man the entire night (effectively my boss) who was not super chatty (nor happy), and who had the odd habit of playing the same John Denver cassette (yes, that’s how long ago this was) every night, multiple times. To this day, if I hear “Thank God I’m a Country Boy” or any of Mr. Denver’s other hits, the song will get stuck in my head for hours. How long before (maybe already?) that job I endured way back when is gone? It was certainly a robotic set of tasks. The big truck would arrive with all the goods, and we would unload, then load them into the smaller trucks. This could be done by robots, loading into driverless trucks that contact the recipient on arrival – which may, in turn, be another robot who could unload at the site.
 
Of course, the idea of driverless cars ferrying us to and fro is a very real near-term application, and that's probably what springs to mind first. Yet this seems like just the beginning. We're on the cusp of so much more. Today, San Francisco's streets are more bustling than I’ve seen in my 30+ years here. We have more people driving in and out of the city. We have more delivery trucks due to e-commerce. We have many Uber and Lyft drivers. And amidst this urban ballet, we now have all these empty cars. But I digress…

Cap Stack Woes

Recently, we have written about the importance of understanding the landlord’s “cap stack” (capital stack, meaning equity and debt). Understanding the cap stack that guides a landlord's decisions is more than just a business detail — it's an integral part of the current real estate landscape. Today, there is a massive chasm between what many owners can afford to do in the current market and what they need to make a deal accretive or even break-even, given the capital stack realities of the underlying market.  In short, many owners simply cannot afford to transact at market. Why? Two primary reasons:
 

1. Transactions require capital.  When both the equity and the debt are underwater, there is no source of fresh capital to fund the deal.

2. More importantly, if a transaction will create value that is lower than the existing cap stack’s values, there is limited incentive for the current equity and lender(s) to pump in fresh capital to transact at a value that will only result in future loss.

The choices that landlords face are not absolute. If a new deal is perceived as more favorable than selling at fire sale price- and very few office buildings in San Francisco will sell for anything above such levels in today’s market- the existing cap stack may collectively elect to fund it. Sometimes, broader considerations, such as maintaining relationships with institutional clients, can motivate partners to invest further and find ways to minimize losses. For example, a general partner who invests on behalf of institutional clients elects to stay in a deal, fund new capital investments and make deals at market to reduce the level of loss, consequently, preserving the relationship with the capital source. Here, decisions made in the context of cap stack realities can have far-reaching implications.
 
As an occupier, why should you care about any of this?  Several reasons.  Firstly, it’s important to know whether the counter party in a negotiation is credible (meaning they are genuinely capable of transacting).  Despite many landlords today maintaining an “open for business” stance to the market, they might be in a financial stalemate.  They’re stuck in a slow-motion car crash – a situation you certainly want to avoid.  Secondly, while there is excellent occupier leverage available today and the opportunity exists to achieve historically favorable rental economics, it is crucial that you know where to go to do so.  Finally, your existing above-market lease may be a gold mine. You may have the opportunity to restructure your lease, negotiating immediate savings in exchange for offering the landlord future lease stability.
 
Cap Stack distress presents both challenges and opportunities.  You can’t avoid the pitfalls, nor leverage the opportunities if you don’t know what you’re dealing with.  Our work involves much more than identifying space solutions.  It also requires comprehensive analysis of the cap stack to ensure that we unlock the best outcomes for our clients. In a time when the cap stack's role is more pronounced, our approach guides you through this financial maze, empowering you to leverage the possibilities and navigate the challenges with confidence.

A Game of Confidence

Commercial real estate, in all its many facets, has always been a confidence game.  Developers make big financial bets their building will lease as they and their investors spend millions of dollars to build it.  Then, they confidently sell the product, pitching its values to prospective occupiers against the backdrop of fluid markets.  Ideally, they’ve underwritten the market correctly and it moves in their direction, meaning supply of comparable space diminishes, making the product more valuable.  But sometimes the market is moving away from them, forcing them to maintain their confidence despite dwindling prospects for success.
 
There’s confidence selling going on all over the commercial ecosystem.  Brokers compete to represent the developer, sometimes “buying” the business by promising outcomes they know they won’t be able to achieve.  This is a classic confidence scenario.   It’s also known as the “tell the client what they want to hear” approach.  The thinking is once you get hired, after months of failing to achieve the target outcome, the client will settle for a lesser outcome and the advisor who oversold the potential still wins (e.g., they get the fees).  You can blame “the market” for the poor result.
 
This same approach plays out in the tenant advisory market, as well.  It’s the same game.  In both cases, since the client typically has a limited operating window in which to achieve the outcome, once the broker has been selected and time has been squandered trying to achieve the over-stated target outcome, it’s too late to fire the broker and start over.  The client must simply accept the market such as it is.  However, this is not to imply they may not be damaged by having spent time trying to execute an unrealistic strategy.  In fact, it’s likely they will be harmed by this activity in that they will have wasted valuable project schedule and be forced to transact under time pressure, impacting their ability to create leverage.
 
When hiring broker advisors, it’s important to be mindful of the fact these advisors don’t have skin in the game.  The “skin” is yours.  They’re trading performance for value (fees).  This is not to diminish the importance of good advisory.  It can and often does make a substantial difference in the outcome.  But clients must connect performance and fees.  This changes the conversation, forcing the advisor to be accountable to its offering.  This might take the form of KPIs or simply connecting fee to specific targeted outcomes.  Under these circumstances, those advisors otherwise prone to confidently overstating their prowess will suddenly become much more realistic…a better place for everyone to make good decisions.