Swimming Naked: The Risk of Non-Performing Vacancy

Over the past decade the San Francisco office market was among the most desirable global markets for institutional office investment.  Valuations increased by 100%+, and many assets traded…some multiple times.  Even those that didn’t trade were often refinanced at substantially higher values, enabling the equity partners to take out significant amounts of capital.  Today values are dropping as demand for office space in San Francisco is at historical lows, causing rental economics to decline rapidly.  This presents unique challenges that are (typically) not entirely obvious to occupiers; namely, a full understanding of the debt and equity stack and the landlord’s ability to perform. 
 
We’ve always believed it’s important to understand the landlord’s financial structure.  But today it’s critical, as many ownership structures (debt and equity) are broken.  There’s simply no way to generate a positive return by doing market transactions, and there is no reasonable future exit scenario which would otherwise compel the landlord to deepen the losses it’s already experienced. When this happens, it creates what we call “Non-Performing Vacancy”.  Non-Performing Vacancy presents a risk to occupiers.  The risk is in not knowing the landlord can’t perform.  You see, landlords won’t hang a sign on the building that says, “closed for business”.  Risk of Non-Performing Vacancy is at its peak at the onset of a major market downturn (right now) because none of broken financial structures have been fixed.  The original equity and some portion of the debt may be under water.  But the lender may not be interested in taking back the keys, leading the parties to negotiate a short term “extend and pretend” arrangement that keeps the lights on but does not allow for market-based performance, for deal making.  Non-Performing Vacancy will continue to be marketed for lease and these landlords will continue to negotiate with prospective tenants.  In many cases, their inability to meet market will become clear through the negotiation process, however, in some cases, a proposed lease may get all the way to letter of intent only to be rejected by a 3rd party, usually a lender.  At this point, the occupier may have squandered a good portion of its timeline, necessitating that it resets its process under significant time constraints which can impact leverage.
 
Counterintuitively, as Non-Performing Vacancy is identified, the assets are effectively removed from the supply brokers will otherwise consider in selecting options for their occupier clients, having the effect of temporarily making the market a little tighter (less supply).  Non-Performing Vacancy becomes Performing Vacancy (is fixed) when one of two things happens: 1) the existing financial partners elect to double down on their original investment and take more losses now by meeting the market in order to possibly recoup their investment downstream, or 2) the asset is recapitalized with new equity and new debt at a new, lower valuation that facilitates productive performance in the market, such as it is (meaning they can make money based on existing rental economics).  Of course, the latter scenario requires the original landlord (and quite possible the lender(s)) to take a loss.  We’re always reminded of Warren Buffet’s great quote about swimming naked:  “…when the tide lets out you see who has been swimming naked”.  The tide is letting out.

Change is Hard

While change is generally a constant state, big changes in one area can have the effect of spurring many additional changes in related areas.  In most cases we’re not very good at forecasting all the add-on changes that may follow the initial change.  We’re like low skill chess players, unable to see the full spectrum of opportunity and vulnerability created by our moves.  And when big change requires us to take action, we often seek the comfort of doing what everyone else does as opposed to formulating our own approach.  In the business world, this is a byproduct of risk aversion, or what can be called CYA at scale.  Our corporate structures don’t typically provide incentive for creative, individualized responses to business challenges.   
 
The effects on the office market is a great example of the kind of ancillary, unanticipated change that occurs as a result of a seemingly unrelated big change; in this case, the global reaction to the pandemic, in which office workers were sent away from their offices to work from somewhere else.   While this safety measure was taken to mitigate the spread of the virus, few could have predicted it would have lasting, dramatic impact on the office markets.  Yet while the current state of the office market can be correlated directly to the changes brought on by the pandemic, other factors, factors which began playing out way before the pandemic, have also contributed, notably the technologies which have steadily separated work from office.  It’s been our observation that corporations have struggled to respond to this moment because doing so requires them to take independent actions that are not widely supported by industry standards.  Companies are mostly formulating their own views on return to office, the extent to which they work in-office, or adopt a hybrid or virtual workplace strategy.  And since the choices they make will translate directly to employee engagement, productivity and happiness, there’s a lot at stake.
 
While we’re in the early days, some interesting trends are emerging as occupiers begin to make longer range choices about the office.  Firstly, corporations are choosing to solve for use and experience, not headcount.  This means that if a company has 100 people in a given market, but only 20 regularly use the office, the office solution will solve for closer to 20 than 100.  At the same time, companies are studying how those 20 actually use the space and seeking ways to enhance employee experience, both in and out of the office.  Many are discovering their offices no longer serve the purposes they once did. This is especially true when it comes to the provision of individual, dedicated work space.  The overall effect is trending toward smaller, custom designed spaces that serve very specific purposes such as brand promotion, team collaboration/culture building and client-facing activities coupled with technologies and improved work flows that enable employees to enjoy greater flexibility in working from anywhere, any time.  The office as a place for employees to go each day to do their work is increasingly uncommon.
 
In March of 2020 we really didn’t know that in March of 2023 we’d be grappling (on a global scale) with how we use office space.  The consequences of this change, from a monetary perspective, are significant and effect market participants differently.  Those invested in the market circa 2019 have been forced into a new normal, which in the case of San Francisco, means adjusting from 4% vacancy to 24% and climbing.  Investors stand to see the value of their assets decline significantly.  Employees generally want more flexibility and a continuation of the kind of work-life they’ve enjoyed since the pandemic began (although there are many nuances here).  The continuance of flexible workplace solutions is valuable to these employees.  Companies, on the other hand, are mostly unsure how the choices they make will impact value because no one can really quantify the value impact of the office on productivity.  It may be a little easier to quantify the impact of the office strategy on employee experience and happiness, which should have an ancillary impact on recruitment and retention.  But the decision to bring everyone back, go hybrid or virtual is fraught with bad judgment, flawed leadership bias and a lack of good data.
 
Once change begins at scale (like that we’re seeing in the office markets), you can’t turn back.  This is no longer about heading back to the office construct of 2019 or simply choosing some other solution.  For occupiers, it’s a complex decision tree that has many important value outcomes.  For the moment, the supply side must wait patiently while occupiers figure this out.  Investors are left to reposition their assets and manage the debt and equity stack in order to stay alive to fight another day.  It’s an unpleasant time.  Change is hard.

Why Flex is Hard (but Inevitable)

The “flex” in flexible office solutions is about the occupier’s ability to limit commitment. A one-year lease is more flexible than a two-year lease, so on and so forth. With occupier uncertainty about why, where and when they should provide office solutions for their employees at an all-time high, you’d think landlords would be eager to offer high flex options in order to meet demand where it’s at. However, it’s difficult for landlords to provide the flex product, despite its potential to command premium rents and increase demand. Why? Because it’s expensive to build office space, and it’s difficult to design space that has broad residual appeal to a large swath of occupiers. 

Let's dig into this a little more by looking at the San Francisco office market as an example. Here the cost to build a new 10,000 sf space from shell condition ranges from $175/sf to $250/sf, with a typical cost of $225/sf, or $2,250,000. The investment required to build new space is underwritten (financed) over the term of the new lease, not the speculative useful life of the improvements (e.g., a guess as to residual value after the initial tenant vacates). Let’s say the market rent for this new space is $70/sf gross and the tenant is seeking a 3-year flex lease. When analyzed over a 3-year period, the net effect of this hypothetical transaction is the landlord loses a lot of money. This is true because even if you straight line the initial investment in the design and construction of the space over the 3-year term without interest, the spend is worth $75/sf per year. Of course, the gross rent also includes operating expenses and taxes (which are typically about $20/sf). Hence the net rent would be more like $50/sf. At this rate, the landlord is losing $25/sf, or $250,000 per year before accounting for other transaction costs (like commissions) or debt service. The only way this transaction makes economic sense is if on expiration of the initial 3-year lease, the landlord can quickly re-lease the space without having to spend additional capital on improvements, a risky bet as occupiers tend to value highly customized space solutions that are optimized to best meet their individual use case. In this way, a space that is designed for a law firm will have limited value to a technology company. Indeed it’s difficult to thread the needle by creating a space that has broad applicability. 

Yet our view is flex space will inevitably become an increasingly common landlord product offering as occupier buying power and behavior leave many landlords with 2 choices; 1) offer flex or 2) endure long periods of vacancy. As landlords capitulate to occupier demands, look for the design of the flex space to become a central element of the negotiation. Landlords will need to believe they’ve created something that has residual value. 

It’s also important to understand what’s driving the occupier's need for flex. It’s not just a preference for less commitment. There’s also the very real challenge of workplace planning for a distributed workforce. This phenomenon makes it much harder for companies to know where they’ll need office solutions because the location of employees becomes more distributed and fluid, as opposed to the highly concentrated approach prevalent before the pandemic, in which companies chose a geography for the office(s) and looked to hire from candidates already in that region or otherwise willing to relocate. It will make sense for occupiers to both pay more for flexibility and to accept that flex solutions may necessarily be somewhat less custom fitted to their specific use case.  Yet in the end, the benefits of having truly flexible leases allowing occupiers to pivot in and out of markets and avoid being saddled with long-term, illiquid lease commitments, will far outweigh some degree of incremental cost increase and loss of customization. 

When will the wave of flex leasing begin in earnest? When enterprising landlords make the first move. Their risk will be rewarded, clearing the way for others to follow suit. Offering more flexibility, more than adjusting rent or increasing concessions, is the single most important thing an office landlord can do in the new market reality to enhance its position.    

Educating vs. Selling

Selling is important.  It’s what makes the world go round.  But sometimes selling crosses the line and gets a little too close to misrepresenting or worse, lying.  After all, there’s always been a healthy dose of deception built into selling.  In sports, teams and athletes sell their opponents on the idea they’re going to zig when they in fact zag.  Governments seek to sell a vision in order to successfully lead their people.  Sometimes the vision is wrong, out of synch with what the people want.  Look no further than China’s Zero Covid policy.  Companies must sell their products and services to succeed.  Startup founders must sell investors on the merits of investing in their companies.  Buyers don’t want to buy an “OK” product or service.  No one ever said, “…hey, let’s go with those guys, their product seems flawed but they’re really honest about it”.  Much of what is sold is imperfect.  Sellers have incentive to craft approaches that distract from imperfection while accentuating strengths.  Even the salesman with a crappy product has to eat.  It’s no wonder we’ve become skeptical.  It’s essential to our survival.  Storytelling is a form of selling.  It often seems the best storytellers are selling the worst products.  Sam Bankman-Fried of FTX and Adam Neuman of WeWork come to mind.  My family loves the classic Christmas movie “Elf” starring Will Ferrell.  There’s this great scene when his character, “Buddy”, first arrives in New York.  He passes by a coffee shop with a sign in the window that reads, “World’s Best Cup of Coffee”.  He sees the sign and runs inside full of excitement to congratulate everyone, much to their bewilderment.   
 
In hindsight, it’s always easy to identify when we’ve been sold a bad product.  Sometimes we can also see when the product or service is not likely to match the hype of the slick sales pitch, helping us avoid a mistake.   Yet other times the seller gets it just right and we’re compelled to buy.  It’s worthwhile exploring this latter instance more closely.  In our experience, this often looks more like educating than selling.  A few months ago I attended a conference at which an outside consultant gave a presentation about marketing.  The presentation was full of useful ideas.  It was sufficiently compelling that I sought out the speaker after his presentation to chat one on one.  During our conversation he remained in what I call a “giving” posture, freely offering ideas and insights.  Months later, by then having established a relationship (but not having hired him to consult for us), he would occasionally reach out to me, always with ideas and insights.  One day, after having reached out to share something he’d seen me do and to offer feedback on how I could improve, I realized that I wanted to learn how I could hire him to consult for us.  I didn’t want him to pitch me on his business.  He’d already shown me his value, I already knew how insightful he is and I knew that he cared about us.  Basically, I just wanted to know how much he cost and how to get started.  I had been educated.  It turns out I like being educated.  We think many people do.
 
This is how we’ve come to provide TenantSee Weekly, Café TenantSee events, the TenantSee Weekly VLOG and share all the content we regularly share on social media like LinkedIn.  Our services, advisory services for office occupiers (tenants), are complicated. They can’t be sold with a simple statement like, “World’s Best Tenant Advisory Services”.  Notwithstanding this fact, many in our industry continue to try.  In contrast, we seek to educate by freely sharing our insights and perspectives.  We want you to know all that we know.
 
Maybe we’re misreading the landscape, but it seems to us the world is changing when it comes to both how we sell and buy.  What do you think?  Drop us a line and let us know your thoughts.