A Big Decline in Rents, Four Years in the Making

Throughout 2020, the prevailing sentiment among investors in the San Francisco office market was one of relative optimism.  After all, despite the fact tenants were prohibited from occupying their buildings, they continued to collect full rent.  The buildings were full, with vacancy hovering around 4%.  Sure, companies weren’t happy about paying for space they couldn’t use, but business was good.  In many cases the tech sector (which makes up most of San Francisco’s office occupancy) was booming due to an even greater reliance on and usage of tech caused by pandemic driven changes in how people were living.  Throughout the course of 2020 there was no reason for San Francisco investors to panic, as few (if any) office occupiers were showing signs of developing long-term hybrid or remote-first strategies.  Most were simply focused on solving for ongoing operations as a temporary reaction to the pandemic.  Yet early indicators did point to a future in which companies would be shedding office space, as some expiring leases were not replaced.  This, coupled with the addition of new supply, caused a big increase in vacancy to nearly 12% by year end.  Despite this large uptick, the brunt of the sluggish demand dynamic was being felt in the sublease markets, where rental economics more accurately reflected the true state of the market.  Despite a total closing of the office market in 2020, average asking rents ended the year off just 6% from the pre-pandemic high.
 
Early 2021 was characterized by optimism for the vaccine.  Office investors were preparing for the great return to office.  There was even a narrative that demand would increase as companies became more thoughtful about addressing health concerns, including shifting away from high density occupancy scenarios to provide workers with more space.  The vaccine came, but by winter a mutated version of the virus was once again surging, causing companies to delay return to office plans.  By the end of 2021 investors were quietly expressing concern at the growing sublease market amidst mounting evidence of companies demonstrating a lack of conviction to renew expiring leases -- often choosing to downsize and do short term extensions, reflecting ongoing uncertainty.  By year end, vacancy stood at over 18%, another large year over year increase.  Somehow defying gravity, average asking rents were off less than 4% from the prior year.
 
2022 was when the new narrative about office officially began to take over the market.  This is when it became clear that prolonged behavioral changes in how people work had become highly valuable to employees.  The tech sector was quick to embrace remote work, realizing how such policies could help them recruit and retain talent.  This is when office investors officially began sounding the alarm.  Macro-economic events were also beginning to shift negatively, including concerns over inflation, prompting the Fed to begin increasing interest rates in the summer of 2022.  By late 2022, companies had begun to throttle back, starting with freezes on aggressive new hiring campaigns, quickly followed by layoffs.  The year ended with piles of sublease space and a direct vacancy factor above 24%.  Yet, here again, average asking rents held relatively firm, down less than 50 basis points.
 
By 2023, the extent of investor and lender distress became widely known.  In the 2 years prior, investors and lenders favored the “extend and pretend” approach to addressing broken capital stacks, a strategy in which the parties agreed to muddle through for another couple of years, hoping the markets would (magically) shift in their favor.  By 2023, there was enough evidence of market destruction that public entities could no longer avoid marking to market.  Capital partners started getting realistic about their options, resulting in several asset sales that showed the scale of the damage – vacancy-challenged assets were worth less than 50% of the pre-pandemic value.  One would expect such a clear indicator of market value to trigger a big drop in rent, yet it didn’t.  Rates finished the year down about 5.5%.
 
Today, four years since the pandemic first changed how we use office space, average asking rents in San Francisco stand at $69.22, down about 13% from the historical high of $82.15.  How is it possible that rents have fallen so little while all other market indicators have moved so much?  New investors are valuing buildings at less than 50% of pre-pandemic values.  We’ve had 17 consecutive quarters of negative net absorption, and demand continues to be sluggish.  34% of the market is vacant and available, and there’s easily another 10% of space that could be available (and soon will be).  The slow and delayed decline in rents has been a function of several factors.  Firstly, the fact so many San Francisco office assets are/were held at a cost basis that could only support peak rent values.  These capital stack structures were built for continued rent growth, with limited margin for error.  Fundamentally, they simply can’t meet the market.  For a time, many have just sat on the sidelines, doing nothing.  There was no reason to lower rents since they would not be able to transact, in any case.  Second, its human nature to avoid that which is painful, to accept loss.  San Francisco was the darling of the office investment market in the decade running up to the pandemic.  Many very smart investors made big bets here.  It’s difficult to tell your investors you’ve lost all their money, natural to want to delay having to do so.  Also, given the healthy net operating income of many buildings at the onset of the downturn, it took time for market circumstances to translate to distress.  Lastly, a higher percentage of the leasing activity has been centered around the so called “flight to quality”, meaning the space being leased is premium space, a subset of the market that has outperformed all others, where rents are still at historic highs.  This has had the effect of pulling the average asking rent metric higher.  Collectively, these factors combined to create an artificial floor on rents.
 
Ultimately, rent values will be correlated with the supply/demand market dynamic.  We now anticipate bigger declines in asking and taking rent based on the reset of capital stacks through steeply discounted building sales.  Investors will have to either recapitalize their investment and choose to lease space at a loss based on the thesis that asset value will return at some future time provided the building maintains occupancy (a tough bet), or they’ll have to sell to give a new investor a lower cost basis and pathway to leasing success.  Either way, market demand, but for in the supply constrained premium space segment, will not continue to pay rents which are untethered from reality.  The market always finds its bottom.