What's the Rate

If you look at the quarterly market reports provided by all major real estate service firms (Cushman & Wakefield, included), you will find that rent data is typically expressed in terms of “Asking Rents”.  Reports will cite the trend in Average Asking Rents by submarket, or by building class.  This is a somewhat misleading indicator.  Why?  Because it does not reflect the rent after negotiations, which often includes reductions in rate from the Asking Rate and potentially significant landlord-funded concessions.  In other words, Asking Rents reflect what landlords are asking, not what they’re getting.

Even if market reports cited the actual rental rates tenants have contracted to pay in leases (“Face Rates”) they wouldn’t accurately reflect the true value of the space in the market. These values are only reflected in “Net Effective Rates”, rates derived after deducting the value of landlord-funded concessions from the Face Rent.  Net Effective Rate is a much better proxy for market value.

Why so much complexity?  It’s because a key chapter in the modern landlord playbook calls for the financial engineering of higher Face Rates.   This is because assets are valued by capitalizing net operating income (“NOI”) which is a byproduct of Face Rate.  The higher the Face Rate, the higher the NOI, the higher the value. 

Here’s an example of how this might play out in a proper market-based negotiation.  Tenant tours a space with broker and decides to include it on a short list of sites with which to negotiate.  Landlord’s initial proposal indicates a $70/sf starting rent with 3% annual increases over a lease term of 8-years, with 3 months of free rent and $50/sf in landlord-funded tenant improvements.  The Average Net Effective Rent (before deducting operating expenses and taxes) for the proposed transaction is $69.41/sf (assuming a straight-line amortization of the $50/sf tenant improvement allowance).  This, despite an average Face Rent of $77.81. 

In other words, there is already an $8.40/sf gap between the Average Face Rate and the Average Net Effective Rate associated with the landlord’s initial offer.  Now, let’s say the market value of the space is an Average Net Effective Rent of $55/sf.  The question becomes how can the tenant get full market value while the landlord still preserves its minimum Face Rent requirement?  The answer lies in the concessions.   For sake of this example, imagine the landlord must preserve a Face Rate of $65/sf.  To meet the market value and secure the tenancy, the landlord must enhance the concessions.  To do so, it might double the amount of the tenant improvement allowance from $50/sf to $100/sf, drop the Face Rate to $65/sf, and increase the free rent from 3 months to 7.  This yields an Average Net Effective Rate of $55/sf, in line with market.

Data is everywhere today.  But do you have the right data, and/or, do you know what to do with it?  The role of a great tenant advisor it to help identify the right data, correctly interpret its meaning, and use it to develop a strategy that ensures its tenant client achieves maximum market value.

Contradictions in Logic

These days, the resetting of capital stacks (the ownership structures for office buildings) is most often facilitated through selling the building.  The current market sale dynamic typically involves one set of financial partners (equity, lenders) taking big losses to permit a new set of investors and lenders to “reset” the capital stack on economic terms that provide a pathway to success (e.g., a productive investment).

In many cases, the assets being acquired have significant vacancy.  New owners have a couple of options when considering the best pathway to success.  The quality of the asset and the market value of the vacant space is a factor.  But much of the available space in the buildings which are now trading at steep discounts to their prior value is commodity space, meaning it is average in its appeal, it does not stand out as uniquely desirable.  The owner’s playbook calls for amenities as a first line of defense against irrelevance.  This is why we’re seeing so many building owners spend heavily on new amenities like high-end conferencing facilities and tenant lounge spaces.  Next, these new owners must decide what to do with vacant space.  In many cases, the prior financial partners (the broken capital stack) had no money to spend on tired, second or third generation spaces.

These spaces are not marketable in their current state, so at a minimum, new owners must plan to “white box” (demolish all existing improvements and bring the space to warm shell condition) available spaces.  But even in clean warm shell condition, office floors can be tough to lease when tenants are less committed to building new space and leasing for long terms.  Smart owners are closely monitoring tenant demand and speculatively building new office space in a variety of size increments.  These “spec spaces” are move-in ready.  This is a smart strategy as it addresses one of the big impediments to getting deals done today, the cost of tenant improvements.

However, we’ve noticed an interesting contradiction in the market.  In some cases, the same landlord who is proceeding to build new spec spaces, spaces it will lease for shorter term (3-5 years), balks at the idea of building new space for a tenant on a 5-year term. This will present challenges as it’s quite possible one of the longer-term realities of post-pandemic office leasing will be occupiers’ insistence on greater flexibility (e.g., reduced term commitment).  The long-term office lease was always a bad fit for tenants whose business needs are constantly changing.  Landlords building and leasing spec spaces for shorter term smartly recognize the tenant’s dilemma.  Yet, in refusing to build new space for a tenant on a 5-year term, they seem to contradict  themselves.

It's true that current market rental economics (in most cases) don’t allow for net-positive outcomes (e.g., profitable) when underwritten over terms of less than 7 or 8 years.  It’s also valid for landlords to stop short of building highly unique office space, designed to meet the individualized needs of a given tenant over a short-term lease.  Ultimately, the solution may be for tenants seeking shorter-term leases on shell space to agree to design schemes which the landlord deems consistent with what it would otherwise build speculatively. 

A Good Desk

Did you know the modern desk dates to 2000 BC?  It was used by ancient Egyptian scribes.  Over the centuries, the desk has evolved, often to keep pace with new technologies.  For example, the steel desks of the early 20th century were designed, in part, to provide better support for heavy typewriters.

I’m concerned we’ve gone too far in its refinement.  First, I must confess to an unusual love of desks, especially unnecessarily large, ornate, wooden desks.  Let me ground this in a bit of my personal history.  To this day, the single most meaningful and memorable gift I have ever received was…a desk.  I was 8 years old.  My parents, noting my love of drawing and pretending to be an architect, decided it would be a good thing for me to have my own desk.  They didn’t have much money, but my dad was good at making things.  In the winter months leading up to Christmas, he secretly designed and built me a desk.  When I came down the stairs that Christmas morning and saw a desk standing near the tree, realizing it was a gift for me, I cried.  But I digress.

Recently, I read with some interest that sit/stand desks may not be as healthy as we thought.  It seems that standing too much can have unintended negative health consequences.  Things like reduced blood flow to the brain and circulatory issues.  Also, turns out there is little difference in terms of calories burned between sitting and standing (80 per hour for the former, and 88 for the latter).  Not compelling -- especially when considering the lack of gravitas associated with the sit/stand desk.  You won’t see one in the Oval Office any time soon.

Of course, in the corporate world, most of us don’t get to choose our desk (or even if we have one).  But maybe we should.  As I write this, employers and employees remain entangled in a bitter battle over return to office.  It would seem, in many cases, the employees are destined to lose this battle.  Perhaps it’s time to negotiate?  A great desk won’t make your commute less sucky, but maybe it can improve your experience of the office?  No matter what, you must (at least) reject the dreaded bench.  That seems like a good hill to die on.  We could all do worse than a good desk.

The Value of Your Lease

People sometimes (mistakenly) think office building values are based on location and architectural design (appearance).  These are contributing factors, however, in most urban centers, investors use the income capitalization approach to valuation.  Here, the building is valued on current and projected net operating income (“NOI”).  To be sure, location and design will translate to differing levels of NOI.  But other variables play a key role, as well.  For example, the landlord’s cost basis which impacts its ability to lease space at market pricing.  Where a landlord has paid too much for the asset, the underlying rental economics of the market may result in net negative leasing outcomes, causing the landlord to lose deals to other assets which have a lower cost basis and can productively transact at market.

How does the income capitalization approach work?  It’s a very simple method.  NOI, the income generated through leasing space less the costs to operate the building, taxes, and vacancy is “capitalized” to generate a valuation.  Capitalization is a function of the expected rate of return an investor seeks and/or the market supports – the “cap rate”.  Cap rates vary based on the risk of the underlying market and the quality of the NOI at the asset level.  A higher cap rate means the asset will sell for less, giving the buyer the potential for a higher return due to the increased risk of acquiring the asset.  Similarly, lower cap rates imply a more stable NOI and less risk (both at the asset and market level).  By way of example, let’s say a building is generating a stabilized NOI of $20/sf and the market cap rate is currently 6%.  To determine capitalized valuation, divide the NOI by the cap rate 20/.06, yielding a valuation of $333/sf.

In 2019, the San Francisco office market was among the most highly valued global office markets.  To acquire assets, office investors often had to compete to win the bid.  This had the effect of compressing cap rates, or reducing the going-in yield for investors, while increasing sale pricing.  It would not be uncommon to see going-in cap rates of 3%-4%.  The quality of the tenancy (credit) and the weighted average lease term (“WALT”) also impact cap rates.  An asset which is leased to AAA credit tenants with long WALT is more valuable.

Each tenant’s lease is valuable.  It’s important for occupiers to understand how their lease impacts value.  In some cases, a lease will create enough value to warrant greater concessions and/or equity participation.  For example, let’s say a very strong credit tenant is leasing a 100,000-sf office building on a long-term (15 year) lease.  The lease generates $30/sf in NOI.  The market cap rate is 6%.  However, the quality of this tenant’s credit “compresses” the cap rate by 20%, making the post-lease cap rate for this property 4.8% vs. the market rate of 6%.  How much value does this generate for the owner? 

At a 6% cap rate, the building is valued at $500/sf.  At a 4.8% cap rate, it is valued at $625/sf.  This is a $12,500,000 difference in value.  Given the right market conditions, this tenant should be able to participate in some portion of the increased value creating by its tenancy.  This could take the form of equity participation, or some percentage of the increased value being translated through other concessions, things like free rent or additional tenant improvement funding from the landlord.

It's important for office tenants to understand how their tenancy impacts building value.  The best leasing solutions are those which fully realize the tenant’s key leasing objectives, while maximizing leverage to access the full value spectrum.  Value is about more than just basic rental economics.

In a Vaccum

Office leases are complicated undertakings comprised of many variables.  The markets offer a variety of solutions, ranging from coworking to subleases to long and short-term direct leases.  It’s always important for corporate leaders to understand the primary objectives they seek to achieve in leasing office space.  But even when these objectives are well defined, it can be tricky to assess which solution is best.

With so much data to analyze (rent, term, tenant improvements, operating expenses, location, amenities, ownership’s financial position, flexibility factors, etc.), tenants need guidance to help create perspective.  Providing our clients with a framework that facilitates the thorough analysis of these variables in the context of the alternatives is among the most vital aspects of our work.  It’s not enough to opine on the quality of an offer.  Yes, a broker should have an opinion, but it’s the data that matters.  The role of the broker is to aggregate data, provide proper analysis to generate key insights, and prescribe strategic actions, accordingly.

Leasing is a process of discovery.  The right solution is discovered through an intentional process that identifies options, extracts value from each through rounds of negotiation, and, finally, compares each based on quantitative and qualitative factors.  

It’s impossible to craft the right leasing solution in a vacuum.  Singular focus on one building, for example, will never yield the best outcome.  Yes, analysis for the sake of analysis leads to paralysis.  But disciplined analysis of each leasing scenario based on how well it achieves key project objectives as compared to all other available and relevant leasing options leads to great outcomes.

Distributed (but only a little)

Surveys indicate most workers favor a distributed workplace in which they can work from anywhere, any time.  When it comes to work, individuals focus (mostly) on their own specific benefits, as opposed to thinking about how the ways in which their work gets done affects the broader organization.  This makes sense, as one of the key benefits of our economic system is how it permits the individual to get ahead, to maximize its value.  Employees realize value in a variety of ways, including compensation and other variables.  Flexibility in where and when people work is high on the list of non-compensation related variables.
 
It’s clear most companies adopted a more distributed workplace, first in response to the pandemic (e.g., not as a strategic choice), and second to retain and attract talent in a tight labor market.  What’s less clear is whether US companies have settled on these flexible workplaces as their new normal, or if they’re now interested in limiting the amount of flex their workers currently enjoy.  There’s certainly anecdotal evidence of the latter, as the drum beat of big corporations announcing return to office mandates continues.  Understandably, when such mandates are made, employees often express a high degree of dissatisfaction, including threats to leave the company.
 
Workers seek a Goldilocks effect in which the degree of distributed work is just right, meaning the employer embraces the distributed model but maintains a hyper-geographic bias.  This “modified” distributed workplace offers employees a sweet spot in which they get to maintain high levels of compensation based on specific (expensive) geographies, while disconnecting their cost of living from such geographies (e.g., living elsewhere).  Many aspects of the future of work are hard to predict, but it seems probable, indeed a basic economic reality, that companies who fully embrace distributed work won’t perpetuate this Goldilocks version.  Instead, they will look to retain comparable talent at a significant discount by engaging the global marketplace.  This practice could gain momentum quickly, as first movers will enjoy a substantial competitive advantage over companies who continue to pay hyper-geographic wages.  This is akin to the loss of US manufacturing jobs to developing markets.  Once some companies began manufacturing products in developing markets at substantially less cost, it forced others to follow suit.
 
What does this mean for the average worker?  Is it possible in continuing to advocate for distributed work they may (inadvertently) argue their way out of a job and/or set themselves up for significantly reduced compensation?  Arguably, US workers benefit more when employers favor an office-centric workplace.  Sure, there’s likely an inflection point at which the worker is willing to give up some level of compensation to maintain other variables it deems valuable (like remote work).  But when employers tap into the global markets, compensation levels will decline so precipitously that even the most pro-remote worker will reconsider her views.

Sell Your Occupancy by Leveraging Options

Negotiating a great office leasing outcome requires engagement with multiple prospective landlords over multiple rounds of negotiation.  It’s not just about having options; it’s about using them to create leverage.

The first step in a good process is to identify the right options.  Sometimes, this is counter intuitive in that it calls for the inclusion of buildings a tenant would not otherwise consider, options which impart specific strategic value.  It’s these building options, the ones a tenant may prefer not to occupy, which may have the greatest impact on value creation.

For tenants, it’s important to realize leasing office space is more about selling the occupancy than leasing the space.  The role of a good tenant broker is to orchestrate the occupancy selling process, to compel landlords to compete for the tenancy by offering incrementally better terms.  A good tenant broker is like a good auctioneer, able to drive others to offer increasingly more value.

Options are also useful for a host of other reasons.  For example, unless and until a binding document is fully executed by landlord and tenant, the subject space may be leased to a 3rd party.  Or, through the due diligence process, tenants may discover unfixable flaws, causing a building to drop from consideration.  When tenants focus exclusively on one option, they fail to harness leverage, and expose themselves to the possibility of losing a space late in their negotiating window which can have negative cost implications.

Don’t lease space.  Identify the right options, sell your occupancy, and choose the best bid.

Planning for the Future, Not the Moment

Urban planning can go horribly wrong.  It often fails the test of time.  1950s America brought a surge in suburban development and car transportation.  It also led to one of the single worst American urban design decisions (my opinion), the development of the Embarcadero Freeway, originally intended to connect the San Francisco Bay Bridge to the Golden Gate Bridge by extending along the northeastern edge of the city as it hugs the bay -- effectively blocking the views along one of the most scenic corridors in any US city.

Thankfully, the double-decker freeway structure was never fully built.  It faced strong opposition from the beginning, opposition that ultimately stalled its progress.  But from the late 1950s all the way to the Loma Prieta earthquake in 1989, a large swath of the beautiful Embarcadero Waterfront was relegated to concrete, steel, and traffic.
 
How could anyone make such a decision?  In a word, perspective.  To be sure, in the 1950s, the loop, or beltway was a very popular solution to the challenge of urban traffic congestion.  It had common sense on its side, directing traffic around the perimeter of the city to avoid congesting its interior streets.  But its application in a city like San Francisco, surrounded, as it is, by the ocean and the bay, was always a poor fit.
 
Many cities are now facing big changes in daytime population due to remote work.  City leaders are scrambling to formulate strategies that bring people back.  It’s just the type of moment in time when big decisions could be made, decision which will have a lasting impact.  Political leaders are especially vulnerable to latching onto anything that looks like a solution so they appear to have a plan at a time when residents are calling for answers.  We’re reminded of the many half-baked ideas that have been posited for the next life of the Westfield Shopping Center.  Good ideas, the ones that will stand the test of time, are not typically conceived in hasty reaction to immediate stress.  They require extensive consideration from subject matter experts, from people who have the capacity to look beyond the current crisis.
 
Interestingly, the topic of how to get to and move within a city like San Francisco continues to vex urban planners.  Unlike in 1950 San Francisco, today much about how we travel is in flux.  Look no further than the preponderance of robo taxis on our streets.  Soon, many of us will use these vehicles daily, ultimately reducing the auto traffic which now congests our city streets.  Looking a bit further into the future, we have the prospect of low flying, short-trip electric air taxi services.  These, too, could have profound impact on regional travel.  At this moment in time, we need to make good choices that help define what’s next, not limit it.

Impossible Math

Imagine you invested in an office building in San Francisco in 2015.  At the time, the building was 95% occupied.  You paid $750/sf for the building and secured a loan on 50% of the value at the rate of 3.5%.  50% of the building’s tenant leases rolled in 2023/2024, a fact you underwrote as opportunity, opportunity to increase net operating income by achieving higher rents.  Then the pandemic hit.

By early 2021, the daytime population in the building was down by 90%.  By 2022, it was clear the 50% of the tenant leases expiring in 2023 and 2024 would not renew, leaving a large vacancy to fill.  Instead of increasing, net operating income has substantially decreased.  Adding to this downward spiral, the loan matures in 2025 and the lender won’t extend.  Your only option for alternative debt is at 50% of the current valuation of building, which is $350/sf, at an interest rate of 7%.  You will need to invest large amounts of fresh capital to maintain ownership of the asset (e.g., to pay off the maturing debt and to release the vacant space).  You would be investing new capital at a significant loss, against the backdrop of a market that by any rationale assessment, offers no chance of a positive return on your investment at any point in the foreseeable future.

Of course, faced with this reality, you will hand the keys back to the lender and run, not walk, from your equity, thus capping your loss.  This is the impossible math some owners of San Francisco office buildings now face.  The outcome for the lenders isn’t much better, as they, too, will take a loss when they sell the asset.

As we write, a surprisingly large number of investors and lenders are approaching this very outcome.  For the past few years, lenders often provided short-term loan extensions while the capital partners hoped beyond hope for the market to snap back.  It didn’t.  We believe we’re near the bottom of the trough, but the recovery will be slow.  Only those investors having a cost basis which is in proper relation to underlying leasing fundamentals will prosper.

Encumbrances

An encumbrance is a burden or impediment.  Office leases often contain rights which are exclusive to a specific tenant and which place constraints on the landlord’s ability to lease space to other, 3rd party tenants.  These rights are referred to as encumbrances.  When tenants consider leasing space in a building, one of the first things they should qualify is the extent to which the landlord’s ability to lease the subject space is subject to any encumbrances.  If so, the specific terms of these encumbrances must be understood before proceeding.
 
It’s all too common for tenants to pursue a lease for office space only to learn (after months of negotiations) the space was subject to the superior right of an existing tenant.  This can create problems for tenants, including increased cost and loss of critical schedule.  The most common issue is when an existing tenant has an expansion right relating to the subject space.  Expansion rights come in all shapes and sizes, but the most common are the Right of First Offer, or ROFO, and the Right of First Refusal, or ROFR.  Each of these rights encumber the landlord in that they cloud its ability to lease the subject space to third parties unless and until the superior right holder has declined to lease the subject space in accordance with the terms of the lease.
 
The ROFO typically states that a landlord must first offer space in a designated portion of the building (or possibly the entire building) to a specific tenant on the terms it would otherwise offer to a third-party tenant before it leases any such space to a third-party tenant.  The existing tenant is then given a set period in which to respond.  The normal response options include, declining the first offer, accepting the first offer, or expressing binding interest in the first offer space, but electing to negotiate the terms of the first offer.  In the latter scenario, the lease will typically provide for a set period during which landlord and tenant are to negotiate in good faith, after which point, if the parties have not reached agreement, the terms are to be determined via arbitration.  ROFOs require careful administration from property management professionals, something that doesn’t always happen.  Ideally, the ROFO obligation is satisfied well in advance of the landlord agreeing to terms with a third-party tenant.  However, it’s not uncommon, especially in smaller buildings, for the landlord to discover it must satisfy a ROFO obligation just as it’s about to execute a new lease with a third-party. 
 
The ROFR is a more complex mechanism.  It calls for the landlord to secure a bona-fide term sheet with a third-party tenant and then provide those same terms to the existing tenant, giving the existing tenant the right to accept or refuse the terms.  Landlords are (generally) more inclined to disclose the presence of a ROFR because failure to do so can result in reputational damage in the brokerage community.  The tenant who negotiates in good faith believing they’ve agreed to terms only to learn the proposal must now be “shopped” to an existing tenant, understandably, feels like they’ve been used.
 
Landlords aren’t obligated to disclose any of these rights to prospective tenants and their brokers.  Good brokers will always seek to clarify the presence of any existing encumbrances which would affect the landlord’s ability to lease the subject space.  It’s a critical element of good due diligence.

I Was Told We'd Be Discussing the Office...

AI has summarized capitalism for me as follows:

“…an economic system where private individuals and corporations own and control the means of production, such as property, businesses, and industries. In capitalism, the core principles are profit motive, private property, and market competition. The government's role is limited to taxation and standard regulatory laws, and individuals are given the freedom to operate their businesses and manage their income as they choose.”

What does capitalism have to do with the long, heated debate corporate America has been having about the office?  Everything.  In fact, capitalism is the topic, not the office.  Here’s the thing, those advocating for more freedom to work when and where they want aren’t simply rejecting a commute, they’re seeking to shift the priority work has historically taken in their lives such that they have more balance, more time to spend on other pursuits (e.g., family, recreation, etc.) and, by extension work less.  The pathway to achieving their objectives lies in decoupling work from place and time.  Understandably, they prefer to center the conversation on how commuting to an office makes them less productive, as this argument avoids a broader exploration of motivations. 

Capitalist ideology is deeply ingrained in our social system.  Identifying as someone who is unwilling to do whatever it takes to succeed seems out of step in a work-obsessed culture, even anti-American.  In many cases, those wishing to modify how they engage with work believe such choices should not impact their opportunity for career advancement and increases in compensation.  But they do.   This is why the conversation gets so passionate.  It’s why the remote-first crowd lost its collective mind when ex-Google CEO Eric Schmidt, recently said, “…Google is losing the AI race to start-ups because the company decided work-life balance and being able to work from home is more important than winning.”  In his comments, Schmidt merely connected remote work and less work to capitalist outcomes.  This correlation is a direct threat to those who seek remote work in that it suggests their choice may diminish the value of their contribution to the enterprise, possibly resulting in less profit.  It makes them less capitalistic. 

To be sure, this entire discussion is focused on a relatively small subset of the total population; namely, highly educated white collar workers who can choose whether to go to an office.  The office is serving as a productive medium in which to better define modern work (say nothing for the massive changes coming soon from AI).  As employees, the extent to which our choices about the office align with those of our employer has become a primary qualifier of engagement.  There’s more transparency now.  It’s possible we’re seeing the emergence of a new subset of white-collar worker, one who intentionally places limits on engagement to support lifestyle choices.  These people have always existed, it’s just that the office conversation has made identifying them easier.

We need transparency such that both employer and employee clearly state their objectives and connect those objectives to capitalist outcomes (e.g., “…we believe in being in the office because it maximizes our potential and makes our company more valuable”).  But there is risk to both employer and employee in being transparent.  The employer who commits to an in-office workplace posture stands to lose some employees, and the employee who chooses to work remotely when the workplace is mostly in-office may lose value, or worse, lose the job.  In the end, employers who define their workplace culture with strong conviction will attract employees who share their vision, a better outcome for all.

We need to be clear minded about our economic system.  Capitalism does not care if we work in an office.  Capitalism rewards that which works best, that which creates the most profit.  Someone is always there, ready to do more to win.  Companies, in turn, will favor that which best serves their capitalist interests.  Or, at least, they should.  They may try new things, but in the end, they will go with what works best.  Maybe this is a remote-first workplace, but my guess is that’s a very small exception to the norm.  Hybrid has been a catchall, but for most companies, we see it as a hedge, a safe middle ground.  Today, labor leverage is shifting to favor the employer giving corporate leaders more cover to articulate their workplace vision.  We expect to see more outcomes like that currently playing out at Dell, where employees can choose less engagement via remote work,  but in so doing, they self-identify for less career advancement and lower pay.  Is this fair?  Maybe not.  But it is capitalist.  Capitalism doesn’t purport to offer equal outcomes to all.  It’s the opposite.  It promises to reward some more than others based on the choices we make.

Connecting Your Advisor’s Fee to Value Creation

In cities like San Francisco, tenant broker fees have increased significantly since the pandemic.  These fees are typically fronted by the landlord and recouped over the term of the lease through the rent paid by the tenant.  You may be wondering why landlords would offer more fee when rental economics are on the decline.  It’s because landlords think of the fee as an incentive to brokers to bring deals to their building.

As soon as one landlord increases the fee, others marketing comparable buildings follow suit because they want to ensure their building gets equal consideration (and they think brokers select which buildings to show the client based on fee – they (mostly) don’t).  When the markets are tight, as they were in the decade preceding the pandemic, landlords hold fees flat.  They don’t need to pay more to attract demand – the simple fact they have available supply is sufficient.

The current market rate for tenant rep fees in San Francisco is $3/sf/year of lease term, capped at $30/sf.  Prior to the pandemic, the cap was $15/sf.  Today, a 10-year lease of 10,000 sf will yield a tenant rep fee of $300,000.  As fees go, these are relatively large sums.  Since the tenant effectively pays the fee, it’s important they understand what they’re getting for their money in terms of services and value creation.

In fact, the primary driver behind how a tenant selects an advisor should be a thorough evaluation of what you get for the fee you pay.  When hiring the right advisor, broker fees are easily justified, as the right broker will deliver value that substantially exceeds the fee.  Good brokers will be able to transparently detail exactly how they create value.

Friday

Walking the near empty streets of downtown San Francisco on this beautiful August Friday, inspired us to ask our friend ChatGPT to craft a poem about the economic impact of workless Fridays.  Enjoy!

The Friday Freefall

Fridays used to buzz and hum,
Now they’re quiet, work undone.
The clock ticks slow, the pace is slack,
And the economy feels the lack.

Idle hands, and dreams on pause,
Profits lost, the hidden cost.
As Fridays drift, the drive decays,
And growth begins to lose its ways.

The markets stall, the engines cool,
With every empty desk and stool.
What’s gained in rest, we pay in fall,
As Friday’s break might break it all.

So here’s the truth we can’t ignore,
Less work today, less wealth in store.
The future dims, the stakes are high,
When Fridays wave ambition by.

It's What's Inside That Counts

If you’re like me, growing up your mother told you no less than twice a day “…it’s what’s inside that counts” or “…don’t judge a book by its cover”.  I’m grateful for that advice, as it helps me be more mindful of bias, more open minded.  Did you know the same is true for office buildings?  That it’s not just about how the building looks, or where it’s located.  The nuanced details of the ownership, debt, and occupancy also matter…a lot.
 
We’re attracted to buildings based on external factors like architectural design and location.  But the extent to which a building is well suited to accommodate a tenant’s needs is a function of more than appearance.  After all, the most beautiful building might have capital stack issues that prohibit it from transacting at market.   It might be owned by an ownership that is notoriously bad at tenant relations.  Perhaps the lender is about to take back the building.  What are the real-world implications of these variables, how would they impact tenancy? 
 
Understanding the big picture requires both deep knowledge of all relevant data and the experience to know how to develop a strategic approach based on such data.  This is among the most valuable elements of the services provided by a good broker.  The best brokers have access to a wealth of knowledge (not easy to get) and know exactly what to do given varying market dynamics.  The big picture is always an aggregation of many small parts.  Capital market intel is vital in qualifying the existing capital stack (equity, debt) as it compares to market.  Understanding the nuances of the existing tenant dynamic (WALT, tenant rollover, in-place NOI) is key to understanding leverage.  It’s the sum of the parts that matters most, including that which is not apparent to the naked eye -- it’s what’s inside that counts.

How Your Landlord's Tax Reduction May Cost You

Over the past several years, the market value of San Francisco office buildings has dropped by more than 30%.  Indeed, in some cases, asset values have declined much more, as evidenced by valuations associated with vacancy-challenged asset sales over the past couple of years.  Importantly, a large percentage of the San Francisco office market either traded or was financed in the years prior to the pandemic, when valuations were high and debt was cheap.  These activities created increased tax revenue for the city.
 
California’s Prop 13 establishes the most recent sale or financing value as the basis upon which property tax is calculated. Hence, much of the market is currently taxed at high valuations.  This creates a disconnect between the amount of tax and the value of the asset, causing owners to appeal the assessed value.  Appeals must be filed annually and can take up to 2 years before an owner will realize the benefit.  But given the disparity between assessed value and market value, many owners are filing appeals. 
 
Tax appeals create a large exposure for the City of San Francisco.  According to Mark Ong of Independent Tax Representatives, LLC, if the 7,585 appeals in 2023/2024 result in just a 10% reduction in taxes, it translates to over $200m in refund obligations for the city.  Remember, market values are down more than 30%, so a 10% estimate is very conservative.  The city of San Francisco has currently set aside approximately $70m for tax refunds, an amount that appears to be substantially below the projected obligation. 
 
Changes in taxation affect not just the city and building owners, but also office tenants.   Tenants must be aware of how tax appeals impact the lease expense.  They should be protected from having the tax base year lowered by temporary reductions in tax liability due to appeal.  Why?  Because these reductions are temporary; and, whereas the tax base is otherwise prohibited from increasing more than 2% annually, it can increase significantly more in any given year in which the appealed value is increased.  Consider, for example, a building that was acquired in 2019 for $800/sf.  The tenant’s tax base year is tied to the $800/sf valuation.  Now, say the current market value is $400/sf and the owner successfully appeals to lower the taxable value to $400/sf.  If the tenant lacks Prop 8 protection, its tax base year will be lowered to the new tax value (e.g., $400/sf).  While the appeal value remains in place, the tenant will pay tax increases above the $400/sf value (2% annually).   However, once the market improves, the city will be able to raise the taxable value, including taking it all the way back to the original assessed value ($800/sf).  In this case, the tenant will suddenly be exposed to a massive tax increase.  Similarly, office tenants moving into a new building must take care to ensure the base tax value is not tied to an appeal value, as this will create an artificially low base tax value, exposing the tenant to big increases.  If not properly navigated, the current tax environment can create significant tax liabilities for tenants.    

What Comes Next For Office

We’ve noticed an interesting shift in how companies are thinking about their offices.  For some time now, many companies have resolved to employ a hybrid approach to workplace, having employees work in office for a designated number of days each week.  In many cases, this solution was chosen more for how it seemingly struck a compromise between employers who wanted employees in the office and employees who sought freedom to choose.  To date, companies have been relatively lax in enforcing their workplace plan.  What’s changed?   Leadership is now becoming increasingly frustrated at spending on underutilized real estate.  Companies track space usage, and they don’t like what they’re seeing.  The occupancy reality is often way below what it would otherwise be if employees were following the hybrid work policy.  The company leasing 10,000 sf to accommodate an average of 10 workers each day is (painfully) aware of the wasted spend. 
 
This frustration is pushing leaders to take a more conclusive stand about the office.  It’s forcing them to (finally) be convicted in their approach.  One might expect this means reducing the amount of space leased.  If no one is coming to the office, why have it?  But that’s not exactly what’s happening.  Instead, we’re seeing leaders lean more toward enforcement of their workplace policies.  They seek to ensure space usage is in line with the planning upon which the office was conceived.  Perhaps this approach is a byproduct of a more challenging labor market in which employees are more risk averse, more likely to accept their employer’s workplace demands.  Whatever the cause, it’s big for cities like San Francisco.
 
The enforcement of workplace policies brings more people downtown.  Once it begins, it’s likely to accelerate because a lot of this is about habits, behavioral patterns.   We experienced this firsthand when we transitioned from working mostly from home to coming back to the office.   Initially, it was somewhat challenging.  But as we got used to commuting, to getting out of the house, we found unexpected benefits and shifted our preference from remote to in office.  Obviously, this will differ for everyone. 
 
Expect to see more announcements like that made by Salesforce earlier this week, in which it explained employees will be held to task on complying with their workplace plan.  We’re out of the hyper-sensitive, “do as you wish” phase, into a place in which companies expect employees to buy-in to workplace culture.  There’s nothing wrong with that.  In fact, it’s entirely appropriate for those providing the job to dictate where, when, and how the job is done.

Work

Over the past several years the concept of work has undergone more change than at any point in recent history.  While there’s many narratives, one common discussion centers on changing where and when we work to make work less harmful to our health.  This is exemplified by remote work. 
 
Work can certainly be harmful.  Yet few among us can avoid harm.  Indeed, harm often comes to us in ways we cannot and do not anticipate.  Sometimes what seems good turns out to be bad.  The very world in which we live is full of harmful realities.  I’m not convinced the absence of work brings less harm.  Nor am I convinced the changes we’re seeing now around how and where we work are as good for us as we hope they will be.  I think we’re generally failing to account for a variety of negative consequences that are slowly becoming more apparent.
 
Work is one of the primary ways in which we spend our time.  Most people will spend more of their life working than in any other activity.  It’s always been about survival.  In the beginning, the survival game was physical.  We worked to stay alive by avoiding predators, creating shelter, etc.  As we evolved, we built things, creating physical work that had the potential to cause physical harm (think Industrial Revolution).  Today, a lot of work is decidedly less physical.  But this less physical version of work can still cause physical harm – for example, the consequences of sitting at a desk and staring at a computer all day.  Less obvious (because it’s less visible) is the impact modern work has on mental health.  To be sure, the modern survival game is more complex, more nuanced.  The binary outcome of life or death has been replaced with the seemingly more civilized outcomes of hire/fire, rich/poor, etc.  While it’s nice to know we aren’t at daily risk of being attacked by a lion, the mental toll of losing a job, or toiling away in a job we hate, or struggling to support a family, can be significant. 
 
As work moved from the life/death realm, it offered more choice (certainly these choices are limited by socioeconomics and other societal realities which impact different factions of society in different ways).  We had the luxury of separating work from other facets of our life.  The idea was we “…go to work” and then we “…go home”.  We created boundaries.  This worked for many decades.  No, it wasn’t perfect, but we built our society around it.  These days, thanks to advancements in technology, we can work from anywhere.  This, with a big push from the pandemic, has caused many to want to relax the boundaries, believing they can create more work/life balance (which is another way of saying less work, more life).  However, there are consequences to these changes, some of which are turning out to be less than ideal.  The “working vacation” which causes us to underperform at both (work and vacation).  The WFH employee who, having merged work more fully into her homelife, no longer has a refuge from her work.  These are all unintended negative outcomes from actions taken to make our lives better.  It happens.
 
Work is undergoing rapid changes that will only accelerate as AI continues to evolve.  Against this backdrop it’s important for us to occasionally hit pause to think more fully about what we’re doing.  It’s nice that we have more freedom of choice, but that alone does not mean we’ll make the right choices.  We must each establish our own boundaries around where and how we work.  We must remain vigilant and aware of how our work affects our lives, our health.  But above all else, we must work.  I can’t imagine life any other way. 

Reinvention

Physical places, buildings, towns, cities, and even entire countries are always changing.  Sometimes the change is progressive and less noticeable, sometimes it's more extreme and jarring.  Near where I grew up is the town of White River Junction, Vermont.  When I was a child, the town was mired in hard times.  But it wasn’t always this way.
 
White River Junction was one of the most important railroad hubs in New England in the late 1800s and early 1900s.  In the 1940s and 1950s, as railroad travel began to decline in importance, the town’s purpose diminished.  Slowly, then faster, it became the kind of down on its luck small town you could find throughout New England, many of them having once been mill towns.  Of course, these towns all have charming bones and if you look carefully, you can see the traces of their prosperous past. 
 
Yet by the time I left Vermont for good in the late 1980s, White River Junction had the appearance of a place that would remain stuck in the tattered rags of its once vibrant past.  Until it wasn’t.  Sometime in the early 2000s, things began to change.  Indeed, today, this small town has the off-beat vibe of an artist colony, with a surprisingly international flavor, including a good Turkish and a good Vietnamese restaurant.  You could say the town has been reinvented.
 
There’s a parallel here for San Francisco.  It, too, needs reinvention.  Unlike White River Junction’s decades long journey back to health, San Francisco is likely to recover far more quickly.  It remains an important city, 7 square miles surrounded by water, Stanford, UC Berkeley, and the capital of venture capital.  It is here that many of the most impactful technologies of our lifetime have been created.  It is here that many of the world’s brightest innovators live and work. 
 
But just as shifting travel habits caused White River Junction to falter, changes in how (and where) we work, have wrought economic destruction on San Francisco.  Of course, this city is no stranger to hard times.  It has risen from the ashes before (literally from the 1906 earthquake).  It has seen its share of boom and bust.  I, for one, look forward to its next chapter, to witnessing how it reinvents itself, to being part of what’s next.

Active Listening, the Skilled Negotiator's Secret Weapon

Office lease negotiations are complex, involving numerous parties (the principals and their advisors), and covering a wide range of issues, from economic to legal.  The most effective negotiators are those who possess both a deep understanding of the markets, and the ability to actively listen while negotiating. 
 
Active listening is a communication methodology established by the psychologists, Carl Rogers and Richard Farson in the 1950s.  The goal of active listening is to achieve a true understanding of the other’s perspective.  This can be a powerful negotiating skill, as misunderstanding fuels protracted negotiations.
 
Despite its usefulness, active listening is not a common negotiating practice.  The opposite dynamic seems to prevail, one in which people take ill-informed positions and cling (sometimes desperately) to entrenched arguments out of ignorance and fear.  For example, it may be that I believe I should receive a certain concession from the counterparty in a negotiation when such concession is non-essential to my outcome.  I don’t really understand what I’m asking for, it’s just something I was told I should get.  Another example is the “this is just how we do it” approach, an inflexible posture which shuts down communication.  Educated negotiators, fluent in both sides of the argument, are most capable of active listening because they’re not scared of making mistakes.
 
Twenty years ago, office lease negotiations were conducted differently.  People sitting at conference tables hashing out the details with verbal arguments of their respective positions.  This practice made for more productive negotiations as it sharpened the communication skills of the practitioners.  It tended to illuminate the differences between the real and the academic as the parties wrestled with the true importance of each issue.  These days, with much of the leasing process digitized and negotiated via the trading of documents back and forth between the parties with limited direct communication, it can feel like no one’s listening.  Why did they come back to us with the same position?  Did they not see our comments?  These digital negotiations usually result in frustration, protraction, and missed opportunities to build relationships. 
 
Active listening-oriented negotiations are simply more effective.  They result in better understanding of the issues by all parties, and they create stronger relationships.  The good news is the best advisory professionals are also those most capable of employing this approach.  Before choosing an advisor, ask how they would handle difficult issues in the negotiations.  Give them an example, let them show you.  This exercise will yield different and revealing results which will prove useful in your selection process.

The Ingredients Matter

Strategy is to occupier real estate what a recipe is to a great meal.  A recipe is more than the sum of its parts.  It’s about how each ingredient is prepared, how and when it’s added to the mix.  As with any recipe in which there are primary ingredients, vital to its success, similarly, every great strategy requires 3 main parts:
 

• Experience

• Resources

• Market Knowledge

 
On the surface, experience should be easy to understand.  However, it’s not just a matter of time in the industry, it’s also about the exact type of work and how that work contributes to the success in projects like yours.  Concentrated specialization in tenant advisory is essential.  Office occupiers need professionals who are experienced in the very specific challenges of creating and exercising leverage in complex office markets.  This is not a skillset your average commercial broker will possess.
 
But even the right experience, by itself, is not enough.  Great strategy also requires resources.  By way of example, our tenant advisory practice is significantly enhanced through our ability to draw from a wide spectrum of resources available to us at Cushman & Wakefield, a global firm.  These include things like our culture of sharing best practices from the global work we do.  It’s the huge investment our firm makes in market research, which helps inform our strategies.  It’s having access to data and insights we derive from other disciplines within our firm, like our capital markets practice, which provides us vital knowledge about equity, debt, and landlord motivations.
 
Real market knowledge, the kind that runs deep and wide, can only be obtained when there is a high level of engagement in the markets.  In all major markets, Cushman & Wakefield maintains a strong presence across multiple strategic disciplines, the cumulative effect of which is a much better view of both the big and small pictures.  And make no mistake, we need to be able to pan in and out to see how all the pieces fit together.
 
Experience, resources, and market knowledge, these are the 3 main ingredients to a good tenant advisory strategy, the ingredients that matter.