New Year, More Leverage

In March, we’ll hit the 4-year anniversary of the date when offices all over the city first shut down due to the pandemic, a time when just 5% of the city’s office inventory was available.  Today, despite having more office workers now than we had then, just under 30m sf of our total supply sits vacant, and even more than that is available.  Citywide average asking rental rates declined 17.5% during this period.  We expect this trend to continue, possibly to accelerate in 2024.  Sublease supply is pulling rates down as companies increasingly view any recovery as a net positive.  There’s little on the near-term horizon to suggest we’ve begun (or will even begin in 2024) the long march toward recovery.  The market dynamic is considerably worse than that which we experienced in the dot-com recession when it took 63 quarters to get from bottom to peak.  We’ve not yet reached the bottom.   

We often talk about the current environment as a “generational opportunity” for occupiers to negotiate favorable lease terms.  While tenant leverage has been excellent over the past couple of years, as we begin 2024 it has accelerated, yet again.  The moment is nothing short of the most compelling time to lease an office in San Francisco over the past 50 years.  This is the silver lining.  Abundant supply, low rent, significant concessions, and maximum flexibility.  If getting the office right is among your objectives in 2024, congratulations, your timing is impeccable.

TenantSee Team San Francisco Market Predictions: 2024

Let us lend our TenantSee perspective to the coming year.  Despite green shoots from 2 large AI sector leases (Open AI and Anthropic), demand for San Francisco office space remained low throughout 2023, yielding 4 more quarters of negative net absorption.  We finished the year with vacancy at >35% - an historical record.  The market is under significant stress, creating sizable opportunities for occupiers.
 
2023 marked a turning point in investor/lender strategy, which post-pandemic consisted of ignoring market realities and hoping demand will magically jump back to pre-pandemic levels.  An understandable approach, given the high value of equity and debt investment in San Francisco assets.  But after 3 years of negative data; quarter after quarter of negative net absorption, increased loan servicing costs, increased operating expenses, rising interest rates, mounting vacancy, falling rental rates, and increased capital requirements, investors began to wave the white flag in 2023.  What does waving the white flag look like?  Usually, it manifests as a distressed asset sale.  We had several such sales in 2023, an important step in price discovery.  When assets trade it has a ripple effect in the markets, causing investors and lenders to mark to market their comparable asset holdings.  2023 San Francisco office trades confirmed investors were willing to pay $150/sf to $275/sf for vacancy–challenged assets.  We expect to see this trend continue in 2024.  The equity and debt positions in a commercial office investment are often referred to as the capital stack.  These distressed asset sales amount to a resetting of the capital stack on terms that are more favorable, enabling the new investors greater margin for error and the ability to better meet the market where it’s at, something the previous capital stack could not do.  On balance, this is good for occupiers in that it makes more of the market actionable and fuels competition for tenancy.
 
Office market dynamics are purely a function of supply and demand.  When either is moving substantially outside the realm of normal, it has a big impact on the other.  For much of the past 20 years, San Francisco’s office market has been driven by strong demand, which, in turn, reduced available supply in a market in which geography and politics already limit development.  This resulted high rents, making San Francisco one of the most expensive global office markets and a “must have” market for institutional investors.  Today, demand is still calling the shots, only this time, it’s moving swiftly in the opposite direction, causing the supply of available space to steadily climb, rents to decline and investors to proceed with extreme caution.  This dynamic, of continued reductions in demand for office, will continue tin 2024, resulting in another year of negative net absorption, creating yet more vacancy in an already saturated market.  Occupiers seeking to lease will enjoy plentiful options and extraordinary leverage.
 
2024 will be an inflection point in the pace at which rents decline.  In the years since the pandemic, rental values in San Francisco have held firmer than one would otherwise expect given market fundamentals.  There were many reasons for this. What’s most important is what’s about to happen.  Landlord capitulation.  Virtually no landlords are sheltered from the reality of a hyper-competitive environment in which they must do all they can to maintain occupancy.  With tenants downsizing and relocating, a building can very quickly shift from 85%+ occupancy to <50%.  This can start a downward death spiral which is hard to correct, including triggering debt coverage thresholds, capital calls, long periods of downtime, and a host of other problems.  It’s likely in 2024 we’ll see among the greatest year over year rent decreases in the market’s history.  Again, this will be a boon for occupiers.
 
Notwithstanding the resets noted above, instability of the capital stack will remain an issue for occupiers in 2024, as investors and lenders struggle with the broken mechanics of their pre-pandemic investment.  We believe there’s easily 30%+ of the market facing major issues which will prohibit market-based performance.  It’s important for occupiers to know where their building stands amidst this uncertainty, as well as any alternative sites they may consider.  Broken capital stacks can result in landlord default, deferred maintenance, and other operational issues which diminish occupier experience, right at the time when companies are most keenly focused on enhancing such experience.
 
Construction costs seemed to defy gravity over the past several years, steadily increasing despite broad decreases in the scale of work.  The market seems to have finally caught up as today we’re beginning to see a flattening, and in some cases, reduction in the cost to build.  With union labor contracts, the brunt of this downturn will fall on general contractor fees.  Adding to this beneficial trend for occupiers, in some cases, landlords are willing to fully fund new tenant improvements on a turnkey basis.  Net/net, the cost to occupiers of building new space will be on the decline in 2024. 
 
In summary, we predict the 2024 San Francisco office market will present occupiers with a “generational” opportunity to transact for space at steep discounts to historical market norms.  This will include early restructuring of leases.  The best advisors will be able to underwrite and create strategies that generate substantial savings.  San Francisco has gone from one of the most expensive and challenging global markets in which to lease office space, to among the most distressed global markets, ripe with the opportunity to achieve big savings.  In short, 2024 will be an excellent year for San Francisco occupiers.