CORPORATE OFFICE PERSPECTIVES | JUNE 1, 2022
June, 2022
Issue: 252
Wow, what a tumultuous past sixty days since the last issue of this newsletter! Between the war in Ukraine, the stock market going up and down 1,000 points at a time, the Feds raising the interest rates by the highest amount in decades, and Roe vs Wade, did I miss anything? Does any of this affect the commercial real estate market? More and more office workers are getting back to the office, but nowhere at the same density as pre-covid and many think the office world will never return but morph into a wide range of corporate strategies and realities. This may vary by industry as some businesses rely on employees being physically in the office while others do not. In some regions of the country occupancy is back up to 50-60%, while here in San Francisco it is still stuck in the 35% range. Regarding rising interest rates, there may be an influence on cap rates and a 6–12-month transition period where buyers expect a lower price, higher return, while sellers are still set on property values being unaffected by interest rates. I know senior brokers who tell me demand is high, and there is so much money chasing a limited supply of certain types of properties (i.e., industrial, warehouse, multi-family) that they do not see an interest rate impact. I disagree with them. There will be an impact, but it may take time. Inflation of construction materials, labor and supply chain issues are having a dramatic impact on commercial real estate. In many regions of the U.S., it now can cost $45-80/rsf to rebuild an office, without any special upgrades or features. Some cities like San Francisco and New York can run $90-150/rsf! Lead times for materials as well as permitting can add months to the delivery date. New construction for all types of commercial have gone through the roof, and with costs escalating substantially over time, contractors may be adding major wiggle room in their bids. With lead times of 2-3 years or longer, what happens if there is a major recession?
Employees Prefer Remote Work Over Promotion, and 50% Said They Would Look For New Job If Required To Return Full-Time to Office
On March 21, 2022, Bisnow published a report that “Half of all companies plan to require full-time in-person work within a year. There seems to be a major disconnect between what employees want and what employers want…perhaps there will be two types of companies with two types of workers, those that require workers to be in the office, and find those employees happy with this arrangement, and then the rest of the companies that will be more flexible with where their employees work… It would be interesting to see which group is more productive. I have been coming into the office daily for the past 18 months, but I live ten minutes from my office…if I had a nasty commute, or didn’t have a great group of associates that I team-up with on a regular basis, perhaps I would be working from home more. The great thing is with modern connectivity, hardware, software, cloud etc. we actually have a choice how we want to work and live. This would not have been practical twenty years ago.
Major Office Building Investment Goes Back To The Lender
I am not sure if this is a harbinger of what might be coming down the road, but Blackstone, one of the world’s largest owners of real estate just gave the keys of 1740 Broadway, New York, to a special servicer on its $308 million dollar loan. It paid $605 million for the building in 2014 but lost two huge tenants. The cost of tenant turnover can be immense, and Manhattan has an office vacancy rate over 17%. It might take a year or two to find replacement tenants and even then, the tenant improvement expense could be in the $100-125/rsf range. Bisnow reported “Blackstone’s decision to cut its losses at 1740 Broadway echoes recent moves in Chicago, another office market suffering from macroeconomic shifts. Last week, two towers each spanning over 1M SF were on track to find themselves in the hand of lenders, according to CMBS tracking firm Trepp…The problems going forward are going to come from primarily markets that have sizable amounts of dated properties that are not particularly desirable to big drivers of demand these days,” Trepp Senior Managing Director Manus Clancy told Bisnow in January. “You’ll see episodes in New York, Chicago and other places where big buildings that back loans with nine-figure balances become distressed.”
Major Commercial Real Estate Executives Very Upbeat On 2022 and Beyond
I recently attended a commercial real estate major investor and developer panel put on by my Northern California SIOR chapter at San Francisco’s Ferry Building. Overall, everyone was very optimistic about 2022 and 2023. Paul Single with City National Bank told us our economy was unbelievably strong and interest rates were already up 175 basis points since December 2021. Drew Gordon, with Hudson Pacific Properties, whose firm owns the Ferry Building, said technology is driving increased headcount and company growth. Class A office buildings with bells & whistles, new health and safety features, will far outperform Class B and C buildings, some of which will not do well in the future. The Bay Area has some of the top universities in the world, and this will continue to draw major innovation, creativity and capital to our region. Comments were made by various members of the panel that construction materials and labor costs over the past 18 months have gone up 1% per month, and some items like steel might require an 18-month lead time which further exacerbates construction. Industrial land in parts of the East Bay have hit $100 a square foot, which just a few years ago would have been unthinkable, but e-commerce has fueled the need for great amounts of warehouse space. Also, companies worried about the supply chain are taking extra space as a safety measure. A new term, IOS, stands for Industrial Outdoor Storage, and it is getting harder and harder to find yard space for company truck fleets and commercial vehicles. There was also mention that worldwide, the United States is still seen as one of the most stable, safe and best places in the world to have major investments and there are billions of dollars from overseas seeking to place money here.
San Francisco Still Lowest Employee Return-to-Office Rate in the Country
Austin is leading the pack, with 53% of its workers back in the office. Los Angeles checks in at 40% and New York at 36%, but San Francisco is still at the bottom with only 31% of workers coming back to the office. This is having a negative impact on the City of San Francisco’s budget, as the business tax is based on work that is actually physically done in the city. They anticipate a $64 million drop in tax revenues. On the other hand, does this mean that companies whose workforce is remote are saving $64 million? There is also a slowdown in the real estate transfer tax revenue that the city gets when an office building sells, and sales are way down in part due to the uncertainty of the office market. The Federal and local governments may mandate an employee return to the office, as well as major employers like Bank of America. The next few months will be interesting!
Who Is Kidding Whom?
Jim Gardner, Managing Editor of the San Francisco Business Times summed up the controversy over whether employees will be working in the office or working remotely. In his editorial titled “Back to the Office: Who’s Kidding Who?” Jim cited several surveys, and the bottom line appears to be, employers overwhelmingly want the employees back in the office five days a week, if possible, while employees want to either not come in at all or at most work hybrid between home and office. We are seeing major organizations mandate a variety of work modes. The Federal government may be leaning towards having folks back in the office, Bank of America totally wants them back in, while I have seen a number of tech firms offer total remote. One yesterday said the worker needs to be in a state where they have an office but only has to come in once a year…no consensus whatsoever! What we will be witnessing over the next few years will be a workforce experiment. Different company cultures, different management styles, and different types of employees will determine what works and what does not. Right now, with unemployment being low, employees have a lot of leverage, but if we slip into a recession, as many are now suggesting, the advantage may shift back to the employer. One thing is for sure-there is at this point, there is no right or wrong answer…
So Much To Be Proud Of!
For years I have subscribed to Business Facilities, in which many of our country’s states tout how wonderful their economic climate is, their economic development departments incentive programs, and where major real estate deals have taken place around the United States. In the past I have felt a smugness about California’s place in our country, with so many strong economic indicators and continued major corporate expansions. Today for the first time, I read the latest issue differently. Earlier in other media posts I read about Wells Fargo giving up a huge part of its San Francisco headquarters, as well reading about yet another San Francisco tech company picking up and relocating to another state. In this case it was Sendoso, who signed a 60,000 square foot lease in Phoenix for its headquarters relocation. It was through this lens that I read in Business Facilities about the Ford Motor Company and SK Innovation planning to invest $5.6 billion in West Tennessee to build a new all-electric F-series truck factory. I read about Samsung investing $17 billion in Texas for a semiconductor facility. One part of me is saddened by companies leaving California, but another part of me is so proud of our great country that we have so much going for us in so many different regions!
Do Flashy Amenities Bring Workers Back To The Office?
“To attract workers back to the office, companies are leaning on the presence of tricked-out offices with leisure areas, modern technology, fitness areas, outdoor spaces and other amenities. Nationally, large companies are hosting parties, pop-up events, free food and even celebrities to paint the workplace as more appealing than home, according to the New York Times.” As Bisnow reported on April 17, 2022, “With workers still visiting retail and entertainment but not at the office, it will take years for the office industry to find a new normal. Experts said getting 100% of the office back at one time is unlikely.” “According to Gensler’s latest U.S. Workplace Survey, about 55% of Americans were working in the office in some capacity as of the beginning of the year, though only 18% were in the office full time – the same percentage that expected to continue working full time in the office going forward….18% said they would prefer to work in an office two days a week, and 15% said one day a week. About a third surveyed said they would ideally prefer permanent remote work.” The San Francisco Business Times reported that Gusto, a payroll and benefits provider with 2,000 employees, let its employees decide how they wanted to work. “About 47% of the company’s workers chose full-time remote work. Just 2% chose to be in the office full time – and the rest picked a ‘flex’ schedule with some days in and some days out.” I don’t think free gourmet food or foosball in the office will change these figures…
Cost Increases in Construction? Maybe Blame It On Amazon!
Amazon has increased its footprint from 97 million square feet at the end of 2016 to over 457 million square feet by the end of this year. This is an increase of 360 million square feet of warehouse and distribution space, which has created huge shortages and price increases in a number of the building material elements needed. Joists, girders, deck materials and more have pushed lead times for other builders to a 20-year high, according to Bisnow April 24, 2022. Our convenience in on-line shopping (60% of which are with Amazon) has caused a huge inconvenience for construction companies. In addition, in many regions of the United States, industrial land prices have skyrocketed. Here in the Bay Area, it is not uncommon to hear of industrial land going for $100/square foot! Of course, we can’t really blame this on Amazon. After all, it is consumers like you and me driving all of this!
The Latest US National Office Statistics
The overall office vacancy is at 15%, and this is true for both suburban and CBD markets. There is almost 122 million square feet of new office space under construction, 27 million of this in New York City Metro, 9 million in the San Francisco Bay Area, and 8.5 million in Washington D.C. Class A lease rates nationwide averaged $40.76/sf, with San Francisco leading the pack at $81/sf followed by Manhattan at $81/sf and Boston at $70/sf.
What Do You Think Of The Bay Area Office Market? I Look Forward To Your Comments!
Where is the office market headed, especially in the San Francisco Bay Area? Yahoo just put its entire new 657,934 sf San Jose office campus on the sublease market. PayPal just announced it was vacating downtown San Francisco, as have a number of other high-profile corporations. Is this due in part to the onerous San Francisco Prop C that taxes businesses over $50 million? In a survey 40% of the workers said they would rather quit than have to return to the office full-time. On a more positive note, office tours in San Francisco are up 20-25% in the past month. In the Tri-Valley Region (Pleasanton/Dublin/Livermore) I remember when we were doing tons of 50-200,000 sf lease deals. It was crazy! I just saw a market report titled “22 Q1 Significant Lease Activity, and the only four deals mentioned ranged in size from 6,000 sf to 9,000 sf! Where do you think our Bay Area office market is headed, and how do you think the Return To Office (Or Not) will turn out in the end?
Great Positive Commercial Real Estate News!!
There are a number of wonderful announcements about our commercial real estate markets. First, here in the San Francisco Bay Area Ripple just leased 130,000 square feet of office space at 600 Battery St. in San Francisco. Applied Materials just subleased 246,000 square feet at 3333 Scott Blvd. in Santa Clara, and on a national level, the retail market has come back alive, with the national vacancy dropping to 4.5%!! There was 24 million square feet of retail space leased in the first quarter 2022. Retail rental rates are expected to increase by about 4% this year.
Hidden Costs In Office Leases Many Don’t Know About
There are a number of costs in office leases and the office leasing industry that many might not be aware of. Most full-service office leases, where the rental rate includes property taxes, property insurance, utilities, sewer, water, garbage, janitorial and building maintenance have an annual adjustment where the pro rata share of the increases over the base year are passed onto the tenant. The base year is usually the first year of occupancy. In recent years there has also been an annual rental increase, up to recently 3% per year but with inflation I have seen more landlords ask for 4% per year, which is applied to the entire rent. This means the tenant is paying twice on that portion of the rent that is operating expenses as they are already paying their prorate increase annually. As an example, if the annual full-service rental rate is $30/rsf, $15/rsf of this may be operating expenses. While we are on the topic of the 3% or 4% annual increases landlords may be requesting, the Federal Reserve has said publicly their overall goal is to get inflation down to 2%, which means if you lock in a 5 year or longer lease with 4%, you may see your rent escalating far above actual inflation figures at some point in the future.
Another office leasing factor some are not aware of is that BOMA, the Landlord industry organization (no, there is no similar group representing tenants), a few years ago re-measured office buildings and in many cases dramatically increased the size of rental square feet, to the tenant’s detriment. If the tenant had control of an outdoor balcony the landlord could charge the same rent on this outdoor space. I have seen a number of our local landlords back off on this when it at times can be draconian, but also have seen unaware tenants end up with greatly increased monthly rent bills. Imagine paying the same rent you pay on your inside space for an outdoor balcony you may never use!
Owning an office building might be a beautiful thing, especially when the market is tight, you have long-term credit tenants who never want to vacate, and you have little or no vacancy. However, in the real world we have submarkets where the vacancy rate is 20% or higher, tenants are down-sizing or leaving town altogether, and rental rates have remained flat for the past five or more years. Today, the cost of tenant improvements can be a nightmare for landlords. In our region of the suburbs of San Francisco, it is not unusual to see tenant improvement costs come in at $25 or $50 or even $75/rsf or higher. To put this into perspective, if the landlord borrows the tenant improvement money at 5% interest (which today may be way too low) and amortizes it over the five-year lease term, $25/rsf would cost $0.47/rsf per month over 60 months, $50/rsf would cost $0.94/rsf per month over the 60 month lease, and $75/rsf would be $1.41/rsf for 60 months. We are seeing these types of tenant improvement budgets in $3/rsf monthly rents. Taking the $50/rsf TI figure, this would drop your rent before other expenses from $3.00/rsf down to $2.06/rsf, and if operating expenses were $12/annual or $1.00/rsf per month your net rent before paying your mortgage would be $1.06/rsf. This is one reason industrial and warehouse buildings are in most cases a more preferred investment! Why do office landlords do these types of deals? The loss on keeping empty space may be far greater.
In the home front, fortunately all is well! Jordan, my 24-year-old who is still running an industrial drone company, works crazy long hours, but then heads off to Montana to ski a week or Hawaii to scuba dive. A nice healthy balance of life! Madison, who turns 20 in August, is still taking college classes but not sure what is in store as a career. Stepson Ryan, a Junior at UCLA, has a couple of internships lined up for the summer reviewing screen plays for directors. Not a bad college gig! Stepdaughter Lindsey, 24, is in Washington D.C. working on her Masters at Georgetown and is fluent in a number of languages. By the time you read this, wife Launa, who teaches French and Spanish, will be on summer break and making the most of a well-deserved time off. Father Arthur, who turns 97 this September, has continually amazed all of us with his energy and enthusiasm for life. There have been weeks where he is at a concert in San Francisco one night, Berkeley Rep the next night, at another event the third night, and complains about not having enough energy to do all he wants to do. When I hear his schedule, it makes me want to take a nap to rest up! A few weeks ago, he joined my high school buddies in a poker game, which we have been having for over 40 years, and won more than the rest of the group combined. What a guy!
The days are now longer, at least until June 22, and summer and all its pleasures and adventures are just around the corner. I hope you and your family have the best summer ever and make amazing lifetime memories!
