News & Research Archive

The Threat of a Five Percent Office Vacancy

Feb 16, 2012

 

Just before the holidays I toured a client who was looking for 3,000 square feet of office space around the financial district in San Francisco. We were looking into more of the Class B type buildings and toured four buildings that made our short list; on average the price per square foot was in the mid thirties. My client indicated that with the holidays coming up, he wanted to hold off on making any final decisions on a new space until after the first of the year. Last week we toured the same buildings again only to find that the very same spaces were now going for high thirties to low forties in rent. What happened in three weeks?

Both the San Francisco Chronicle and the San Francisco Business Times ran articles discussing how the city is running out of commercial space in South of Market and how the market has tightened in the core financial districts all due to our new tech boom. Once these articles hit the streets, building owners were raising prices the very next day.

Today, core financial district and close-in South of Market locations are looking at a vacancy rate currently at or below five percent; this is not good for landlords or tenants in the long run. To understand why a five percent vacancy is in fact a threat, one must first understand how buildings are financed. When a building is financed it is never given credit for being one hundred percent leased. There is always a five percent vacancy factor that is customary to be taken into account in the value determination for an office building. Once a building hits ninety-five percent occupancy or less, the building owner no longer has any incentive to lease out the remaining building by being more competitive in rents. In fact, since there is no financial incentive to rent this space, in terms of seeking higher financing options it is better to seek the highest rents possible and hold firm on that price even though the remaining space may never lease at that rental rate.

Building are valued most often by the last deal done in the building. Using my tenant as an example; if he were to accept a low forties rental rate the building would be looked upon more favorably since the rental rate for the entire building would be in the forties against the overall average for the rest of the building which may be in the twenties or low thirties. Building owners would be well positioned with added value for their buildings because as spaces become available, their lenders would anticipate those rents at the new high rental rate mark. The problem with this logic is that building owners today are dealing in a market place that is based upon a growth sector (tech) that, as a whole, is not profitable. The technology sector is made up of start-up companies seeking to gain acceptance and profitability but the realty is the majority of these firms will not make it.

Another hard truth is that conventional businesses, like the rest of the country, are now at best stabilized from the effect of this long recession. Most businesses are still short of cash and are not seeing anywhere near the growth needed to pay twenty to forty percent more in rent. This was clear to me on the tour mentioned above when I went to a building to tour five spaces: four of these spaces still had businesses in place. In the past it was rare to tour a building with the majority of the spaces still occupied; this only happens in a tight market. My guess is that these businesses were nearing the end of a typical five year commitment in a building that had original rental rates in the mid to high twenties. Now, with building owners notifying their tenants that renewal rates will be in the high thirties or forties, tenants simply cannot afford the rent.

Overall, the ripple effect of a five percent vacancy creates an uncertain future for businesses and business owners who, in all reality, stand more of a chance for longevity than the current up cropping of start-ups. Building owners will soon awake to the slowing of the tech boom and the reality that real rental rates are nowhere the prices that they are now quoting. As business people and residents of San Francisco, we have to ask the question of whether this current situation will be detrimental in the long run to our city and economy.

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Written by: Hans Hansson

E-mail: hans@starboardnet.com


Hans Hansson is President of Starboard TCN Worldwide Real Estate Services as well as a member of the Board of Directors for TCN Worldwide Real Estate. Hans has been an active broker for over 27 years in the San Francisco Bay Area and specializes in office leasing and investments. If you have any questions or comments please email hans@starboardnet.com or call him at (415) 765-6897. You may also check out his website, http://www.commercialspacefinder.com/.

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