Other tech-heavy office markets too.
For some time, we’ve heard through the rumor mill that commercial real estate brokers in San Francisco are getting nervous. Then Savillis Studley released its report on the San Francisco office market for the fourth quarter. A very mixed bag for the first time since 2009. And now even Fitch Ratings is getting antsy.
“Overall vacant availability posted its first material increase since 2009, rising by 0.6 percentage points to 8.0%,” Savillis Studley reported for Q4. “The Class A rate spiked by 0.8 pp to 8.5%.” And worse: “More sublet space hit the market.”
A prominent sublet space to hit the market is an entire floor at Twitter’s headquarters. Twitter has been laying off, and it won’t need this space. This comes after Twitter abandoned plans to lease an additional 100,000 square feet at the nearby headquarters of Square, the other company where Twitter CEO Jack Dorsey is the CEO. Those 100,000 sf then came on the market as well.
Yet, according to Savillis Studley, overall asking rent in Q4 “spiked” 14.1% year-over-year to $63.87 per square foot. Class A asking rent “jumped” 11.7% to $65.94 per square foot.
As new office space came on the market, absorption has been negative for two quarters in a row, reaching -500,000 sf during Q4. With supply and vacancies up, even as prices soared, something had to give: demand collapsed. Tenants leased 5.9 million square feet in 2015, down 35.7% year-over-year.
San Francisco cloud-storage startup Dropbox is emblematic of what is going on in tech-based local economies, including commercial real estate (CRE), which has been in a phenomenal boom in terms of lease rates and construction, powered by a global money tsunami.
Dropbox does what Google, Apple, Amazon, IBM, Microsoft, and other companies with cloud-storage services are doing. So this is going to be tough. Nevertheless, it has a “valuation” of $10 billion, as of its last round of funding in January 2014. It’s one of the deca-unicorns. Or perhaps, “was” because, to let some folks cash out, it has authorized the sale of common stock on the “secondary market” at a 34% discount, BuzzFeed reported. While some discounting is not unusual in these situations, it is a big cut, reminiscent of the “valuations” cuts of other startups since last summer. Not a propitious sign.
With these sorts of valuation cuts ricocheting through tech land, Fitch Ratings warns in its manner: “Tech-oriented U.S. commercial real estate market fundamentals have cooled but are unlikely to collapse.” And then it lays out just how likely these fundamental are to collapse.
The risks: “lower tech-tenant demand in markets such as San Francisco, Silicon Valley, Seattle, New York and Los Angeles,” “cooling tech employment,” and “capital availability.”
This “capital availability” is crucial. But the IPO window shut late last year and big corporate buyers have largely lost their appetite for gobbling up startups at multi-billion-dollar valuations. As the exit doors for investors are closing, they have trouble converting “valuations” into real money. And so the new money, seeing this happening, is drying up.
Fitch points at the bane of office markets: “speculative leasing.” It turns a growth market into a dizzying boom, and it turns the next downturn into a rout.
The amount of speculative leasing is a key unknown that will influence the severity of office market downturns due to lower tech tenant demand. Speculative leasing occurs when companies lease more space than then they currently need in anticipation of future growth, typically motivated by concerns over rapidly rising rental rates and limited space availability.
Speculative leasing was “a key reason for the collapse in office rents in San Francisco and Silicon Valley following the tech bubble burst in the early 2000s,” Fitch reminded us.
At the time, market participants generally expected the San Francisco market to weather a tech industry downturn reasonably well, since new supply was balanced with demand growth. In hindsight, investors underappreciated the artificial demand boost from rampant speculative leasing by weak credit tenants.
And now speculative leasing is back in all its glory. See Twitter’s headquarters, which is far bigger than what Twitter now needs or wants. Or Square’s headquarters. Or the big ones….
Among the massive amounts of new office space coming on the market this year and next is the 61-story Salesforce Tower. Salesforce leased 714,000 sf in it. That’s a lot more than the 423,000 sf it currently occupies.
Salesforce sold its old site to Uber and its development partner. Once Salesforce has moved out, Uber will move into these 423,000 sf, which is a lot more than what it has now.
LinkedIn is also moving into its new space of 452,000 sf, in two phases, starting this month and to be completed by 2017.
Companies like these have made plans to hire lots of people and fill the huge vacant spaces that they leased or bought. If those plans don’t pan out – see Twitter – this office space becomes “speculative space” and ends up on the market. This type of office-space hoarding has been a big force on the way up.
With space seemingly in short supply and lease rates soaring, panicked companies awash with money, even startups with no revenues, have hoarded office space to grow into, thus injecting steroids into the office boom.
If they don’t need it, they can always put it on the market and sublease it. That’s the logic. But if push comes to shove, they will all put it on the market at the same time, just when practically no one needs more space.
There is an additional problem with startups: when the moolah dries up, many will burn through their cash before they figure out how to get a positive cash flow and sustain themselves. When these companies reach the end of their road, landlords end up with empty office space, and that too is going to hit the market.
These forces happen simultaneously. The office market turns into a glut. It puts enormous downward pressure on lease rates – and everything that comes along with them. Real estate is highly leveraged. When it gets ugly, a chain reaction mauls banks, creditors, and investors of REITs or commercial mortgage backed securities (CMBS). That’s what Fitch is warning about.
As miracles are deflating, a brutal process has set in. And debris from the collapse is hitting investors left and right. Read… It Gets Ugly in the Startup Bust