We are nearing the longest period of economic expansion in U.S. history. At this stage of the cycle, some U.S. office markets are extremely tight, resulting in reduced occupier leverage and more expensive leases — none more so than the San Francisco Bay Area. As of the fourth quarter of 2018, according to Cushman & Wakefield (our parent company), the San Francisco office market is 6.4% vacant, the lowest vacancy of any major U.S. market. The average asking rent is $75.57, the highest in the country, and office rental rates increased 41% from 2013 to 2018. Similarly, JLL’s Q4 Office Insight report estimates total vacancy at 7.1% and average asking rent at $80.97, and Newmark Night Frank notes in its San Francisco Office Market research for Q4 2018 that overall vacancy is 8% with asking rental rates averaging $82.51. The bottom line: Space options are limited, and rental economics are at all-time highs.
Navigating these markets to achieve successful leasing outcomes is a challenge. Market results generally fall within a spectrum of good and bad defined by the overall environment. However, good leasing results are always measured in terms of how well they address non-financial considerations (i.e., employee wellness and productivity) and mitigate costs. In tight markets, leasing outcomes priced at the top of the spectrum and achieving comparatively little of a company’s non-financial objectives are common. Yet some still manage to transact at 10–25% below the top and get much more of what they want. Over the 30 years of my practice, I’ve been on both sides of the negotiating table and learned firsthand the three essential steps occupiers must take to combat tight markets. The following steps won’t make a hot market seem reasonable, but they will protect against lease economics that set a new record high.
Analyze The Trade-Offs
Firstly, tenants must prioritize the desired outcomes of a leasing transaction at least 12 months prior to the notice date for a renewal option (most leases have such options). This means analyzing the trade-offs associated with different leasing outcomes to fully understand what matters most to the firm. Leasing decisions affect people and financials. In tight markets, most companies can’t afford to “have it all.” Maybe near-term financing activities necessitate a hyper focus on earnings before income taxes, depreciation and amortization (EBITDA), a key financial metric often used in valuation. Or, perhaps the company’s main goal is capital preservation. Maybe it’s time to create a new facility that enhances employee wellness, happiness and productivity? Every company has unique drivers that, when prioritized, will dictate the appropriate leasing strategy. Getting this resolved well ahead of any market engagement is crucial.
Once the desired outcome has been prioritized, a company can set strategy and timeline for market engagement. Strategy development is the second essential step. An effective tight market strategy must ensure that exercise of the renewal option is preserved as one possible course of action. In San Francisco, for example, we have seen instances in which other tenants have identified space having a future lease expiration and arranged with the landlord to lease such space if the existing tenant fails to exercise its renewal option. The space has effectively been leased out from under the existing occupant without its knowledge, and the only lever that remains for the existing tenant to maintain control of the space is to exercise its option. We rarely encourage the exercise of options, as they are typically not structured to create the most favorable outcome. Usually, a better result can be achieved by negotiating outside the option. However, highly constrained markets call for greater awareness and strategy.
The final step is market engagement. Here, companies must consider leasing alternatives to the existing facility, negotiate with these alternatives and run comparison models that clearly show how well each option fits with the desired outcome defined in step one. The strategy and timeline noted in step two should provide for at least six months of market engagement ahead of the renewal notice date. During this market engagement phase, occupiers must also seek to negotiate with the existing landlord outside of the formal renewal option. While not always possible, this can be a very effective way to gain insight into the landlord’s perception of value and to flush out whether the landlord has third-party interest in the space.
Failing to properly plan for a tight leasing market can result in significant negative outcomes, including the loss of a lease. These market conditions necessitate clearly defined objectives, coupled with thoughtful strategy and appropriate allocation of time. The margin for error created by softer markets, which often permits companies a second chance to get it right, is simply nonexistent in tight markets. By following these essential steps, corporate occupiers can plan for the best possible outcome.