“The Perfect Storm”?

Written by:	Hans Hansson
E-mail:	hans@starboardnet.com
Date:	03.10.08

“The Perfect Storm”?

The Turnaround of the San Francisco Bay Area Office Market

For years, Wall Street viewed the San Francisco office market as stable but mature. It no longer was considered a headquarters market, but its core markets—including technology and medical research—its strong branch market, and its attractiveness continued to draw a robust workforce.

Wall Street also pegged office market rents in the San Francisco Bay Area to those in New York. Historically, Bay Area rental rents on average have been about 50% of New York rents. In 2007, New York Class A office rents hit $200 per square foot. With the Bay Area’s office market average rental rates as low as $28 per square foot in 2005, the Bay Area looked like a real bargain. As a result, buyers flooded the Bay Area, buying and selling some buildings two or three times in a couple of years, with each buyer anticipating higher and higher rental rates.

What Wall Street did not consider were the tenants who will be entering the market in the next couple of years and their options for keeping rental costs down. In addition, the looming recession is sure to impact rental rates.

During the dot-com boom, many traditional firms were forced to downsize their offices to pay high rental rates. After the dot-com economy went bust in 2001, Bay Area office vacancy rates exceeded 20%. Many tenants entering the marketplace today signed their leases five years ago—when they could afford to take on more space than they needed so they could compete for employees and absorb future growth. It was not uncommon for firms to lease entire floors in the face of rents 60–80% less than what they had been paying in the dot-com days. Now that these leases are expiring, firms that took surplus space can simply downsize their offices to keep their total rental costs in line. This means overall less demand for office space.

What can a business actually afford to pay in rent? The rule of thumb is that businesses should spend no more than 6–8% of gross revenue on rent. If rents exceed this calculation, businesses will be forced to make adjustments by taking less space and consolidating their offices or moving their employees to cheaper office space in other markets.

These two factors—the reality of the situation that tenants face today and the impending recession—could lead to a “perfect storm”: an adjustment in rental rates and a major correction in office building values. Such a turnaround would be felt throughout the economy.