THE WOLF STREET REPORT
San Francisco Office Market Turns into Nightmare, in Two Easy Steps. Step 1: Hogging Office Space; Step 2: Working from Home
by Wolf Richter • Apr 4, 2023 • 125 Comments
Step 3: The economy… but that step hasn’t happened yet.
By Wolf Richter for WOLF STREET.San Francisco had been the hottest office market in the US in 2019, when the office vacancy rate was just 7.1%, when tech and social media companies and all kinds of startups piled all over each other, leasing office space they didn’t need and couldn’t use to prepare for a future that wouldn’t come.
Now, Q1, 2023: The vacancy rate is 32.7%. Nearly one-third of San Francisco’s office space was on the market for lease, an all-time record, according to Savills. And all the trends are going in the wrong direction. During the worst year of the Dotcom Bust, in 2003, the vacancy rate topped out at 18%.
The vacancy rates in Q1 ranged from 28% in the South of Market Area (SOMA) to 55.4% in the Yerba Buena area.
Of the 86.6 million square feet (msf) of total office space, over 28 msf are vacant and on the market. This includes a record 8.9 msf of sublease space, up from 7.7 msf a year ago.
This type of pileup of sublease space is rough. This is when companies, such as Meta, realize that they will never move into the space that they leased years ago for a future that didn’t come, and that are then trying to find a tenant for the remaining years of the lease to help them defray the carrying costs. They tend to undercut landlords trying to directly lease their own vacant space because the objective of a sublease isn’t profit, but lowering carrying costs.
Meta said in January that it plans to list for sublease its 435,000-sf office at 181 Fremont Street.
Salesforce, the City’s largest tech employer, put another 125,000 sf on the sublease market in March, this time at the Salesforce Tower, which is owned by Boston Properties. This brings Salesforce’s total sublease space to over 1 million sf.
I mean, what were these people thinking when they leased this space? These big tech companies that think they will grow forever have big real estate departments, headed by highly-paid executives with titles such as VP of Global Real Estate, whose job is campus-building and office-leasing, and that’s what they did, and that’s what they ended up with.
The first big defaults — because of interest rates. PIMCO’s Columbia Property Trust defaulted on two office towers in downtown: 201 California Street and 650 California Street. The latter is where Twitter leased the 30th floor, and then after Musk took over, just stopped paying rent, according to a lawsuit filed in December by Columbia. In theory, Twitter is on the hook for the lease until January 31, 2025.
One problem behind the default is the floating-rate mortgage note. Columbia took out the floating-rate mortgage in December 2021. I mean, what were these people thinking? This was the time when inflation was spiking and the Fed was tapering QE and warning about rate hikes, and these morons, perhaps entrenched in the camp of the pivot mongers, blew off the Fed, and got a floating-rate note at 3%, and by early 2023, it had doubled to 6%. OK, game over – which is where the talks begin.
The company said it’s in discussion with the lenders to restructure the mortgage. Lenders don’t want the towers under any circumstances. Defaulting on the mortgage of office towers in this market is like putting a gun to their heads. And they’ll talk.
But this time, it’s not yet the economy, that shoe has yet to drop. This time, the primary drivers are two factors:
1. Hogging of office space in the years through 2019 to prepare for a future that wouldn’t come. As everyone was hogging office space they didn’t need, it created an office shortage that fired up the office-hogging even more. Human brains are funny about hogging, as we learned during the empty-shelves episode in the spring of 2020.
2. Working from home since the pandemic. Many employers in San Francisco have embraced it fully, others are desperately trying to bring some workers back to the office for a few days a week in hybrid fashion. But they realize that they don’t need all this space that they hogged over the past few years.
Leasing activity fizzled in Q1. Only 900,000 sf were leased, compared to 1.5 msf in Q1 2022, and 2.5 msf in Q1 2019.
The biggest transaction was Gap’s sale-leaseback of its Athletica headquarters. It sold the 162,000-sf building at 1 Harrison Street for $80 million to Sobrato Organization, and leased it back for one year. So that took no office space off the market.
The third-largest transaction was a renewal by Bank of the West. That didn’t take any office space off the market either.
The fourth-largest transaction was Reddit’s downscaling move: It’s moving out of its 78,000-sf office on Market St., which it subleased from Block, and it’s moving into 47,000 sf of space at 303 Second St. This move will put even more vacant space on the market.
Average asking rents declined further. For Class A space they dipped to $74.59 per square foot per year. This is down about 16% from the peak in 2019.
Price would normally solve demand problems in that prices drop until demand materializes. But in commercial real estate that is leveraged up to the hilt, it’s not possible for landlords to lower the rents beyond a certain point because they wouldn’t be able to pay the mortgage with lowered rents, even if they could fill the building, and language in the contract could put them into default. And so they default.
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