“Britannia est insula. Italia est paeninsula.” The first two sentences of my freshman year Latin book were easy to understand: England is an island and Italy a paen or almost island. After that easy beginning, Latin tumbled into incomprehensibility, but the thought stuck that England was fully insulated and peninsulas only a bit less so. Decades later I learned real estate’s two-word formula for lasting success: supply constraint.
Islands—small ones anyway—are perfectly supply constrained; peninsulas can be nearly as limited. Until the virus struck a year ago, business islands like Manhattan and peninsulas like San Francisco’s were fortresses high-walled by supply constraint. Until the virus rolled up its siege wagons, smug landlords (such as ourselves) considered full occupancy a birthright and rents a stairway to heaven. In short, we had forgotten the other half of real estate’s magic formula: demand.
On April 7th , the San Francisco Chronicle reported that office rents in the City had dropped 14.7%. On the same day, the Wall Street Journal reported that, “…landlords are offering long- term leases at discounts up to 13% below rent rates reached in the first quarter of 2020…”.
These numbers are so understated—so laughably wrong—that the articles should have come with Twitter warnings about their veracity. Why so off?
The landlords failed to disclose how much they had to fork over to tenants to achieve even these reduced rents. Since we have no holdings in either San Francisco or Manhattan, I’ll focus on the Peninsula where we do, where we know the real numbers first-hand.
Here’s Palo Alto’s office story:
Asking rents downtown haven’t changed since 2019; landlords are still quoting about $96 per square foot per year for prime office space. Leases are, however, inking 10% to 15% lower than that; but here’s the kicker, landlords are only getting deals signed by nearly doubling the upfront money they hand to tenants. Landlords are now giving tenant improvement allowances up to $80 per square foot more than in pre-Covid deals and throwing in an extra 3 months of free rent.
If your tenant signs a 5 year lease on these terms, your net rent works out like this: $96 annual rent minus 15% minus $16 excess allowance ($80 annualized over the five year term) minus $4.80 excess free rent ($24 annualized over the five year term) equals $60.80 rent. Or 37% — not 14% — less than you would have achieved at the beginning of 2020. If you impute an interest carry (you should) on the $104 a foot you’re handing your tenant on day one, the numbers are even drearier.
Why not just sign a lease at the effective rate of $60.80 and skip the side giveaways? Because landlords, like car dealers and their sticker prices, desperately want to save their face rates. They fear that, if widely known, the $60.80 would become their rent’s new ceiling rather than floor.
https://wolfstreet.com/2021/04/22/silicon-valley-supply-in-need-of-demand/