Silicon Valley: Supply in need of Demand

“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 are often 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 percent. 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 10-15 percent lower than that; but—here’s the kicker—landlords are forced to nearly double 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 percent—not 14 percent—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 with their sticker prices—desperately want to save both face and their face rates. They fear that, if widely known, the $60.80 would become their rent’s new ceiling rather than floor.

Back to demand. As of this writing, there is little—the FAANG’s may be kicking tires, but they’re writing few offers. A top Palo Alto broker suggested that, in a normal market, one might see a dozen larger leases (10,000 square feet plus) signed a year. There has been just one in the last twelve months. Put another way, demand is down 91.67 percent over the last year. To a casual observer, it feels worse.

Is this the end? The second inning of a painful blow-out? No. Likely not. To paraphrase Hugh Fennyman from Shakespeare in Love, “Strangely enough, it will all turn out well.” When asked by his skeptical moneylender how, Fennyman replies, “I don’t know. It’s a mystery.”  I have no idea either, but somehow demand will return and rates will stabilize. They always do.

Turning briefly to the Peninsula’s residential market. For-sale housing is robust and anything listed under $3 million is getting multiple offers. A senior Compass broker opined that home prices should end up 10 percent higher this year than last. The apartment rental market is less cheery. Rents are off 20-25 percent and, for those landlords unwilling or unable (because of, say, lender debt covenants or internal expectations) to mark their rents down to market, vacancy rates are soaring. “The tide was all the way out on December 15th, but it’s been creeping back ever since,” said the manager of a sizeable portfolio. “Tesla is now hiring, Stanford Hospital is hiring and the kids are starting to move out of their parents’ basements. And Google is requiring that its workers all return by September 1st. I’m expecting this summer to go gangbusters.”

Hopefully, it will. And hopefully, despite our lovely supply constraint, we won’t take demand for granted again. Islands and peninsulas may be better insulated than, say, Kansas, but they still get frost bite in a deep freeze. 

This essay first appeared in the San Francisco Business Times. All of John's essays may be viewed at McNellis.com.