Have We Hit Bottom Yet?

A Mid-Year Survey of the East Bay and Bay Area Office Markets

Speech Given to East Bay Chapter of IFMA

Jeffrey S. Weil, MCR.h, CCIM, SIOR
Senior Vice President
Colliers International
1850 Mt. Diablo Blvd., Suite 200
Ph: 925-279-5590 Fax: 925-279-0450
jweil@colliersparrish.com
www.officetimes.com

Have we hit bottom yet? I’m going to present a mid-2003 survey of the Bay Area and East Bay office market. What are the current market strengths? What major trends for corporate real estate departments are affecting us now and what trends might be just over the horizon? How does the office market today compare with what happened to the office market of the late 1980’s? What’s happening to the office building investment market, to synthetic leasing and to CEO personal liability in accurate reporting and the effect this might have on corporate real estate departments? And finally, and possibly most importantly, where the heck are we headed over the next few years?

Let’s take a moment to look at the office market in historical perspective. I started leasing East Bay office space in 1976, when I did my first office lease at Hollis and Powell Street for 2,200 square feet at a whopping $0.22 a square foot net. During the late 1970’s and early 1980’s San Francisco rents shot up and a number of major firms relocated to the East Bay, including Chevron, Pacific Bell an AT&T. The tax laws back then were set up so an investor could make money even if the building didn’t lease, and hard as it might seem to us today, back then savings and loans were making 100% and 110% office development loans, with no preleasing required and no personal recourse, so everyone and their brother ran out and built office buildings. In 1986 they changed the tax laws, the RTC shut down the S&L industry, and by the late 1980’s we had 30% vacancy rates and one in every four Class A office buildings along the I-680 Corridor was foreclosed. Nobody wanted these buildings when they went to courthouse auction, and I remember buildings selling for $50 to $75 a foot, 85% leased, with 90% Seller financing and almost nobody wanting to buy. There were buyers who bought foreclosed buildings who guessed wrong and themselves were foreclosed on one year later. This real estate depression lasted eight years, then in the mid-1990’s we stabilized, and rents didn’t really go anywhere for 5 to 7years. Hello, dotcom and that feeding frenzy pushed Bay Area office rents to double, triple and quadruple just within a 2-3 year period. We built new speculative offices like crazy, high-tech companies used synthetic leasing to build their own campuses at a relatively low cost (or so they thought), warehouses and factories were converted to offices, and then in March 2000 the market peaked, although in some sub-markets we didn’t know this for some time due to the lag time in real estate transactions. It is also human nature to be optimistic about the future, so to many the tech recovery has been just around the corner. For the past three years and counting it is just around the corner.

I’ve had on our Officetimes.com website methodology for determining when the office market is starting to improve. One indication is to track daily how many companies are still laying off employees versus how many are announcing corporate expansion.

10-31-02 Tri-Valley Hearld-Clorox Reports Soaring Profits.
                 First-quarter profit rose 84 percent as the company
            cut costs and increased sales of high margin products.
             Corning to fire 2,200 after more losses.
             Electronic Data System will fire as many as 1,000 workers

11-19-02 Contra Costa Times-Bank of America to cut 163
                workers at its Concord Technology center.

11-19-02 San Francisco Chronicle-Agilent to cut up to 2,500
            jobs, tech company reports $236 million loss in fourth quarter.
            Advanced Micro Devices said it will take a pretax re-
            structuring charge of between $300 million and $600
            million in the fourth quarter as part of the costs related
            to numerous layoffs the chipmaker announced last
            week. The Sunnyvale chipmaker last week announced
            the firm is slashing 2,000 jobs as part of an effort to
            get5un to the break-even point at $775 million in
                revenue by the end of the second quarter next year.

11-20-02 Tri-Valley Times-Xerox announces 2,400 more job cuts.
            Conseco with more than $6 billion of debt, near bankruptcy
            Home Depot sales slowing

11-20-02 USA Today-Xerox plans to cut 2,400 jobs worldwide

11-21-02 Contra Costa Times-Boeing to cut 5,000 jobs as orders fall.
            Sega cuts profit forecast by more than 70%
            Charles Schwab cut 660 jobs in San Francisco this month.
            Reuters Group has started firing 163 workers at its
            Palo Alto product development center

Maxter plans to eliminate 200 more jobs next month in Milpitas.

11-21-02 San Francisco Chronicle-HP Profit up 300% for
quarter ‘But the Palo Alto technology giant also said
the number of jobs it planned to cut as part of the
merger has gone up by an additional 1,100. The
projected number of jobs to be cut by the end of its
fiscal year 2003 will now be 17,900’.

11-22-02 Contra Costa Times-Morgan Stanley to lay off 2,200 employees.

11-27-02 San Francisco Chronicle-Sun vows to meet expectations.
Intel likely to raise forecast for earnings.
Contra Costa Times-PeopleSoft’s results not pretty

1-29-03 Contra Costa Times, Xerox has aided profit by cutting
back more than 17,000 jobs in the past two years.

2-28-03 Agilent Technologies announced plans to cut 4,000 jobs,
on top of previous job cuts.

3-18-03 San Francisco Chronicle, Gateway to fire 1,900
workers, reducing staff will shave $200 million a year
off Gateway expenses.

3-18-03 San Francisco Chronicle, Applied Materials to fire
2,000, restructuring plan to save $60 million.

3-20-03 Tri-Valley Herald, The Air Transport Associates
predicts its members will eliminate 70,000 jobs.

Here is a chart I did starting October 2002 and I just updated it for the past 60 days just to check where we stood. A few spots of sunshine but mostly doom and gloom. I subscribe to about 30 business trade publications and newspapers, so for a quick spot-check on April 4, here are the headlines, (San Francisco Chronicle).

Okay, you will soon hear my opinion of the market but what are some of my esteemed colleagues saying? In the March 30, 2003, San Francisco Chronicle, Dan Milholovich, a San Francisco tenant leasing specialist, says “There has been talk about the commercial market finally hitting bottom in San Francisco,” but tenant leasing specialist Dan Mihalovich says we haven’t seen it yet. “In the first quarter, despite some new leasing, there were 590,000 square feet of negative absorption,” Mihalovich said, referring to the amount of unused space returned to the market. “Brokers are looking for the proverbial bottom, but until we approach net zero absorption or get positive absorption, we won’t see it. Negative is negative.” Wow, that’s real upbeat!

I met with the Colliers San Francisco office division earlier this week, and they believe the San Francisco office market has hit bottom and is slowly on the way back up. They cite about 400,000 square feet in recent South of Market deals, one with Steinhart Aquarium who will be converting office space to fish space for a few years while their facility gets rehabbed, and one with Exploratorium, again taking a huge chunk of vacant office space and turning it into a scientific entertainment center. So, two views of the same market, and both very different.

What about other parts of the Bay Area? Just last Sunday in the San Francisco Chronicle, “Everyone knows the grim story in the San Francisco commercial market, but it’s even worse in San Mateo County, which has a 28.3 percent office vacancy rate and more than 5.3 million square feet of available Class A space. “The economy just doesn’t seem to be moving, and companies we talk to are seeing revenues fall”, said Michael Pitre, co-branch manager of Julien Studley. “There’s going to be more belt-tightening this year.”

Now to put a positive spin on all this remember that our unemployment rate is only about 6%, which means 94% of the Bay Area workforce has a job, which is a pretty high figure. There are many countries that would be happy if their unemployment rate went below 20%, so in this respect we are in great shape.

I put together a graph to show another positive spin to the market, this one showing how office rents have actually gone up. Of course, this chart only works if you go back in time, as here is the more normal presentation of what has happened to office rents.

Okay, what is the big picture in the Bay Area office market? Before we get into market predictions, let’s take a look at some of the trends affecting corporate real estate.

The relocation of office operations overseas has been happening for years, starting with engineering and software programming which for the past 5-10 years has been sent to India, the Philippines, South America and elsewhere. With the high-speed Internet now able to transmit huge amounts of information, and with advances in telecommunicating and software this trend has continued to flourish. Call centers are being set up all over the world, with employees in India and China being taught to speak in flawless English even with a Tennessee or Texan drawl. What corporate real estate functions can also go this direction? Do all your accounting or property management folks need to sit in U.S. offices, or can some of this be farmed out at pennies on the dollar to lower-cost alternative locations? Yes, your roving guards still need to be here to rove, but what about spending a hundred dollar a month salary to get a top-notch security officer to watch your monitors while sitting in his or her office overseas? To quote the April, 2003 OfficeTimes, “Forester Research, Inc, estimates $136 billion in U.S. wages-or about 3.3 million jobs in software, product development, back-office accounting and call center support-will move offshore to India, Malaysia, China, Russia and the Philippines in the next 15 years.” At 200 square feet per employee this works out to 660 million square feet of office space we won’t be needing in the good ‘ole United States.

Real estate departments continue to run lean and mean. Do more with less resources, outsource whatever functions can be done more efficiently and effectively, whenever possible to utilize technology to leverage time and money.

Continued downsizing as corporate America sees long-term profit gain in layoffs and real estate dispositions. Merrill Lynch earned $603 million last quarter as CEO Stanley O’Neal cut expenses faster than revenues fell. Job cuts helped Kodak rebound to a profit. Cnet Networks posted its first profit in three years after firing hundreds of workers to reduce expenses. Selectron seeking a return to profitability, reported it will take up to $300 million in restructuring changes during the next several quarters to consolidate faculties and cut jobs in Europe and North America.

Shadow space, no matter if planned or unplanned, accounts for 10-20% of corporate space utilization. Proactive lease renewal planning can eliminate this. I do a lot of early mid-term lease restructurings to get this off the corporate bottom line, and this trend will continue.

Increased centralization - If you order restroom supplies from 50 locations, but centralized, with web-based inventory, tracking, purchasing and pricing costs go down, and it can take less personnel.

Synthetic leasing reaffirms the old saying, if it sounds too good to be true, it usually is a sign to watch out - Corporate America, mostly high-tech, who did synthetic leasing over the past 10 years will be taking big financial hits as they unravel these transactions in a market where rents might be a fraction of what the original financial structure was based on. The silver lining-low long-term commercial interest rates, and investors lined up around the block to purchase anything halfway decent, so it could be a lot worse.

Another corporate real estate trend is super-caution in taking on large-scale technology or web-based real estate initiatives, especially involving non-branded companies that may or may not be around in 5 or 10 years. It almost doesn’t matter how great the product is, or how much money you can save, if your job is on the line if after convincing your CFO to do a major investment and the vendor goes under. The platform must be low-risk and a long-term player, in most cases, and there are a lot of unfortunate examples, with the “dot bombs” over the past five years.

Lastly, there is an increased concern about personal liability for CFO and CEO’s and thanks to the ENRON and Worldcom fall-outs, how this might impact how the corporate real estate department is run. In a recent article published in the January 2003 Corporate Real Estate Leader, “The Sarbanes-Oxley Act directly impacts corporate real estate in at least three ways. Corporate real estate executives will be required to become more involved in the certification of financial statements. Secondly, corporate real estate departments will have to adhere to their companies’ policies regarding audit committee pre-approved of services provided by the external auditor, as required by the Act. A third area affected is the rules for Synthetic Leases.” CEO and CFO’s of publicly traded companies have to personally certify the accuracy of their financial statements. Congress imposed strict penalties up to $500,000 and 5 years in jail.

Let’s take a minute to put this in context of what goods and services cost in 1981 versus 2003.

The Changing Cost
Of
Goods & Services

1981-2003

Annual CPI 10-14%	Executive Secretary $45,000/year

Commercial Interest Rates 11%	2003 Chrysler luxury, loaded $32,000
Cost of parking stall Downtown Walnut Creek $25/month	Cost of parking stall Downtown Walnut Creek $65/month
Executive Secretary $14,000/year	New Office Building $250/sf
New Office Building $100/sf	Annual CPI 2.5%
1981 Chrysler, luxury, loaded $3,800	Commercial Interest rates 6%

1981 2003

Now, rental rates in some places have fallen to 1992 levels when adjusted for inflation.

I wanted to share a few sources of information for the corporate real estate executive. Officetimes.com is one source for a lot of corporate real estate information. New articles and information is posted every few days like this one on what to watch out for when you do a paint and carpet on a lease renewal. We keep the calendar for almost all of the Bay Area real estate organizations like IFMA, CoreNet and BOMA and with one click you can find out when events are scheduled and even sign-up online. Our newsletter is posted and you can get a free subscription. Furniture vendors, tenant improvement contractors and hundreds of relevant articles and links are there to make your life easier.

I wanted to touch on what has become one of the most significant elements of our Bay Area office market, that of sublease space. This is a huge percentage of the vacancy, and there have been various ways and methods corporations have used to market their excess space. Here is one promotion where a PT cruiser was offered and here in order to attract all the brokers to the open house I invited my competition to speak, had all the press there to ask the speakers questions, had thousands of dollars in door prizes, and even got broker participation from the guests who ended up getting their names published with their quotes. We sublet the space from this event. Here is another, with 40 brokers throwing darts to get weekend trips, senior brokers doing market forecasts at the open house, and again, a transaction resulted directly from the event.

Here is a low-priced promo, with the first week balloon bouquets holding a $5 Blockbuster gift-card getting personally delivered to the 50 most active office brokers, the second week big sheet cakes were delivered, subleasing this space is a piece of cake!, then next week 50 CD’s with this, but one CD will have a secret code with $250 cash so we expect the brokers to all take this virtual tour.

Okay, just where is the Bay Area office market today? Here is the big picture.

As of April 1, 2003

Total Available Office / R & D Space

San Francisco Bay Area

95,000,000 square feet

Breakdown Summary

Santa Clara / Silicon Valley 60,000,000 square feet

San Francisco 15,000,000 square feet

Peninsula 8,400,000 square feet

I-880 Corridor 4,900,000 square feet

I-680/Tri-Valley 6,500,000 square feet

These are my ten reasons the office market will get worse before it gets better.

Jeffrey Weil’s

Ten Reasons The Office Market Will Get Worse

Before It Gets Better

10. Subleases running out and going back to the Landlord

9. Significant governmental layoffs of almost every level (Fed, State, County, City,
Schools, etc.)

8. Long-range new office projects being completed in 2003.

7. Big floors finally beginning to get broken-up, Landlords getting realistic & competing with sublease space.

6. Foreclosures predicted in SF South of Market/Santa Clara already started in 2003.

5. Lag-time between sustained corporate profitability and need for more space.

4. Effective lease rates still declining.

3. Reality just beginning to set in, Santa Clara has $1.00 rents, San Ramon has 99¢ full-service long-term Class A plug + play subleases.

2. Shadow space, 10-20% of vacancy will be first to fill.

1. More layoffs still ahead, telecommunications, financial services, technology

When will we see recovery? I mentioned this chart earlier, but here is how to tell that we’ve bottomed.

Ten Signs the Office Market has Bottomed

From an office leasing broker’s perspective:

By: Jeffrey S. Weil, MCR.h, CCIM, SIOR
Senior Vice President
Colliers International

10. The inventory of sublease space is diminishing.

9. Office Brokers are starting to work longer hours and even come in on weekends to catch-up.

                  8.    Developers begin dusting off previously shelved office project plans.

                  7.      Local governments are once again more receptive to business growth, and less restrictive on anti-growth issues.

6. A lot of things are better, but people just don’t know it yet.

5. There are no layoff announcements during a seven-consecutive day period.

4. The previous daily deluge of new sublease announcements had turned into a trickle.

3. Landlords are courting the tenant rep brokers, but a little less aggressively.

2. Your golf game is finally getting good.

1. Broker open-houses are almost non-existent.

So, as long as corporate profits stay down, as long as layoffs exceed new hiring’s, as long as new available space comes on the market faster than it gets leased, expect the market to continue to slide or at best stay flat. Once companies start making money, they will need sustained corporate profits, maybe 6 to 18 months worth, before they rush out and start hiring like mad. Remember, it costs them a fortune to downsize, to pay all those early termination agreements and write-off all those operations. Do you think they will turn around and jump right back in at an upward profit bleep or wait and make sure the financial recovery is real? Then, the first space they will put these new bodies will be in their shadow space, so there may be a two or three year market lag before we see a significant office market recovery. Remember also, most of us don’t have a burning desire to rush out and buy the latest personal computer or palm pilot like we did back in the last frenzy. We have no Y2K problem requiring tens of thousands of programmers all needing office space, and who knows what form the next dotcom investment frenzy will take, but most of us are still hurting from the last crash so it might be awhile for the next explosive demand for office space.

But hey, we’re 94% employed, we live in the absolute most exciting and beautiful place in the world, and our industry needs our services more than ever. To paraphrase that ancient saying:

Please God, give me the knowledge to know what I can do to make an impact and a good living in today’s commercial real estate environment.

Please God, give me the insight to know what I can’t do or can’t change in my company or in my industry.

And most of all, dear God, please give me the wisdom to know the difference.

Thank you!

Jeffrey S. Weil, CCIM, SIOR, MCR.h, is a Senior Vice President with Colliers International and has spent the past 27 years representing Corporate America in the leasing, subleasing, acquisition, disposition and just about everything else involving commercial property. Jeff can be reached at jweil@colliersparrish.com and his extensive website is www.officetimes.com.

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