Special Tenant Alert
Office Rents May Double In The
Medium-Term Future
April 2005
Prepared by:
Jeffrey S. Weil, MCR.h, CCIM, SIOR
Senior Vice President
Colliers International
1850 Mt. Diablo Blvd., Suite 200
Walnut Creek, CA 94596
Ph. 925.279.5590 Fax 925.279.0450
I have been making predictions about the future office market for 25 years, and almost always these predictions have proven to be correct. This alert could be an exception, but there are so many supporting signs I felt it important to share this with you. As these past predictions have all been published in my OfficeTimes newsletter (past issues can be viewed at www.officetimes.com) you can verify this for yourself.
The reason I am sending this Alert in a special letter to you versus my regular newsletter format is that I exclusively represent only tenants and do not take on any landlord for-lease listings. My bias is for the tenants as landlords have more than enough industry networking to take care of themselves. Landlord brokers who occasionally do tenant rep usually have long-term lease listing contracts and their job is to get their landlords the highest rent and terms not always as favorable to the tenant. I make no excuses – I am first and foremost a tenant broker and rising rental rates are bad news for most of my clients. During the past four years, since the collapse of the dotcom industry, I have been predicting a doom-and-gloom Bay Area office market. I remember being on broker panels in 2001 and 2002 when I was the only negative voice as most of my industry felt recovery was “just around the corner.” Fortunately or unfortunately, they were wrong and the office market continued to deteriorate during these past four years. Across the board, office rents that had hit record highs in late 2000 were cut in half or more by mid-last year. As two examples, Class A office space at the Pleasant Hill Bart Station hit $4.66/sf as-is in Dec. 2000, and last year this same area was leasing Class A space at $2.00 to $2.25/sf. The Pleasanton Class A office market reached $4.25/sf in late 2000, but at the end of 2004 had sunk to $1.75/sf in the same office projects.
My new forecast is that we have, for the most part, hit bottom in 2004. Vacancies can be expected to decline and rental rates increase now and into the foreseeable future. There will be submarkets recovering quicker than others – as an example, Downtown Walnut Creek did not suffer the overbuilding that Pleasanton experienced. Overall, it will be a very long time, if ever, that we again see the low rental rates experienced today.
It is my belief that in the not-too-distant future Class A office rents will be double what they are today for a number of reasons.
1. Companies are finally beginning to hire, albeit slowly. Recent surveys show 57 percent of corporate respondents plan to increase their existing occupancy in primary markets, and 42 percent plan to expand in secondary markets.
2. Corporate “shadow space” (vacant or underutilized office space not on the sublease market) is slowly being absorbed.
3. Most of the quality, long-term sublease space has been sublet.
4. Many of the un-built available zoned Bay Area office land parcels have already been or are in the process of being rezoned for residential development, and are selling for 200 to 300 percent of what they would have sold for as office sites. This will drive up the cost for future office development sites considerably.
5. There are a number of vacant flex/older office buildings in the process of being rezoned for residential and a number of these office buildings will be demolished to make way for housing. Again, less office land will drive up future office site costs substantially.
6. Office buildings are selling at top dollar prices, with $250 to $300/sf suburban and $300 to $400/sf urban prices the norm. These investors at some point will ratchet rental rates upward to obtain the financial returns required to justify their purchase price.
7. New office construction prices have risen dramatically, due in part to China and India’s thirst for raw materials. Steel and concrete prices have soared. The high price of oil is also a significant factor, as production and transportation costs have also escalated.
8. There are new governmental life/safety requirements which add to the cost of new office development.
9. A number of local governments are either adding taxation on new commercial development or are contemplating doing so in the future. As a recent example, in February 2005 the City of Walnut Creek passed a $5 per square foot tax on new commercial development to pay for affordable housing.
10. Operating expenses have escalated to record heights. As an example, Class A Downtown Walnut Creek office buildings now cost $11 to $12/sf per annum to operate and Downtown San Francisco buildings $15 to $17 per annum to operate.
I’ve recently been involved in several East Bay build-to-suit studies. New Class A mid-rise steel/glass construction with 3.5/1000 structured adjacent garage parking (not underground), all inclusive is estimated at $350 to $375 per rentable square foot, including land. Projecting realistic future interest-rate increases on construction and long-term financing rates and using a 3% inflation factor on both construction costs and operating expenses strongly suggest that rental rates will have to double from what they currently are to justify new office construction.
During the past 30 days I have seen a few of the East Bay landlords raise their rental rates, a phenomenon our market has not experienced since the dotcom days of 2000 and 2001. A few of my more “geographically-challenged” sublease assignments have seen more tenant activity during the past month than the past two years combined. During several recent office tours with clients, space that had been available during the tour was already leased just two weeks later when we submitted our proposal. There will be peaks and valleys in this recovering office market, but overall there will be a consistent decrease in vacancy which will lead to increasing rental rates. Tenant improvement allowances will go down and tenant concessions, such as expansion, contraction and other tenant-favored options will become more difficult to obtain.
There are many ways to look at this, but based upon a $350/sf Class A new construction estimate, with a 70% fixed loan at 7% amortized over 25 years, requiring a 10% return on the cash invested and adding $12/sf annual operating expenses, the break-even full-service rent would be $43.29/sf per annum or $3.61/sf/month. If in three to four years inflation and interest rates have pushed permanent financing and operating expenses upward, it is not inconceivable that the Pleasanton Class A rental rate today of $1.75/sf could be $4.00 to $4.50/sf or the Downtown Walnut Creek rate of $2.50/sf today be $4.50 to $5.00/sf in the not-too-distant future.
When will this occur? During the next few years vacancies will decrease, pressuring rental rates upward. Developers will begin dusting off long-shelved office plans, and as soon as they can convince their lenders or investment committees they will begin moving forward. It usually takes 18 to 36 months to get a project completed, so perhaps this may occur in a 4 to 6 year time-frame. Save this article and tell me how close these predictions were!
Meanwhile, there are a number of strategic actions an office tenant can take advantage of this in transitional window of opportunity as the market pendulum shifts from a Tenant’s market to a Landlord’s market. It is up to you to take advantage of the strategies available while you still have this opportunity.
I do only tenant representation and commercial property sales, I do not represent for-lease listings and I look forward to your feedback. If you need more space, less space, different space or have a lease coming up for renewal during the next 24 months, please call me at (925) 279-5590.