Should Tenants Be Fooled by the Landlord's Optimism?

Everyone is talking about it. The impacts of COVID-19 on our economy have been far reaching with no industry left out, though some are bouncing back quickly. Residential real estate, for example, has seen a boom with interest rates at all-time lows and people looking to be more comfortable while stuck at home. The office market has, understandably, gone the other way, as companies reconsider the size of their office footprint due to the surge in operating a remote workforce. They realize this might be a sustainable future, so why pay for excess real estate?

The San Francisco office market has been one of the hardest hit in the country. Nearly 70% fewer transactions were completed in 2020 vs the prior year, putting San Francisco far behind the velocity it once enjoyed. Historically, San Francisco had market fundamentals that fueled a quick rebound, but even the most optimistic projections suggest that landlords should be concerned. Is it fair to say that with only 7.3M SF of direct vacancy in a market with 82.7M SF - things could be worse? Maybe so. In years past, total vacancy (direct plus sublease) did not exceed 8.5%. Today, direct vacancy alone records 8.8%. This represents more than a 4.0% increase YoY on a direct basis. Current direct vacancy would be manageable if nothing else changed. The problem is, the current market landscape is about to create more vulnerability for landlords and consequently, opportunity for tenants.

With an additional 1/3 (2.1M SF) of marketed sublease space expiring by the end of 2022, the reality for landlords is that there will be nearly 9.5M SF of direct space sitting vacant in two years. At that rate, direct vacancy would hit 11.5% in the direct market. Typically, tenants look for space 1-2 years ahead of their lease expiration, so smart landlords should be treating the 2022 market as if it’s the current reality. Basic supply and demand economics suggest an even steeper vacancy cliff is coming and tenants should be encouraged by the coming market shift. Meaning, tenants are the ones who should be optimistic.