The morning after

The Bay Area’s dramatic office market decline is nearly over. But it will be a long slog until full recovery five or six years out.

The Bay Area’s dramatic office market decline is nearly over. But it will be a long slog until full recovery five or six years out.

By Steven Brull
March 2003
Institutional Investor Magazine

Cruise along Highway 101, midway between San Francisco and San Jose, and the region’s real estate debacle is hard to miss. Start with the three new class-A office buildings, the former headquarters of bankrupt Internet service provider Excite@Home, that sit vacant in Redwood City.

Business is little better for TMG Partners, the owner-developer of Mid-Point Technology Park, a 13-building, 1 million-square-foot complex spread over 45 acres in Redwood City. It’s 80 percent vacant. Rental cash flow is so anemic that in early January, Crédit Lyonnais, which had lent $150 million to TMG Partners, swapped an unspecified amount of its debt for equity and formed a joint venture with the Bay Area developer. The deal gives the bank a cut of the property’s income, but Michael Covarrubias, CEO of TMG Partners, prefers to see the bright side. “If the banks are not comfortable, they prefer to foreclose,” he says. “Crédit Lyonnais believes it has a stake in a quality asset that can be repositioned to make money.” Crédit Lyonnais declined to comment.

During the past three years, commercial property values from Stamford to Seattle have fallen in a downturn that has left few markets unscathed. None has suffered more than the Bay Area’s. With 227 million square feet of office space in the region, which encompasses San Francisco, the East Bay, the Peninsula and Silicon Valley, the Bay Area ranks as the fourth-largest office market in the country, behind New York, Chicago and Los AngelesOrange County.

After ballooning from 1.6 percent in the first quarter of 2000 to 14.8 percent at the end of 2001, vacancy rates in San Francisco’s central business district rose to 19.5 percent at the end of 2002. By contrast, at the nadir of the 1990'92 recession, San Francisco vacancy rates reached 12 percent. Rents dropped by about 10 percent last year after plummeting nearly 50 percent the year before. In 2003 they are likely to fall a further 5 to 10 percent, analysts say.

Some local real estate agents profess to see signs of hope. “It feels like we’ve found something of an equilibrium,” says Jon Wittemyer, a top broker in San Francisco for New Yorkbased Insignia/ESG, which last month agreed to a merger with Los Angelesbased CB Richard Ellis. “That’s because rental rates, although still trending downward, have stopped their dramatic descent and begun to stabilize.”

But the particular weaknesses of the Bay Area market -- a painful hangover from the dot-com bust, high unemployment and sluggish job growth -- portend a protracted recovery. John Herold, a senior analyst at Green Street Advisors in Newport Beach, California, reckons it could take five or six years before the region stabilizes at a 10 to 12 percent vacancy rate. That would be twice as long as is expected nationwide.

“In the previous cycle, developers all got into trouble by building on spec,” says Covarrubias. “This time, we didn’t build many spec buildings, but we built for spec companies.”

In the Bay Area over the past year, 5 million square feet of new space went on the market. Close to 40 percent of new buildings remain vacant in San Francisco and Silicon Valley, while just over half of new offices in the East Bay are empty, as are 78 percent of those in the Peninsula. In San Francisco itself about 8.5 million square feet of space came on the market over the past decade, including projects due to be completed in the next two months, reports Colin Yasukochi, research director at Grubb & Ellis Co., a Northbrook, Illinoisbased full-service real estate company. He estimates that it cost about $2.5 billion to build the space, which might be worth one third to one half that today.

New and renewing tenants benefit from lower rents, of course. But in this shakeout in values, the losers far outnumber the winners. Bay Area developers and landlords, real estate investment trusts with a presence in the region and lenders have all been hurt by the steep decline in property values. Among the hardest-hit REITs is the nation’s biggest, Chicago-based Equity Office Properties Trust, which has 20 percent of its office space in San Francisco. The REIT has seen its share price fall 17 percent during the past year.

Mission West Properties, whose slogan remains “We Build the Buildings for High-Tech Companies that Build the Internet,” is a Cupertino, Californiabased REIT whose 7 million square feet of commercial research and development space is all in Silicon Valley. Its shares tumbled 20 percent over the past year. Although Mission West’s funds from operations inched up to $117 million in 2002 from $115 million the year before, investors focused on the REIT’s occupancy rate, which fell to 84 percent from 97 percent.

The most vulnerable local lenders are regional banks. Palo Altobased Greater Bay Bancorp, for example, has just over half of its $4.7 billion loans in Bay Area commercial real estate. The bank reported a 56 percent jump in core net income last year, to $124.3 million, with much of the improvement stemming from one-time gains and a smart bet made in 2001 to buy mortgage-backed securities and refinance them at lower rates. This strategy has run its course, suggests Charlotte Chamberlain, senior bank and thrift analyst at Jefferies & Co. in Los Angeles. She reckons that the bank’s real estate credit losses will amount to some $48 million this year, versus $59.8 million last year. The bank’s shares have slumped 37 percent over the past year. Greater Bay Bancorp CEO David Kalkbrenner says his bank’s knowledge of borrowers and local markets reduces risk. “We manage risk by being very careful who we’re doing business with, not just making transactions. Over 50 percent of our real estate is owner-occupied.”

Not surprisingly, the real estate loan portfolios of Bank of America Corp. and Wells Fargo & Co. are more diversified than those of most regional lenders. “There is an increasing trend of bad loans but it’s very, very mild so far,” says Tanya Azarchs, senior bank rating analyst at Standard & Poor’s.

From a landlord’s perspective, the market is bottoming out at a painful level. Average vacancy rates of 20 percent are well above the national average of 16 percent. Rents have fallen to about $30 per square foot for class-A space in downtown San Francisco and to $26 in Silicon Valley, down from $67.90 and $51.73, respectively, in the fourth quarter of 2000.

A weak regional economy will continue to depress commercial real estate values. At the end of last year, regional unemployment was at its highest levels since the early ‘90s recession -- 6.1 percent in San Francisco County and 7.5 percent in Silicon Valley’s Santa Clara County. The region’s industrial companies must grapple with the maturation of the PC industry and the increasing outsourcing of manufacturing to Asia.

“We’ll need to see a real recovery in technology spending and capital expenditures to see companies like Cisco Systems and others growing and needing more space,” says Steve Sakwa, a REIT analyst with Merrill Lynch & Co. “That’s several years out.”

Another negative: Bay Area residential property prices remain high, fueled by low interest rates and the movement of capital from equities to real estate. High home prices tend to depress the demand for office space, because they make the region less attractive for companies considering expansion or relocation.

To be sure, the Bay Area isn’t the only region suffering from a commercial real estate downturn. Vacancy rates in high-tech hubs such as suburban Boston, Seattle and Austin, Texas, are also running above 20 percent, as they are in overbuilt markets like Atlanta and Dallas. But the Bay Area experience may be the most extreme. As the epicenter of the late-1990s technology bubble, the region attracted tens of billions of dollars in venture capital, propelling real estate values, along with Nasdaq stocks, to absurd levels. In October 2000, Commerce One, a business-to-business e-commerce firm, paid $115 per square foot for 13th-floor space at One Market Plaza in downtown San Francisco. Today the space might rent for half that, and Commerce One, which lost $590 million last year, is looking to buy out its lease. Overall commercial property values reached their peak in the second quarter of 2000, when average asking rental rates in the city’s central business district hit $78.21 a square foot.

Even as the bubble expanded, developers thought they were being prudent by avoiding the mistakes of the late 1980s and early ‘90s, when many enjoyed easy access to capital and built on spec. This time around there was much less speculative development, and builders insisted that tenants have high-quality credit or pay higher deposits. Lenders also demanded that developers put more skin in the game. They tightened loan-to-equity rates to 70 percent, from 80 percent, and required that developers use cash-generating properties to support new projects.

Still, the dot-com frenzy got the best of almost everyone. Venture-backed start-ups demanded ever-larger tracts of space, much of it to be held in reserve for future growth. Developers believed that their dot-com tenants were creditworthy -- after all, their cash was real, at least until they started to go belly up.

The inevitable result: a massive glut of vacant space. The 5 million square feet of new office space that came on the market last year boosted total vacancy to 45.6 million square feet, or 18.75 percent of the total, according to data from Insignia/ESG. During the past 20 years, San Francisco has absorbed an average of 1 million square feet of space a year; in 2000 that figure grew to more than 4 million square feet.

Downtown San Francisco fared somewhat better than Silicon Valley because its economy is more diversified. But it has plenty of high-profile disasters, including Equity Office Property’s Foundry Square. The REIT and its partner, Wilson/Equity Office, originally planned to construct four office buildings with a total of 1.2 million square feet two blocks south of Market Street, the busy boulevard that bisects the business district into north and south.

In late 2000 Sun Microsystems signed a lease on two of the four Foundry Square buildings, reportedly paying more than $50 per square foot for roughly 460,000 square feet of space, an annual rent of more than $23 million. Last year, with its business in free fall, Sun paid $85 million to EOP to extricate itself from one property, as yet unbuilt, with 327,000 square feet of space. But Sun still holds a lease on a 130,000-square-foot building that is nearing completion. If the company decides to sublease that space, as many expect, it could wreak havoc on the complex’s newly opened 500,000-square-foot building across the street, built on spec and 85 percent vacant.

“Because of Sun’s buyout, we’ll do well in aggregate, but some rents will be far lower than we thought,” says Richard Kincaid, president (and CEO come April) of Equity Office Properties.

Some analysts suggest that EOP is downplaying the severity of its problems. For instance, the REIT reported that funds from operations rose to $1.51 billion in 2002, up from $1.18 billion a year earlier. But analysts point out that some 10 percent of these funds resulted from termination fees, a nonrecurring event. EOP calculates that funds from operations will decline to between $2.80 and $3.00 a share in 2003, down from $3.21 in 2002. “Everyone at Equity is surprisingly optimistic, but I can’t imagine it’s going to turn out as well as they expect,” says Rob Haines, a real estate analyst at Credit Sights in New York City. “They are particularly leveraged in the Bay Area, and their whole business depends on job growth.”

Yet economists project that any improvement in employment levels in the hard-hit Bay Area would lag behind a nationwide upturn by about a year because of the region’s dependence on the struggling technology sector. History, however, offers developers reason for hope. The Bay Area enjoys superb economic fundamentals, including a highly educated workforce, an attractive quality of life and a culture of entrepreneurship and innovation. “We’ve not yet identified the next new thing,” says TMG Partners’ Covarrubias. “But when it occurs, it always comes faster and sooner than people expect.”

Sounds like a developer.

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