Imploding Office Fundamentals Up Ahead

18th March, 2024

When you think of real estate comprising land and improvements, you think of wealth creation, especially in Australia where so many billionaires have made their wealth off the back of real estate. So, it’s hard to talk about something failing and even harder for Australians to imagine failure being long term. 
 
Cycles come and go and long term it doesn’t usually matter because everything goes up when it comes to real estate, especially in Australia….right? So, what happens if Australian workers don’t return to office space? 
 
The answer is that demand shrinks, and the market becomes over supplied. Then rents fall, incentives increase, and values drop and I haven't mentioned the impact of rising interest rates or credit worthiness. 
 
In all the major US city markets like New York, San Francisco, Washington, and Chicago the official vacancy factor of around 19-20% became irrelevant. It was the availability factor, (the shadow vacancy) which the industry experts were only interested in and that was around 40%. That means that 40% of the total stock is available for lease. Try to picture that! That’s precisely what I witnessed in the US on my last trip in April/May 2023. 

That’s why buyers were offering 25-40c in the $1 to buy and what followed was the collapse of Silicon Valley, Republic, and Signature Banks. To be clear that usually means losses of 50 - 66% of the value of each asset. But of course, that’s not here in Australia where fund managers are saying the worst cases will be 25-30% drops in value. 
 
Let’s look at the role of fund manager and if they are the beacon of wisdom. Fresh capital in the non-residential sector is very hard to find, why put good money after bad when you can’t even protect your capital. So, the role of fund manager has become defensive. It’s all about valuations and those are predicated on comparable sales evidence. If there isn’t a market, there’s no reason to amend the valuation. In many ways, not having buyers and therefore transactional activity is a good thing. However, company directors of property funds are nervous. They are accepting the valuation evidence when their gut feeling is that the numbers are no longer supportable. The noose is tightening around their necks. We have entered the phase in the US called “Extend and Pretend” or better known in Australia as “Kick the can down the road”. This is a delirium which people can find themselves in when the news is all bad but hope still prevails, like a gambler rolling the dice again.

For the past year and of course through COVID I was a crusader for the property manager and that’s precisely what we need now. We need problem solvers. At least when you deal with a competent property manager, they understand problems and they work towards solutions. Fund Managers refuse to accept the obvious because they are smart and know that the answer is horrific in lost capital. The problem is that you need a property manager, someone at the coal face to communicate with tenants and the owner, collect rents and outgoings, manage arrears, renegotiate leases and to protect the asset and any residual investment value. Cash flow is critical so you must know what the tenants will pay and it's not much because there is so much choice. 
 
The difference in Australia is that loans mean full exposure to debt unlike the US where many loans are non-recourse. Non-recourse is like a “get out of gaol free” card. You can disclaim responsibility for future non-payments. The consequence there is that borrowers walk away, they hand back the asset, shrug their shoulders and say guess what I’ve lost all my equity. Here, the banks are in a strong position and it's the borrowers who are in a precarious situation. In the US the banks had to take back the properties once the equity evaporated. No one really wants an illiquid asset in a market you have to sell into. I always remember Cliff Marriott, Deputy Chair of Raine and Horne Australia telling me “When you have to sell property it's always the worst time”. 
 
By way of example, The Real Deal reported on 14th Dec 2023 the sale of 115 Sansome Street San Francisco which better outlines the office market today. I know this building, its location and The Swig Company who sold it in 2016. You'd be proud to own it at the right time or at any time with a modest debt facility. 
 
Before you read the article, I feel that I need to clarify that it was purchased in 2016 by the current owner on a non-recourse loan. As the value dropped the owner offered the property back to its bankers and to walk away. The bankers appointed an agent, in this case JLL who consider all bids and sold it back to the owner. I calculate the loss in value to be 58% based on the numbers in the article.
 
"Another major Downtown San Francisco office building has sold at a considerable discount. 
 
— but in the case of 115 Sansome, the price was bid up 40 percent by a diverse array of buyers, indicating the city may be past the bottom of the commercial market.

The winning bid came from the building’s current owner, Vanbarton Group, according to a source close to the ownership group. With the short sale, Vanbarton has cancelled out its debt on the building it bought for $83 million in 2016. Instead, the all-cash deal this week closed at around $35 million. The 2016 loan from Bank of America amounted to about $53.6 million, according to public records, and city documents recorded on Dec 11 confirm that the loan went into reconveyance.
 
In the heart of the North Financial District, 115 Sansome Street closed for north of $300 per square foot, or about 40 percent higher than the $25 million dollar price guidance when the property was marketed by the brokerage JLL, which declined to comment on the sale.  
 
The Beaux Arts building, which dates to 1912, has 14 stories plus a penthouse with 118,000 (sq feet) in rentable square footage.
Bidding in the short-sale auction was heated, with more than 20 offers in the first round and more than 10 in the best and final, according to a commercial industry insider. Interest came from not just the local buyers with private money who have dominated the few other commercial purchases this year, but from institutional and international investors, as well as high-net-worth individuals.
 
So my summary is as follows: Building acquired for $7,571.21 pm2 in 2016. Building reacquired for $3,192.68 pm2 in 2023. Bank loses $18.6m Owner loses $30m. Owner retains ownership. Property price plummets from $83m to $35m or by 58%.
 
Consequently, the issue in the United States is a lack of confidence in the banks and the chance of a run-on deposits. That’s how bad the commercial real estate market is in the US and the potential contagion effect on banking. 
 
I have had difficulty conveying that Australians should be very wary about this same trend occurring in Australia. We’ve overlayed our passion for residential real estate into the non-residential markets and now we need to take those rose-coloured glasses off. Houston there is a big problem which should become apparent shortly.
 
I believe that the problem in Australia is quite like the US, Europe, and Asia but the difference is that over the past 30 years our institutions have tried to make all the usual risks in commercial property as smooth as possible. 

Investors and fund managers hate surprises, especially retail investors (Mums and Dads). So, the fund managers have created a bond-like product where risk is spread over time and returns are regular with the huge advantage of growth via fixed rent escalation. To create this product, we’ve incentivised the tenant with attractive upfront financial incentives to move from one location to another, each time paying for their new fit out. In the US they are gobsmacked at how much money Australians give tenants as a portion of the whole deal and in Australia our rents are higher than the US which dumbfounds them too. How do Aussies do this? Well with financial wizardry and potions. Not the Fund Manager again? 
 
Perhaps we are about to witness the emperor’s new clothes moment or as Warren Buffett says, “Only when the tide goes out do you learn who has been swimming naked.” Well, the tide is receding. So don't be surprised as bare bodies start to appear."

So, we’ve built this model which on the outside looks amazing but on the inside I’m not sure what’s holding it up, other than the major players. The issue now is the incentive. In my experience an incentive of 20-25% gross (includes the outgoings as well as the rent) is common on a 7-year lease. This usually facilitates the tenant being able to apply the full incentive to a brand-new fit out and pay rent from the start of the lease. The problem now is that the incentives are all over 35% and some start at 45% and end up at 55%. I believe once incentives clear 50% then face rents fall. This is not occurring but then neither are spaces leasing. We have entered an environment I haven't really seen before, but no one is saying anything. It is surprisingly quiet out there.
 
In the past I've heard private investors say, "if I'm only going to get rent for 5 years on a 10-year deal then what's the point of doing the deal I may as well shut the building up and wait for the market to improve". I get that sentiment but it’s hardly what a seasoned investor would do. Astute investors do two things, firstly as per The Real Deal example I provided in Sansome Street, The Swig Company exited in 2016, that’s smart. If you could have won, the Rolex award for timing then 2019 would have been even better. Secondly, an astute investor would be talking about the property’s true value and trying to evaluate if it was better to sell out or retain it and if retention was an option, then how much future capital was required and if this in itself was another trap.
 
I’ve done a few deals lately where I was desperate to get my clients out of the market. Consequently, I've been the lowest rent in the market. My edict is that when a market is falling you must learn to get ahead of the fall, not follow it downwards. I’ve had success recently. I have set the lowest gross Sydney CBD rents in the sought after prime financial district twice with asking rents of $495 pm2 gross and $595 pm2 gross and I am finding real tenants. My clients get to sleep at night because we all appreciate the value of cash flow. I'd suggest that the majority of owners are sleeping restlessly. 

When I've represented my clients in negotiating new leases, I've done deals for my clients at such high levels that they don't know what to do with the money/savings. I call this an unhealthy market.
 
I’ll continue my thoughts in my next article. I'll look at bifurcation or bs, yields and interest rates, fit outs and what tenants are thinking. 
 
Think about this for a moment - yesterday tenants paid rent for 7 days and used the space for 5 days. Today tenants use the space for 2.5 days and still pay for 7. I wonder how long that level of unproductiveness or misallocation of the rent expense will last?
 
For now, I am long on commercial real estate and encouraging my clients to slip towards the side-line and off the field altogether. It’s not time to come on the field unless you want to get hurt. I’ll also give you my ideas on how to fix the market and what is getting in everyone's way.