May 5, 2005

View from Silicon Valley- A tidal wave of commercial real estate.

(c) copyright, View from Silicon Valley, 2005. All rights reserved.

Last month, Peery-Arrillaga, a large holder of commercial Silicon Valley real estate announced they are selling off ~10 million square feet of office space, representing ~66% of their local portfolio. Quoting from the news article, "The properties are being offered with no asking price, though marketplace rumors put the average value in the neighborhood of $250 per square foot, over $1.5 billion for the entire portfolio. The buildings are 67 percent leased and spread across Milpitas, Santa Clara, San Jose, Sunnyvale and Mountain View, according to offering documents. Net operating income and other financials were not available."

"No asking price," should be our first clue that something is fishy. I'm no expert in commercial real estate but since when does prime real estate go on the market without an asking price? Second, my elementary school arithmetic ciphers $1.5B at $250 per square foot and finds only six million total square feet, not 10 million. Are large chunks are worth less than $250 a square foot? Are they discounting the vacant space? One hopes the buyers have enough sense to find out before plunking down their cash...

The cities mentioned are central in Silicon Valley's geography. I would really love to know how the actual occupancy rate compares to the "67% leased" figure so prominently cited. I would bet good money the actual occupancy rate is lower, perhaps much lower.

The same week this news hit locally, the Wall Street Journal had not one but two articles on Sam Zell and Equity Office Properties Trust (EOPT). On top of the Peery-Arrillaga deals, EOPT was selling off all or parts of seven Bay Area buildings worth $620M, described as 40% vacant at $240 per square foot. (Implying ~2.58M total square feet.)

As an aside, two major organizations have now admitted to 33% to 40% vacancy rates. Meanwhile the local real estate cartel continues to claim "R&D/Office" vacancy numbers in the low-20%'s. Don't you wonder how many of our residential real estate "investors" recognize this difference?

Long-time readers may recall, from January, 2004, "EOPT paid $103M for the 75%-leased high-end Opus Center in downtown San Jose," which was $300 per square foot. EOPT was publicly proclaiming a policy of bailing out of small markets to concentrate on "hot" areas like Silicon Valley. The purchase was hailed as a sure sign of a budding employment recovery in Silicon Valley. (Editor's note: From January, 2004 to March, 2005, Santa Clara County gained only 1,100 net jobs (+0.14% or 0.0014).

If the Opus Center is in EOPT's package, they are losing serious money. (Selling at $250 after paying $300 per square foot with a vacancy rate at 40%, up from 25%.) How many residential real estate "investors" are tracking these details?

"What had been a strong flow of valley properties coming to market beginning late last year has morphed into a tidal wave of offerings in the last month to 60 days." EOPT's Eric Luhrs was also reported as estimating "there are 15 million to 20 million square feet on the market today in the South Bay."

Luhrs also said, "It feels like there is so much product out there that it's a little distracting."

At 20 million square feet, almost 10% of Silicon Valley's entire inventory of R&D/Office space is up for sale. (The corresponding residential real estate figure is 2,994 homes currently for sale(#) in a universe of ~400,000 which is 0.75% (0.0075).)

Let's run some numbers, generously assuming the sellers really get $250 per square foot. The most expensive category of lease rates tracked by the local paper is "R&D/Office." Lately, those lease rates run:

Milpitas:           $0.83
Santa Clara:     $0.81 -$1.77
Sunnyvale:        $0.80 -$1.71
Mountain View: $1.02 -$2.25

Peery-Arrillaga's cash flow figures to be running 1.9% to 5.4% (remember, they're 33% vacant, at least). Best case, if the new buyer brings the occupancy to 100% without cutting the lease rates, their cash flow can increase to a range of 3.8% to 10.8%. Clearly, if 100% occupancy was possible, the current owners would not be selling, so figure 2% to something a bit over 5.4% is a reasonable expectation for cash flow.

With those returns, investing in six-month T-bills (3.085% today) or 30-year bonds (5.375%), with guaranteed return of principle, seem like reasonable alternatives.

The head of Peery-Arrillaga also volunteered, "The move in no way represents a fall off in confidence in the long-term prospects for Silicon Valley."

Oh puh-lease!! What else is he going to say? Big-time real estate developers do not sell boatloads of their property if they feel it will be more valuable in the immediate future. The pros do not see the prices for these properties going up. They see an on-going problem with low cap rates. (Sam Zell was reported as saying he expects low cap rates to persist for nine years, "rather than 90 days.")

I admit I lack imagination in regards to several aspects of "modern finance," such as the genius of interest-only and/or 100% financing. However, in this case, I can imagine another strategy --REITs. It seems likely the real reason both Peery-Arrillaga and EOPT are selling is there are still boatloads of investors desperate for yield who think REITs are the answer.

Maybe such investors think commercial real estate has yet to be fully exploited by the tools of "modern finance"? Even with 33% -40% vacancies, they imagine the top-line value of the property will appreciate? A prospectus promising 2% but hinting at 6% (or even 10%?!?) will sell a lot of REIT shares to the masses.

Yes, the Peery-Arrillaga and EOPT pros are selling to other pros. However, if the properties end up in a REIT, they are essentially being flipped to amateurs. The REIT pros are spending other people's money.

Besides this general rant, there is a point: Last year, EOPT and others were generating publicity over the strategy of snapping up Silicon Valley office buildings.  With these pros now bailing out of Silicon Valley, in some cases at a loss, the obvious conclusion is they do not see a recovery in the Silicon Valley economy.