Does commercial real estate matter?

July 6, 2005

View from Silicon Valley- Does commercial real estate matter?

The Silicon Valley housing bulls are "winning." Prices are up and volume is nearing 2004's peak. It doesn't matter that Silicon Valley housing is not affordable for the vast majority of residents. It doesn't matter if it's cheaper to rent in most cases. It doesn't matter there are 200,000 fewer Silicon Valley jobs than during the 2000 boom, with zero net job growth the last two years. It doesn't matter commercial real estate is weak and experiencing high vacancy rates.

What's that? You heard Silicon Valley commercial real estate was getting better? That availability was declining?

Sorry. we are convinvced Silicon Valley commercial real estate availability is systematically under-reported. Driving to work every day, there are literally dozens of buildings with few, and sometimes even zero, cars in the parking lot. Empty parking lots abound in office buildings of all shapes, sizes and municipalities.

We are convinced commercial space available is mis-reported much the same way the Santa Clara County Association of Realtors reports housing statistics. (i.e., they only track deals for which a fellow cartel member gets a commission). For example, SCCAOR reports -24% fewer sales in May, at a +15% price premium, compared to like-period figures from DataQuick. (And we get complaints DataQuick figures are inflated.) We believe commercial real estate availability is similarly distorted.

Competing with our admittedly incomplete and anecdotal impressions are continued news reports of gradually declining percentages of Office and R&D space available. The monthly statistics claim total space available is now below 23%. (We still think the true number is closer to 40%.)

There are stories of businesses whose late-90's leases are running out, freeing them to relocate. Some find they can upgrade to "Class A" space for about what they paid for lower-grade space five to seven years ago. The bulls claim low lease rates are filling up commercial real estate offices the same way mortgage rates are fueling housing price increases. In turn, "Class B" space is being converted to office condos which is clearly another by-product of the housing boom- own it even when renting is cheaper because real estate "always" (and only) goes up. We wonder why businesses are succumbing to the monthly payment syndrome mentality instead of focusing on lowering their costs, but that's just us...

Also reported from the bullish camp, office buildings are being torn down and re-built as retail or housing (or both) The former Philips Semiconductor Sunnyvale offices at Wolfe and Arques, once home to a couple hundred marketeers, were torn down to make way for a new Lowe's. (What do you suppose this Lowe's P&L will be after a few quarters of competing with Home Depot nearby on El Camino?) Palo Alto made a great show of allowing some empty office buildings to be torn down after the developer agreed (the word "blackmail" was not actually in the news article) to include "affordable" housing units. We are aware of a few other, similar stories...

Silicon Valley commercial landlords claim the market is OK, just waiting for the next innovation and boom. Isn't this like "analysts" in 2000 theorizing stocks might flatten for a few years while earnings caught up to valuation? Does anybody remember how that strategy worked out?

Enough with the factoids and anecdotes already, let's find some dang numbers. (After all, that's what we do around here.)

1) Initial sales from EOPT's bail out from Silicon Valley are closing, putting some actual occupancy figures in the public domain. The four properties were as follows:

Property SqFt(K) Occ Vac Empty(K)

301 Howard 307 70% 30% 92

Foundry Sq 502 59 41 206

Parkside Twrs 398 16 84 335

San Rafael Ctr 155 38 62 96

Total 1,364 729 =53% vacant!

Admittedly, 1.36M square feet in a 200M+ market, do not statistically prove much. (Of course, neither did the Philips or Palo Alto stories...) Even so, 53% vacant is an eye-opener.

2) The local paper is now publishing a commercial real estate update on Tuesdays. The first three installments were divided into R&D, Office and Industrial. We pieced together the snippets for a bigger picture (which is now a new feature on our "Stats" and "Housing" pages)

A few points from this data stand out:

-office and R&D space (22.3% vacant) is in worse shape than industrial space (10.2% vacant);

- despite the alleged y-o-y reductions in space available, lease prices fell -4%;

-San Jose's 1.9M+ square feet worth of downtown vacancies (27%) is BEFORE the city opens it's new 550K square foot ($388M and counting) city hall. The move figures to add ~500K+ to downtown's vacancy lists;

-at today's rates, an incremental $54M per month(!) is needed to occupy just the Silicon Valley office space which is admitted as being empty.

3) Sunday's local paper included some useful data but also another dose of un-disprovable "facts."

Qualifying as useful (and consistent with earlier) data:

Type Total Available 3-yr Chg Avg Rate 3-yr Chg

R&D 159.2M 36.8M +14% $0.85 -47%*

Office 57.7M 11.4M -17% $1.96 -31%*

Industrial 51.6M 7.5M -5% $0.56 -23%*

*- published as "n/a," actuals derived from earlier data

Since mid-2002, the depths of the previous recession, Office/R&D lease rates are down up to -47%. This has to be sobering news. (Bulls claim the fall in lease rates is just the other side of the coin of median houses up +36%. However, lease rates are set by, professionals, and are declining to lack of demand (=jobs). What's the long-term return on "investing" in houses, by amateurs, when no new jobs are created to fill the offices?)

Un-disprovable news comes in as:

Subleased space for rent drops:

% of space offered as sublease by current tenant:

R&D Office Combined

2002 41% 45% 43%

2003 35% 35% 35%

2004 26% 22% 25%

2005 22% 20% 21%

More space actually vacant now:

% of space offered for lease which is vacant:

R&D Office Combined

2002 52% 50% 52%

2003 66% 65% 66%

2004 83% 82% 83%

2005 83% 80% 82%

Accepting these figures are accurate, this is also sobering news for Silicon Valley's cheerleaders. Rates dropped up to -50% over three years and only now is 80%+ of the available space actually empty.

We already know 10% of all Office/R&D space in Silicon Valley is up for sale. The 80%+ vacant-for-lease figures suggest we may now see a tidal wave of "motivated sellers." (Or "motivated lessors"?)

What are lease rates likely to do when we get these "motivated sellers" in the market?

What are the implications for Silicon Valley's housing market once our weakness in commercial real estate becomes clear?

We think commercial real estate will soon start to matter a great deal.