Commercial Real Estate Blog

We’re starting to see more reports of the credit crunch infecting Silicon Valley make the mainstreem press. IHT came out with an article the other day discussing how startups in Silicon Valley are beginning to feel the crunch.

For the most part, landlords and brokers have remained fairly bullish on the prospects of Silicon Valley with some landlords continuing to raise rents on some buildings despite having signed no deals in the building at the lower rental rate they were asking only a few months ago. It should also be noted that some landlords such as Jay Paul at their Moffett Towers project have been lowering rents at the same time.

But I think many people are making a mistake here. They’re looking at what’s on the ground now and assuming that because we have so many multi-national companies here, we will somehow be okay. But Silicon Valley has never been about “today”. It has been about innovation, and “tomorrow”, and that’s where I think people need to look when assessing the situation.

What is happening with the capital markets is affecting startups today, but tomorrow it will be the VC’s themselves who face a tight capital market when looking to raise capital for their next fund. VC’s with solid track records will likely be able to raise additional funds, but many others will likely not be as fortunate. As a result, we’re seeing some VC’s becoming increasingly cautious with their existing capital, and funding fewer companies and under better terms. It is that reason why that unless the capital markets are able to sort themselves out, Silicon Valley will not be immune and the downturn may be worse than many think.

Over the past 24 months, rental rates in the Silicon Valley, the Peninsula, and San Francisco have all seen a dramatic increases. Rental rates in some buildings have jumped nearly 75% over the past 24 months thanks to aggressive new owners looking to benefit from increased demand.

During the past two quarters however, that trend has seemed to have stalled in many buildings and submarkets, and in fact we are now beginning to see some reversal. One of the more notable and bold spec projects currently under construction is the Moffett Towers project being developed by the Jay Paul Companies. The project which sits at the intersection of 237 and 101 in Sunnyvale originally was being marketed at $3.25 NNN.

The economic realities facing Silicon Valley today along with a fairly packed pipeline of office space in Sunnyvale has now caused Jay Paul to lower asking rents for the project to $2.95 NNN hoping that some leases can be signed. There were some rumors swirling around in the past that Google had signed up for some space in the project but that now seems unlikely.

The market in Sunnyvale remains to be one which developers such as Menlo Equities, Sand Hill Property, RREEF, and Jay Paul, amongst others are together delivering well in excess of a million square feet Class A office product.

This translates into an excellent opportunity for tenants seeking Class A office space to pit landlords against eachother and to strike a deal at favorable terms.

The Fed’s recent actions to help stabilize economic conditions are not impressing foreigner’s holding US debt instruments. The inflationary actions of the Fed have resulted in foreign buyers of US debt to essentially boycott government auctions for treasuries.

Over the past eight weeks, the share of foreign buyers participating in these auctions was somewhere around 25%. In last week’s auction, they represented only 5.8%.

Additional steps the Fed has taken or will take this week include bailing out Bear Stearns by essentially financing a JPMorgan takeover of Bear Stearns. The emergency overnight rate for bank’s was cut by 25 basis points, and in the Fed’s next meeting, they might cut interest rates by as much as seventy five basis points.

Unfortunately though, the Fed can only control short term rates. What the Fed cannot do is control long term rates and that is what will affect commercial real estate going forward. The current economic conditions, compounded by inflationary pressures and increasing long term rates does not bode well for holders of such real estate. What we see is people continuing to be bullish in certain market sectors, but it is hard to see how they envision that some sectors, such as Silicon Valley, will escape unscathed.

Time will tell who is right, but with a weakening dollar and thereby increasing commodity prices (for those priced in US Dollars), the effect will be felt in Silicon Valley. We are seeing some Venture Capitalists increasingly wary of their ability to raise any more money in this market and have become increasingly conservative in placing investments.

This has already and will continue to have an impact on the Silicon Valley Market.

Fresh & Easy, the grocery store concept by british-based Tesco who has been on an aggressive expansion plan in Southern California and soon to be Northern California reported sales numbers well below the $100M estimate over six-months.

Turns out that sales only came in at $30M. The poor performance comes at a time when the retailer is continuing its expansion plans with four stores planned in the South Bay.

I attended a broker luncheon of NAIOP’s (National Association of Industrial and Office Properties) Silicon Valley chapter today. The panel was comprised of three brokers, two brokers who spend a majority of their time representing landlords, and one who is a predominately tenant representative.

There seemed to be some concern in the air about the overall economy, but at the same time there was a fairly positive outlook on the current economic situation. The two brokers who provided insight into the market from a landlord’s perspective indicated that rents remained fairly unchanged from a decade ago and that the general expectation was that there would be sufficient demand to drive absorption of the nearly 4M square feet of new product coming online over the course of the next 12-18 months.

I tend to hear investors and brokers discuss construction costs quite a bit and how there is a disparity between face rents today and the rental rate required to support new construction. Right on cue today was an audience member who raised that very same point.

While I agree there is a disparity, I disagree with the philosophy that construction costs are a significant factor which will drive future rent increases. Rent is a function of demand, pure and simple. The only time when there is a divergence from this is when the supplier has pricing power so great that they are able to shift the supply curve.

We have seen rents increase most in the markets such as Palo Alto, Menlo Park, and Cupertino. In those markets, rents have increased because the demand has materialized.

In and around San Jose, rents have increased as well, but the rate of increase has been fairly consistent with the growth rate of of demand. In markets such as Redwood Shores where a single landlord (Equity Office) controls a large portion of the supply, they have been able to move rents upwards at a rate which can be classified as a bit artifical. By large, this pricing power does not extend much beyond niche submarkets and it is therefore very important for investors and tenants to discern between what is simply hype and reality.

The economy is really teetering on recession. The next few weeks and months will be vital in determining if the steps the government is taking will be enough to keep us out of a recession. While there are some large requirements likely floating around right now (Facebook, etc.), it is difficult to see how nearly 4M square feet of new product will lease at rates representing a 30-40% premium to existing space in a matter of 12-24 months.

If the performance of the S&P Index during the first week of January is right again this year, the markets and the economy may be facing a bumpy ride ahead.

Below is the performance of the S&P 500 index over the last ten years; and 2008 has had the worst showing in a decade. We’ve been advising our clients to take a cautious approach and we believe that while the fundamentals in Silicon Valley remain strong, the pockets of weakness will expand and both tenants and investors should apporach any investment or lease with that in mind.

Scott Herhold, a writer for the San Jose Mercury News wrote an article for Sunday’s paper outlining some of his favorite contemporary architecture in Silicon Valley. His list included:

• Plaza De Cesar Chavez, Downtown San Jose
• Stephen Schott Stadium, Santa Clara University, Santa Clara
• San Jose Marriott Hotel, Downtown San Jose
• Central Park Library, Santa Clara
• Googleplex, Mountain View
• Circle of Palms, Downtown San Jose
• Mountain View Civic Center, Downtown Mountain View
• 60 S. Market Street, San Jose (Downtown)

While Scott’s list is heavily focused on public spaces and places, my list would include:

• Santana Row
• 225 W. Santa Clara Street, Downtown San Jose
• VMWare Headquarters in Palo Alto
• Oracle Headquarters in Redwood Shores

If there are buildings or projects in Silicon Valley that are on your list of favorites, please comment!