A Tale of Two Economies

The market for commercial properties in the San Francisco Bay Area has stabilized, even improved some. But why? Vacancy is still high. Rents are fairly static. Instead, purchasers are considering lower rates of return. That is a sobering thought when capitalization rates on non-investment grade buildings in San Francisco are on the order of 5%. What's happening?

First , the real estate portfolio managers appear to have been wrong-footed. Many did timely sales, but eventually cash is an unattractive asset. And bottom feeding has been more difficult this time as compared to a decade ago. Yes, it is possible to buy some buildings at below replacement cost, but often encumbered by long term leases. While the lessees may have only a tenuous hold on corporate existence, those leaseholds will continue to burden lessor's returns. As they shrink, lessees will simply sublease surplus space into an eventually rising market and pocket the difference.

The returns on money are bad, and corporate borrowing rates are related. As leases share some pricing characteristics with debt, buildings leased to viable, creditworthy, companies are not cheap.

The hope must be that either cap rates stay low, or rents rise. My crystal ball is low on batteries. If anyone had wanted to bet me a year ago that ten year t-bills at this time would be lower, I would have given odds and lost money. The latter is more likely than the former. Vacancy has stabilized in the region. Rents have stabilized. Meantime, while the photo, taken about two months ago, is representative of some buildings built to house dot-coms, others have survived that implosion in fair health. And the economy, driving employment and space absorption, might be good for at least three of W's four more years.

So, "Are you feeling lucky?" At least, in contrast to Dickens' novel, a mistake is unlikely to cost you your head.