Sharon Simonson
During his second-quarter conference call with Wall Street analysts, Mission West Properties' founder and chief executive Carl Berg itemized his real estate company's woes.
Tenant quality in the Silicon Valley marketplace is generally poor, Mr. Berg said. The enterprises are often losing money. They have little cash in the bank. But, they want the kind of terms reserved for a "Triple A national," and competition for their business is "enormous."
His company's occupancy rate has fallen from 80 percent a year ago to 72 percent today, and there's every indication that it's going to get worse. Three of Mission West's significant tenants, including two that have occupied properties for 20 years or more, won't renew leases that expire next year.
The three will leave 275,000 square feet behind, pushing Mission West's vacancy rate up 3 percent. Worse, one of its largest tenants, Microsoft Corp., is in lease negotiations, and its rental rate could fall.
"Consistently, in any situation that seems to occur, we seem to be on the losing side of it," Mr. Berg lamented.
His comments would seem to echo what many a valley landlord is experiencing. Nearly 44 million square feet of research & development property remained vacant at mid-year, 26 percent of the total, according to CPS/Corfac International. The office vacancy rate was 24 percent, with 10.2 million square feet up for grabs.
R&D rents, at 80 cents a square foot a month, are 15 percent of what they were at the end of 2000. Office rents have fared little better.
Mission West, with nearly eight million square feet of commercial real estate in Silicon Valley and one of the region's largest portfolios, is one mirror of commercial real estate health. While the company continues to make money -- $7.5 million in net income in the first six months on assets of more than $1 billion -- during the same conference call, Mr. Berg admitted that he may have to cut Mission West's 96-cent a share annual dividend, something he had assured investors he had no plans to do.
Yet, amid all of the gloom, Mr. Berg and others in the marketplace are optimistic. If the company keeps Microsoft as a tenant and conditions improve, Mission West dividends could stay steady, he said.
"There is a consistent and clear trend with more and more activity and some reduction in overall inventory," says Jeff Fredericks, managing partner for Colliers International in the valley.
Indeed, expectations are strong that the second half of 2004, barring a major terrorist attack or some like catastrophe, will bring incremental improvement. Still, no one is predicting a major turn, particularly in rents, for at least three years.
"A year ago, you could do almost anything you wanted to upgrade a building, and it was hard to get any reward for your investment. Today, if you take a 75-cent building and upgrade to a 95-cent building, tenants will pay," says Jim Beeger, a senior vice president at Cornish & Carey Commercial, Oncore International.
Class A space -- property in the best locations, newly constructed, with fresh paint and carpeting and fully outfitted with attractive furniture -- has become increasingly scarce, he and others say. Mr. Beeger says he thinks tenants might even tolerate rent increases on this type of space, if the landlords could bring themselves to do it.
The vacancy rate at the Stanford Research Park, arguably the most desirable location in the valley, has dipped below 10 percent. Cornish & Carey Commercial reports a three-cent uptick in monthly R&D rents in the Palo Alto market, the first increase in at least eight quarters. CPS reported positive net absorption of more than 2 million square feet of office and R&D space in the second quarter. It's the first time the market has seen net absorption since the first quarter of 2000, they say.
"I'm optimistic," Mr. Beeger says. "I think we are in a fragile recovery."
Joe Moriarty, a senior vice president at CPS, notes a recent string of larger leases, measuring some 80,000 square feet and up, citing Hyperion Solutions Corp., Agere Systems and WebEx Communications Inc. "Deals this size are really what the market has been missing," he says.
On the investment side, commercial real estate, and California commercial real estate in particular, has been a backhanded beneficiary of the technology bust, as institutional investors have fled the stock market in search of better returns, says Raphael Bostic, an associate professor of real estate and urban economics at the USC School of Policy, Planning and Development.
Target investment rates for institutional investors have risen on average to anywhere from 8 percent to 12 percent, considerably higher than in the past, he says.
The California Public Employees' Retirement System, the largest U.S. pension fund with assets of $162 billion, currently has 7 percent of its portfolio dedicated to real estate, but its allocation goal is 9 percent, according to its Web site. The system is moving away from equities and global fixed income.
The CalPERS board recently voted to devote another $500 million to high-risk real estate acquisitions, pushing its anticipated investment to $1 billion. Some of the initial set-aside has already made its way to the valley.
The institutional shift, along with low interest rates, has helped stabilize commercial real estate values and, in some cases, push them higher, Mr. Bostic says.
The question remains -- and values depend to some degree on -- whether institutional investors will maintain their brick-and-mortar holdings or flee if other investments begin to look better. The answer to that question won't likely emerge for another several years, he says.
Of course, ultimately, institutions won't decide the fate of California's commercial real estate values -- or rents, for that matter.
"If business decided it didn't want to be in California, then value would erode, regardless of what capital wants to do," he adds.