The Ugly End of the Office Space Bubble

Baldwin Louie — Mon, 20 Aug 2001 18:00:00 -0400

One Market Plaza. The name alone elicits a knowing "aha" among business-savvy San Franciscans. The office complex overlooks the scenic Bay Bridge and sits at the head of Market Street, the main thoroughfare that divides the city. On one side are downtown and the financial district. The other side is known as South of Market, or SoMa. It's a location that gives One Market's two high-rises - the 27-story Steuart tower and the 42-story Spear tower - trophy status in one of the hottest office markets in the world.

During the long boom of the 1990s - a time when the San Francisco area acquired more new major corporate headquarters than any other metropolitan region - One Market Plaza thrived. That was, until 1999. Then One Market Plaza virtually exploded.

In just a few months, as the Internet bubble neared its peak, rents at the complex went from pricey to ridiculous. In January 2000, Wilson Sonsini Goodrich & Rosati, Silicon Valley's marquee law firm, signed a lease on a space that was priced at $65 per square foot, according to CoStar Group, a real estate research firm. By the time OmniSky and WitSoundview signed on a few months later, the asking price was $90 per square foot. By October, Commerce One, fresh from closing one of the largest leases of the year in the East Bay, was taking space on the 13th floor for a staggering $115 per square foot - a San Francisco record.

It's a record that's likely to stand for quite a while. Today at One Market, you can sublease floors 19, 20 and 21 from Internet Capital Group for $65 per square foot (ICG is paying $90). A few floors higher, longtime tenant Accenture is subleasing part of a floor for $45 a square foot. Three of four floors OmniSky rented are on the market. The price: negotiable. To lure leasing agents, the company is offering $100 gift certificates to Neiman-Marcus for merely showing up to see the space.

All in all, One Market Plaza remains a healthy property with low vacancy rates. But its brief ride on the Internet roller coaster is one that was repeated all across the San Francisco Bay Area - and in many other urban centers around the country. And now, as lease after lease unravels, landlords and tenants both are facing the fallout from the gross miscalculations and misplaced ambitions that infected every aspect of the bubble economy.

For landlords, vacancies are mounting to levels not seen since the recession of the early 1990s. As office space sits idle, some buildings that were for sale have been pulled off the market. And new construction is expected to slow: Of the 7 million square feet of office space approved for construction in recent years, only 3.8 million are being built, says Colin Yasukochi, director of research for Grubb & Ellis. Most of the remaining projects "won't get built because there is a fairly large available supply right now," Yasukochi says. "Rents have declined to the point where construction may not be financially feasible."

Even for a colorful speaker like Steve Ballmer, it was an impassioned performance. Like a hotshot trial lawyer working the jury, the Microsoft CEO clenched his fists, gritted his teeth, alternately whispered sweetly and shouted explosively to the gallery. Delivering the closing keynote at the company's annual Financial Analysts Meeting, he turned to the subject of Passport.

Microsoft has been accused of an array of crimes over its plans to implement this online user ID service by hosting a massive centralized database of personal information. The charges: It would destroy online privacy; it would threaten security; it would position the company as an all-powerful middleman between Internet businesses and their customers.

"People say, 'Ooh, is there some big plot here?'" said Ballmer. Then, in Johnny Cochran rhyming rhythm: "The customer gets to choose how their data is used." Furthermore, he insisted, the businesses that partner with Microsoft and use its .Net services needn't worry, either. "They own their own data," said Ballmer. "They own their own customers."

To achieve broad adoption for its Web services platform, Microsoft must win the trust of both consumers and business partners. So Ballmer is out there making promises about privacy and security that will be difficult to break. "There's no other philosophy that makes any sense at all," declared Ballmer, resting his case.

But if consumers and Internet partners buy Ballmer's defense, it's the software giant's competitors who really need to worry. Unlike the browser wars, no company yet has a product to compete with Passport; and Windows XP, which is almost ready to ship, will support no rival service. Microsoft could win simply by being there first, providing the gateway - maybe the sole gateway - between users and Web services. Passport's potential to dominate the market raises the stakes in the current antitrust settlement talks.

Passport is a key part of Microsoft's .Net Web services strategy, which entails building a services infrastructure that's integrated with all its products. In the .Net future, your travel service will contact you on your desktop, handheld, pager, smartphone or even game console with a special offer, perhaps a hotel package for dates you've designated in your online calendar. It'll book a plane ticket for you, and on the day of travel it will message you details of the inevitable flight delay. With your pre-approval, these activities will happen automatically.

WE'RE HERE FOR YOU
When Windows XP hits store shelves - officially Oct. 25 but perhaps weeks sooner - Passport will provide the bridge between the new operating system and Microsoft's Internet strategy. A glossary of some of the components of that strategy:
Web Service	An XML-based application delivered over the Web that provides a preprogrammed service to the user, accessible from any device running on any software platform. While Web sites present information, Web services do things for users and may act as agents for them. Examples: online notifications of travel information or stock data; online calendar updates.
.Net	Microsoft's strategic plan to create a Windows-based infrastructure for Web services by baking deep XML support into all its products, including Windows, Office, its enterprise servers and developer tools.
HailStorm	A set of basic services, due in 2002, that Windows developers will use as "building blocks" to create complex Web services. HailStorm will enable business partners such as eBay to build cheap Web services.
Harmony	Code name for a set of premium services that Microsoft itself will create and market directly to users through MSN on a monthly subscription basis.
Passport	Authenticates a user's ID when any .Net Web service is accessed. User data is stored on Microsoft servers. Passport also includes an option to store credit card numbers and shipping addresses, which will later be collected separately as a HailStorm service called MyWallet.

For many overspent dot-com tenants, things are much worse. Some have already been forced into bankruptcy, in part by lease commitments they could not afford. Healthier Internet companies with decent cash reserves are waking up with a real estate hangover that is certain to be a drag on their bottom line for years: Leases on idle office space now rank among the top liabilities for many companies.

For a dot-com seeking San Francisco office space in 1999 and 2000, the consuming emotion was panic. Their business plans called for rapid growth, but they had nowhere to put employees - they needed space, any space, and price be damned. Landlords, enjoying the rare luxury of picking and choosing among prospective tenants, pushed the unproven newcomers as hard as they could.

"Getting your client in the front of the line was difficulty No. 1," says Kevin Brennan, a senior VP at Staubach & Co. "You had to sell the dream." Brennan succeeded in selling his client, Atlanta-based consulting firm iXL, to a landlord, but not before the company's chief marketing officer flew in to tout its potential. In June 2000, iXL got its 105,000-square-foot lease at 575 Market Street. The terms were onerous: $82 per square foot, a 15-year commitment and two years in rent up front in a letter of credit - essentially a security deposit of about $16 million.

Experts say Internet companies showed the same naivete in dealing with leases as they did in other areas of their shaky businesses. Few had experienced real estate managers, and the highly strategic job of managing space needs often fell to the CFO, says Martha O'Mara, a lecturer at the Harvard School of Design who advises large companies on real estate matters. "CFOs don't know anything about corporate real estate," O'Mara says. "They took advice from their brokers ... Hello?" Brokers get paid a commission based on the initial value of a deal, not on whether the lease is completed, O'Mara notes.

Against that backdrop, you could say iXL rival Organic got lucky: It found enough space for a massive planned expansion of its San Francisco headquarters in November 1999, just before the real estate market boiled over. Back then, Organic's revenues were soaring as it signed on new blue-chip clients such as DaimlerChrysler and Blockbuster every week. Organic was on track for a $110 million February 2000 IPO. It found an entire building in the SoMa area. The site's 212,000 square feet would be enough to house about 850 workers - more than the company employed worldwide. And Organic paid a not-too-pricey $40 per square foot.

Still, the 10-year lease amounted to nearly $85 million - a steep sum for a company with 1999 revenues of $78 million and losses of $39 million. Organic promptly proceeded to improve the space, hiring a top architectural firm for the roughly $10 million job, or about $50 per square foot in improvements, according to building owner Ronaldo Cianciarulo.

Since then, Organic has hit the wall. Revenues have plummeted, forcing the company to lay off hundreds of workers. Its headquarters are nearly three-quarters empty, and the company is attempting to sublease 140,000 square feet. So far there are no takers. That represents a minimum of $5.6 million per year in rent for space that is collecting dust. "They pay the rent every month," says Cianciarulo, adding the two sides are in discussions to resolve the issue. And that's just one of Organic's buildings. Worldwide, Organic has long-term leases worth a whopping $198 million, according to its most recent annual report.

Real estate planning snafus like Organic's can quickly turn into a company's biggest liability. After all, excess employees can be fired and unsuccessful product lines can be cut short. But leases linger. Consider iXL, which recently laid off scores of employees and closed offices around the country, including its nine floors at 575 Market.

IXL negotiated its way out of its San Francisco lease, and neither the company nor landlord wants to discuss the terms of the settlement. But in regulatory filings, iXL listed restructuring charges of $76.6 million tied to the recent layoffs. Of that sum, a remarkable $65 million is linked to lease losses and write-downs on office improvements. And iXL faces an additional $41 million in restructuring charges over the next several quarters.

While some dot-coms paid immense sums because the demand for space far exceeded supply, many were blinded by the notion that there was no such thing as risk: A downturn was unimaginable. (Standard Int'l. Media, parent of The Standard, was among the companies that rented considerably more space than it ultimately needed.) In April 2000, eGroups, a community e-mail company with about 175 employees, snapped up eight floors at 555 Market Street, the building next door to iXL. The 125,000-square-foot space would give it room to grow to about 400 people, according to former CEO Michael Klein. The privately held company signed a 10-year agreement at $57 per square foot - a total lease of about $71 million. Even though the rent was costly, Klein thought eGroups would either use the space or rent it to others for a profit. "At the time of the transaction, we had other companies that wanted to sublease from us," Klein says. "We were thinking it wasn't going to be too difficult to find someone to take it."

The space now sits empty. Yahoo took on the liability for the rent when it acquired eGroups in June 2000 for about $428 million in stock. Yahoo spent months negotiating a way out of the lease and will pay a "modest" restructuring charge, according to spokeswoman Shannon Stubo. While Yahoo managed to wiggle out, building owners with cash-rich leaseholders have little incentive to play ball. "Landlords are pretty happy to sit back with the knowledge that they have a creditworthy tenant on the hook and a huge deposit," says Dan Mihalovich, founder of real estate firm Mihalovich & Partners. Like Yahoo, NBC might be acquiring an enormous real estate headache as soon as it absorbs online affiliate NBCi, which signed some $88 million in long-term leases for space that is mostly empty throughout San Francisco.

Smaller companies are hurting even more. Defunct Internet access firm Spinway, for instance, had a crucial $2.5 million tied up in a real estate deposit before it shut down, says Martin Pichinson, CEO of Sherwood Partners, a crisis-management firm that handled Spinway's closure in December 2000. "You are talking about a lot of money" that represented a substantial part of the capital available to Spinway, he adds. In most cases, real estate costs alone are not sufficient to pull a company under. But they have often tipped a company into bankruptcy. "Some people are threatening bankruptcy to try to negotiate down the rent," says Doug Van Gessel, a partner in real estate law at Brobeck, Phleger & Harrison in San Francisco. Leases, he adds, can be the major stumbling block for a company seeking new financing. "Most everybody who comes to me and says they want to negotiate a lease termination [does so] because their VCs won't give them additional financing unless they can get out" of existing leases, Van Gessel says.

During the first nine months of 2000, the vacancy rate for office space in San Francisco was near zero, and rents on top space surged from about $50 per square foot to more than $80 per square foot. Today, virtually every block of SoMa has at least one For Lease sign clamoring for attention. Some have more than half a dozen. Entire buildings that were refurbished for dot-coms are empty. Vacancy rates have soared to 10 percent citywide, according to Grubb & Ellis, and have a reached a staggering 26 percent - and rising - in SoMa.

The market is so weak that brokers say there isn't even enough activity to get a firm handle on prices. And for the few firms looking for space, landlords are suddenly rolling out the red carpet. For the local chapter of the environmental organization Greenpeace, the turnaround is a blessing: A year ago, its landlord in a marginal office building threatened the group with a threefold increase in rent - from about $20 to $60 per square foot - that would have forced it out of the city. This year it's been offered several dozen spaces in the low $20s, many nicer than its existing offices, with sleek furniture left behind by dot-coms thrown in for free. "Greenpeace has now become a very desirable tenant," marvels Bill Richardson, Greenpeace's national administration coordinator. It's no secret why: "We've been around for 30 years," he says.

As tenants negotiate with landlords to be let out of leases, sublease space at a loss or simply stop paying rent and wait to be sued, no one really knows how low the market will go. Most experts think the downturn won't be as tough on landlords as the recession of the early 1990s was, mainly because this year's bust was not preceded by the kind of speculative construction that took place in the late 1980s. And this bubble simply didn't last long enough to affect a significant proportion of the total office market. "There wasn't enough time for the debt to build up," says Mark Ritchie of Ritchie Commercial, one of the largest independent real estate firms in the Bay Area.

Still, many landlords, and especially the small landlords who developed modest properties hoping to cash in on the dot-com boom, are sure to regret their investments. Just ask Herve Vatinel, who in May 1999 bought a 50,000-square-foot building from a local school district for $8 million. The building at 330 Grant Street near the financial district was fully financed, Vatinel says, but as a condition for the loan, the bank insisted he have a tenant. Vatinel got his tenant in Groundswell, a technology consulting firm that agreed to pay $75 per square foot. Shortly after the sale went through, Groundswell pulled out. "Now we are at a standstill in this project," Vatinel says. "It is vacant and the space isn't finished."

In retrospect, the bloody collision between the real estate world and the Internet economy seemed inevitable. One is an industry of long lead times and careful planning. The other was moving too fast. And planning? That was so old economy. And so the two fed on each other to create an explosive mix. "I think it was one of the great speculative bubbles of modern commercial history," Ritchie says. As with so many other excesses from the dot-com bubble, the fallout will be felt for years to come.

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The Ugly End of the Office Space Bubble