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Are San Francisco tech companies disclosing real estate risks adequately? October 15, 2013

Posted by Bob Cook in Company Case Studies, Financial Planning & Analysis, Real Estate Markets, Silicon Valley.
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Twitter HQ - big enough?

Twitter HQ – big enough?

Tech companies in San Francisco ought to all know that one of the main growth constraints they face is the availability of office space to house workers.  Availability of the highly-sought-after so-called “creative space” is near zero.  Even if a company is willing to forego exposed timber, high ceilings, skylights and other cool features and settle for more conventional space, according to Colliers research, only 9.7% of the downtown San Francisco office space is vacant, and that percentage is declining fast.  The amount of space being sought by tenants currently in the market represents about half of the limited vacancies.  Undoubtedly, some companies are not going to be able to find the right space in the right location at the right price to meet their needs.

Boilerplate 10k disclosures

Yet, while San Francisco-based companies disclose in their 10K’s a seemingly endless list of risks, I don’t know of any who have cited availability of real estate as a risk to the growth of their business.  Almost all tack on a boilerplate nothing like the following at the end of Item #2 regarding Properties in their 10-K’s: “We believe that our facilities are adequate for our current needs.”  If any mention is made of future needs, it’s usually a statement like this one from a well known tech company headquartered in downtown San Francisco:  “If we require additional space, we believe that we will be able to obtain such space on acceptable, commercially reasonable terms”.

Really?   With downtown San Francisco vacancy possibly approaching 5%?

Maybe it’s time for disclosures about real estate to be taken more seriously.  After all, the value proposition to prospective shareholders of most tech companies is not based on their current level of profitability, but rather projections of much greater profitability in the future.  In our “new economy”, where office space to house knowledge workers needs to be considered a factor of production, the availability of this resource cannot be treated so cavalierly.

The issue of real estate as a constraint looms particularly large, one would think, for companies filing for IPO’s, but it’s unclear whether disclosures are taken much more seriously there.

Twitter’s IPO

Take the case of Twitter which has recently filed its IPO registration statement.  The statement reveals that Twitter currently has negative net income, so clearly the value proposition is all about growth.  The statement lists 28 pages of “Risk Factors” many focused on constraints to growth, but the only reference to real estate as a constraint is about data centers: “we cannot be assured that we will be able to expand our data center infrastructure to meet user demand in a timely manner, or on favorable economic terms”.  There’s no mention of real estate to house all the folks doing software coding, administering data systems, selling advertising, and generally managing the enterprise.

Now, Twitter, to its credit, may have its non-data-center real estate needs under control more than most companies.  In April of 2011 it made a bold, visionary move when it leased space in a giant building on Market Street in a prominent, easy-to-reach location, but one that is adjacent to a red light district.  After amendments, Twitter now has about 300,000 square feet under lease until November of 2021.  In moving to a less-established office location, Twitter was able to grab a lot of contiguous space at a price that, presumably, allowed it to bank space for the future.

Apparently, though, it wasn’t enough.  There are reports that Twitter is currently in negotiations for another 320,000 square feet.  What happens if its negotiations are not successful?  Will growth be limited?  I’m sure enquiring investors would like to know.  It would have been nice if the IPO registration statement had explicitly addressed the question of availability of real estate to grow.  As it is, we don’t know if the omission of listing real estate availability as a risk to growth is because Twitter actually has its needs covered for the foreseeable future or because it was simply following bad industry practice of not taking real estate availability seriously enough to disclose it as a risk if, indeed, unavailability might be a problem.

Is availability of real estate a material risk?

Some observers might say that availability of real estate is not material enough a risk to list in financial disclosures.  Any real estate executive, however, who has been ordered “don’t let real estate limit our growth” is keenly aware of how real this risk can be, particularly in San Francisco.  And while there are workarounds for San Francisco companies, like hiring people elsewhere or letting them work from home, companies are in San Francisco because that’s where they think the talent is or at least to where it can be recruited.  That’s where they think there’s a unique tech vibe that energizes their companies.  And that’s where they go to great lengths to make their workplaces cool so they can attract the best talent.  They wouldn’t be paying the premium to do business in San Francisco if having workplaces in the city were not so important. So … if they can’t find that space to create cool workplaces to house the workers they want to hire, isn’t that a material issue?   And shouldn’t the risk that they might not be able to get the space be disclosed to investors?

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Is Employee Housing Far-Fetched? What is Google up to now? November 22, 2010

Posted by Bob Cook in Company Case Studies, Corporate HQ, Financial Planning & Analysis, Real Estate Markets, Silicon Valley.
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Ask virtually any corporate real estate exec whether it makes sense for his company to provide housing for its employees, and you’ll get a dismissive “we don’t do that”.  So sums up conventional wisdom on the subject.

Now, it is true that some companies have provided housing for manufacturing employees in China where workers expect to receive it, but most U.S. companies now tap Chinese labor through contract manufacturers like Foxconn (infamous for its worker housing), so few provide housing themselves. 

And while it’s true that companies have in the distant past provided worker housing domestically, for example in Pullman which was built by the Pullman Sleeping Car Company way back in 19th Century Chicago, few companies provide employee housing today.   The exceptions are lumbering and mining operations and resorts, remote from existing housing.  Most companies, though, are located in urban areas with plenty of housing available, and in most cases, it makes sense for companies to rely on the “the invisible hand of the market” to provide housing for workers.   This is the conventional wisdom.

But, what kind of unconventional situation would make this conventional wisdom not wise?

And what is secretive Google planning for the Googleplex, its headquarters complex in Mountain View CA, where it has been reported it may build housing?

And are the two questions related?

Last week, the San Jose Mercury News reported on how “Google’s growth online [is] reflected by [its] expansion in Mountain View”.  The Merc revealed that Google may be building housing as part of its 1.2-million-square-foot expansion of its present four-million-square-feet of real estate holdings in Mountain View.  Previously TechCrunch and others had reported that Google was pushing the City of Mountain View to allow more residential and retail development in the vicinity of its campus … evoking visions of a “Googletopia” … so news of Google building housing is not surprising.

What exactly is Google up to, though?  One of the Merc’s sources says that as much as 120,000 square feet of residential could be built in the new campus development Google is planning … and “that would be the rough equivalent of 60 homes of 2,000 square feet”.   My thoughts on the math:  while the arithmetic is technically correct, it just doesn’t add up.

What on earth would Google want with 60 homes?  It’s not a number that would make a dent in Google’s ability to house its local employees … which the Merc estimates to be around 17,000 … and why would Google want the headache of deciding who should be allowed into such plum housing?  (A 2,000-square-foot house might not sound like much, but in Silicon Valley, that’s actually a pretty big home.)

Here’s what might make sense, though:  Google builds dormitories.  Google could squeeze as much as 400 dorm units (think small “nerd capsules”) in that 120,000 square feet.  While not enough to house a large percentage of its workers, it’s big enough to be noticed and plenty large enough to serve as a pilot to see if building and owning more dorms might make sense.  This is why it might …

Each month, Google hires a raft of twenty-somethings … many straight from university life, many from overseas … and many don’t want to live in the houses or two bedroom apartments that the market provides.  Why should they?   They don’t need kitchens; Google feeds them for free.   They don’t need space; they spend most of their waking hours at a desk.  They don’t need family rooms; they don’t have families … they’re nerds (which, BTW, today, is a complement … at least in Silicon Valley).  And they certainly don’t need to spend a lot on rent; it’ll be a while before their stock grants and options vest. 

Furthermore, these are not, of course, conventional people Google is hiring.  These are the cream of the crop.  They’re the people other companies oogle, and competition for them is the reason Google just announced it is raising salaries 10% across the board.  Providing these people with dorms on campus would be a great recruitment and retention tool.  With dorms, maybe the next salary increase would only have to be 5%.

So, if the demand for dorms is there, why can’t “the market” provide? Where is the “invisible hand”?   Zoning is the problem.  Two reasons.  The first has to do with geography.  The zoning in Mountain View has heretofore envisioned non-residential uses on the Google side of “the 101”, the U.S. highway that separates recreational, commercial, and aviation uses from the more residential, neighborhoody part of Mountain View.  A private developer would not be able to build a dormitory near Google’s campus… let alone right on it.   The second reason is that zoning in Mountain View and all the surrounding communities tends to limit the number of dwelling units that can be built on a site, either explicitly as a “DU per acre” limit or implicitly because of the physical and economic practicalities of providing the required parking.  Developers, therefore, being dictated how many units they can build, develop large and luxurious units which allow them to more easily recoup their high-Silicon-Valley land costs.  While some cities force developers to build some affordable housing as a condition of gaining their entitlements, the zoning still applies such that dorms are not in anyone’s product line.

So, the “invisible hand” isn’t working:  Googlers want dorms (or so one would think), but developers can’t get the zoning and, even if they could, couldn’t afford to build dorms.  Google wants to make the Googlers happy, but can’t rely on the market.  Google does, though, have influence over zoning (by virtue of being Mountain View’s biggest employer), and so could  act on its own if it wants dorms for its employees.  It certainly hasn’t been shy about providing Googlers with the good life on campus … from free gormet food to massages to pool tables to swimming pools.  Will it build housing?  The situation is unconventional enough to make conventional wisdom unwise.

Now … to be clear … there has been no announcement, as far as I know, that Google is going to build a dorm, and I have no insider knowledge to that effect.  But … putting two and two together … what do you think?

And if Google is not going to build dorms, maybe some of those other companies who are oogling the Googlers should think about doing so.

Window for Bargain Rents Closing Fast for Big Tenants: when being the 800 lb gorilla hurts November 14, 2010

Posted by Bob Cook in Financial Planning & Analysis, Real Estate Markets.
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Big users of office space have gotten used to throwing their weight around and getting what they want.  With the economic downturn, many have used their bargaining power to renew or “blend-and-extend” leases, relocate to better digs or consolidate operations.

The end of the party for big tenants, though, may be approaching … at least in some key markets.  Colliers’ Chief Economist Ross Moore provides interesting data in a blog post with an assertive title: “Office Vacancies are at Cyclical Highs, But Shortages Loom”.   He shows that “many cities have just a handful of options available to large tenants.”  One of those is LA where there is only one block of 200,000 square feet of contiguous space available downtown.  The same is true of downtowns in Philly and Cincy.  

Moreover, some tech and energy capitals … Houston, Seattle, and Denver … have fewer than five such blocks of space.  With their primary industries doing pretty well, it might not take too long for those spaces to go.  Consider: On-line-job-posting-aggregator Indeed.com shows Houston having 84K job postings, Seattle having 73K postings, and Denver having 56K postings … indications of the job growth that is starting to take hold.   How long will those big blocks of space be around?

The squeeze on large blocks of space results mostly from the dearth of new construction.  According to Colliers, if one ignores the large project at Manhattan’s 1 World Trade Center, there is only about 8 million square feet of office space under construction in downtowns across the U.S.   For comparison, I’ll add that in the past, it’s been common for larger CBD’s  like mid-town Manhattan and Chicago’s Loop, to have that much under construction all on their own.

Now … to be sure … it’s not time for office landlords, in general, to start partying.  Downtown occupancy rates will remain low for a while.  Mid-size to smaller tenants are going to have a lot of pickings to choose from and will continue to be able to demand low rental rates even as the big blocks of space get eaten up.  Landlords with large blocks will, though, benefit from the lack of such spaces.  Prices for those spaces will firm up quickly as landlords, anticipating the day when large blocks command a super-premium, become reluctant to lease at too low a price.  Landlords without large blocks of space, though, will continue to suffer.

This bifurcation of the market … the market for large spaces getting tighter and tighter and moving to a “landlords’ market”, while the market for middle-size and smaller-size spaces staying in oversupply and remaining a “tenants’ market” … will take many by surprise.  The conventional wisdom that large tenants can demand better rental rates than smaller tenants will become out-of-date.

For a period of time … until new construction is started to provide large contiguous blocks of space … it’s going to be better to be the one-ounce mouse than the 800-lb gorilla.

In the headlines: Suicides and Chinese corporate real estate May 27, 2010

Posted by Bob Cook in Asian Expansion, Company Case Studies, Real Estate Markets, Silicon Valley.
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Update:  September 13, 2010:  The cover story of this week’s BusinessWeek is a profile on Foxconn and its founder Terry Gou.

Foxconn, a business unit of Taiwanese-headquartered Hon Hai Precision Industry, has, to its dismay, been in the news as of late. Foxconn and Hon Hai are not household names, even though Hon Hai is #109 on Fortune’s Global 500 and has the largest contract manufacturing operation in China. A slew of high tech companies – Apple, HP, Intel, Nintendo, Sony, Dell and others – outsource manufacturing to Foxconn, and the products manufactured by Foxconn are, in fact, household names:  iPhone, iPad, iPod, PlayStation, Xbox, Wii, Kindle and others.  Hon Hai / Foxconn typically shuns publicity and has developed the secretive culture necessary to assure customers that the IP entrusted to them remains guarded. Lately, though, the company’s operation in Shenzhen has garnered unwanted headlines: “String of suicides continues at electronics supplier in China”.

iPhone factorySome think the number of suicides (nine, confirmed, as of this writing) is not all that high given the fact that Foxconn employs at least 200,000 workers (and according to some reports, over 400,000) workers in Shenzhen. Over the years, though, there have been allegations of poor working – and living – conditions. You see, Hon Hai / Foxconn doesn’t have just factories for its workers, but it also has dormitories, all in an environment that – depending upon your point-of-view – is either like a college campus or like a prison labor camp. A few years ago, a famous muckraking article was written about “iPod City” where Apple products are assembled and assemblers are housed. The recent suicides have drawn attention to the factories and its dormitories once more.

The Hon Hai / Foxconn complex in Shenzhen is a city within a city.   In a walled compound, measuring roughly two miles by three-quarters of a mile, in amongst the factory buildings, there are dormitories, restaurants, a hospital, and all sorts of recreational facilities – a 21st Century company town, the responsibility of what-must-be one of the world’s largest corporate real estate departments.

Whether conditions are deplorable or not (which has been Apple’s appraisal) – whether it is a 21st Century Chinese version of 19th Century America’s Pullman or not – the scale of the real estate operation that supports the Hon Hai / Foxconn business is mind-boggling. Hon Hai / Foxconn doesn’t file SEC reports so there’s no public record of exactly how much of its real estate operation is devoted to housing employees, but you can get a sense of the scale from the SEC filings of Nam Tai Electronics, another (albeit much, much smaller) Chinese manufacturer. Nam Tai reports that it has 1.7 million square feet of real estate in Shenzhen. Of this, .7 million square feet – more than 40% – is for dormitories, cafeterias and recreational facilities. Nam Tai’s provision of housing accommodations is no small side-line. The same is probably true of Hon Hai / Foxconn which must be providing many millions of square feet of dormitories and related facilities to its employees.

The willingness of Chinese-based companies to provide living accommodations for their workers sets them apart from foreign companies and may be why they are the low-cost producers in the country. The word “willingness” may not, however, be apropos here. Some think Chinese-based contract manufacturers benefit from the resulting “dormitory labour regime” which gives them more control over the workers. In any event, the provision of worker dormitories is certainly part of  the engine that makes China the “World’s Factory” and is likely to keep it in that position for a long time. And, the lack of willingness on the part of foreign companies to adopt the practice is likely to keep contract-manufacturing as the predominant method that foreigners tap that Factory.

It will be interesting to watch the Hai Hon / Foxcomm story unfold. Apple’s involvement as a customer is going to assure press coverage. Today, it was briefly the world’s most valuable tech company, and for awhile, it’s been  the cultiest – just perfect for muckraking. Expect to see a lot of footage about poor working conditions and poor living conditions, debates about the benefits and evils of company towns … and maybe even an interview with a Chinese corporate real estate exec or two.

Cisco’s Real Estate Valuation Dilemna: How much is enabling face-to-face collaboration worth? April 5, 2010

Posted by Bob Cook in Alternative Workplace Strategies, Financial Planning & Analysis, Real Estate Markets, Silicon Valley.
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Last week the San Jose Mercury News reported that the State of California is moving along on its efforts to sell the last large parcel of the Agnews Development Center property – 86 acres in north San Jose. See “Last of Agnews property up for grabs”.

While other state agencies, county government, local government, and school districts have first dibs on the property, if none of them bite, it’ll be offered to tech company Cisco which has an option, dating back to 1996, to purchase the land for $90 million. If Cisco doesn’t bite, the property will be made available to the public.

Cisco might very well bite. The property is adjacent to its giant, sprawling headquarters campus and would fit Cisco’s modus operandi which has been to consolidate virtually all of its 11,000+ Bay Area employees on this campus. If it thinks it might want to expand its employee population in San Jose at some point in the future, the Agnews site might offer the last chance to expand its campus with contiguous land.

That’s a big “if”, though, because in recent years, Cisco has been expanding its R&D efforts considerably oversees — most notably in Bangalore where it has 6,000 employees and aims to have a total of 10,000 employees in a few years. This overseas expansion has, arguably, been at the expense of growing R&D and other jobs in San Jose, and might be an harbinger of where job growth would be for the company in the future.

Assuming, though, that Cisco wants the land, the issue it needs to deal with is price and bidding strategy. While it has an option to purchase the site at $90 million, the California General Services Administration estimates the value of the land to be only $60 million. If Cisco were to exercise its option, it seems, on the surface, that it would overpay.

But if Cisco doesn’t exercise its option and chooses, instead, to try to be the successful bidder in an open bidding process so it can get the property for something closer to $60 million, it risks not being the successful bidder at all. This is particularly true because price won’t necessarily be the State’s only criteria for selecting the winning bidder. It might, for example, give preference to bids from developers who would convert the site to housing, the promoting of affordable housing being one of the State’s goals.

So that’s going to make Cisco think long and hard about passing on its option to buy. Some might say that the 50% premium it would have to pay above the site’s estimated value is too high, but that estimate of value does not take into account that this property is probably a lot more valuable to Cisco, if it thinks it needs the expansion space, than to anyone else.

As one of the world’s most profitable companies (with net income of $6 billion per year, equal to 17% of revenue), Cisco could, and probably should, look at the value of that land differently than would others. If, in fact, the aggregation of so many employees near one another so as to maximize face-to-face interactions is an important feature of what makes Cisco tick (and it seems that the company’s decision to aggregate so many employees in one place indicates that it does see this as an important feature — and if it wants to provide for future growth — then its valuation of the land should be based on an evaluation of the incremental profit that the company would derive from expanding jobs in San Jose. It should not be based on any of the traditional land appraisal techniques. In fact, this methodology of basing value on what incremental benefit the property would bring to the company would be in line with how companies typically evaluate whether their owner-occupied properties are impaired and should be written down on their balance sheets. Companies typically do a test to see if the cash flows likely to be generated from the enterprise substantiate the property values on their books. If it does, then there’s no write-down — even if the aggregate of all the “market values” (using traditional appraisal techniques) of the properties is less.

Cisco’s high level of profitability would, I guess, easily allow it to justify “overpaying” for the Agnews site. By how much is difficult to judge, but for a company with net income of $6 billion per year, a $30 million premium would not seem too much to me. What Cisco would have to do is think through the value of being able to expand its campus onto contiguous land. Ultimately, that’s a judgement-call on the value of face-to-face communication – a big picture question if there ever was one. Be sure it’s not just a calculation of how much time would be saved in getting people together because they don’t have to drive very far. Instead, the true value would be based on the benefits of the face-to-face meetings – some serendipitous – that just wouldn’t happen at all if folks were not so proximate to one another. These may be just the type of interactions that may be at the core of Cisco’s success.

The irony of all this, of course, is that Cisco makes networking gear that facilitates virtual meetings, remote work, electronic communications, etc. It advertises how it supports “The Human Network” through other-than face-to-face communication (although it’s telepresence product, I suppose, sort of supports face-to-face encounters for those who can afford it.) These analogies aren’t quite on target, but: Cisco’s placing a high value on “face-to-face” would be like McDonalds serving only health food in its company cafeteria, like Nike not allowing employees to exercise at lunchtime, and like the State of Kentucky outlawing smoking.

Is San Jose Really a Supply-Constrained Market? March 9, 2010

Posted by Bob Cook in Real Estate Markets, Silicon Valley.
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ING/Clarion has released some thoughtful work that suggests that San Jose and San Francisco are among the most supply constrained metropolitan office markets in the country.  The work uses the relationship between increases in rental rate and supply increases as a measure of price elasticity, which ING/Clarion thinks is a good proxy for how constrained supply is.  

It’s no surprise that San Francisco is high on the list of constrained metros with it’s challenging  geography and its regulatory constraint on downtown growth — the so-called “beauty contest” that allows only so much office space to be built each year.

San Jose, though, is not quite so clear.  There have been and continue to be plenty of good sites to develop along the 237 corridor, in the Moffett Field area, along the 101, and in downtown San Jose — not to mention many sites with one story office structures that are prime for redevelopment.   In fact, there have even been some developer-requested downzonings in recent years — commercial to residential.  All this had me thinking that office supply is not particuarly constrained in the San Jose metro – which most people, of course, call “Silicon Valley”.

Nevertheless, one of the benefits of a statistical study is that it can challenge our thinking which tends to be based on anecdotes.    And so I’m going to be doing some rethinking.  And I’m wondering what others are thinking.

Here’s the article:

Why Supply-Constrained Markets Hold So Many Advantages.

Please comment.