Fitch: Tech-Oriented U.S. CRE Markets Cooling, But Not Collapsing

Tech-oriented U.S. commercial real estate market fundamentals have cooled but are unlikely to collapse, said Fitch Ratings, New York.

The report said office and multifamily real estate investment trusts are most at risk from lower tech-tenant demand in markets such as San Francisco, Silicon Valley, Seattle, New York and Los Angeles. Company exposures vary, said Fitch Director Steven Boyd, but each subsector has West Coast market specialists with concentrated portfolios in these markets.

“Retail REITs with exposure to these markets face some risk from cooling tech employment and capital availability but should benefit from longer leases than multifamily properties and less tenant failure risk and shadow space relative to office assets,” Fitch said. “[We] see limited risk for industrial and healthcare REITs beyond the scope for broader regional and local economic softening.”

Fitch said the amount of speculative leasing is a key unknown that will influence the severity of office market downturns due to lower tech tenant demand. Speculative leasing occurs when companies lease more space than then they currently need in anticipation of future growth, typically motivated by concerns over rapidly rising rental rates and limited space availability.

“Widespread speculative leasing–enough to meaningfully affect market dynamics–is rare,” Boyd said. “However, it was a key reason for the collapse in office rents in San Francisco and Silicon Valley following the tech bubble burst in the early 2000s. At the time, market participants generally expected the San Francisco market to weather a tech industry downturn reasonably well, since new supply was balanced with demand growth. In hindsight, investors underappreciated the artificial demand boost from rampant speculative leasing by weak credit tenants.

Fitch said many of today’s fast growing social media and sharing economy companies are using technology to disrupt a diverse set of established industries, arguably making them less cyclically sensitive to changes in corporate capex than the manufacturing-oriented companies that dominated Silicon Valley in the second half of the 20th Century.

“Indeed, some sharing economy companies such as Airbnb, Inc. and Uber may have counter cyclical business model elements,” the report said. “Fitch expects more people will look to monetize the value of their largest assets, such as homes or cars, to supplement or replace lost incomes during periods of economic and labor market weakness.”

Fitch said the outlook for venture capital funding has dimmed during the past year against the backdrop of generally weak tech IPO performance and down round private equity financings and selective layoffs at marquee fast-growing tech companies.

“Most tech employment resides at larger, established tech companies, but smaller startups play a key role in marginal office demand and pricing,” Fitch said. “And the enviable stories of wealth creation surrounding their success can set the market tone. Unlike companies in traditional office-using industries, smaller tech startups frequently do not cover their lease payments with operating cash flow. They may have adequate financing to avoid a payment default during the lease term, but renewal/re-leasing risk may be high if leases expire during a period of weak capital access.”