The Perils of Ubiquitous Tech

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Is the restructured tech industry downturn resistant? Maybe, but worries are mounting.

THIS ARTICLE WAS PUBLISHED IN THE ‘Q’ – THE REGISTRY’S PRINT PUBLICATION – IN MAY 2015

By Joe Gose

[dropcap]F[/dropcap]ifteen years ago, the dot-com frenzy fueled a commercial real estate boom in Silicon Valley. Venture capitalists handed out more than $100 million in funding in 2000 alone. Aware of the largesse, office landlords were fetching rents upward of $50 per square foot a year, and the average vacancy rate hovered around 3 percent as startups aggressively pursued IPOs.

But when the dot-com bubble popped, so did the heady fundamentals. Some 200,000 jobs vanished, the average office vacancy ballooned to around 35 percent to 40 percent when including sublease space, and the rental rate plunged some 60 percent.

Now, with the Nasdaq Composite index flirting with its early 2000 historical high of nearly 5,049 and venture capital funding hitting $48 billion last year—its highest level since 2001—the debate has resumed over whether a bubble is once again artificially inflating Silicon Valley property fundamentals.

In 2014, technology tenants absorbed 17.8 million square feet of office, research and development, industrial and warehouse space in the market, according to Clark Steele, director of research for the Santa Clara office of Newmark Cornish & Carey. That represented about 56 percent of all commercial real estate leased in Silicon Valley over the year.

On average, technology tenants absorbed nearly 4.5 million square feet each quarter, with office and research and development space accounting for 1.3 million square feet and 1.7 million square feet of that total, respectively. In 2014, asking rental rates for office space increased 7.6 percent, while the average vacancy rate tumbled some 240 basis points to about 9.8 percent, according to Newmark Cornish & Carey.

Despite the hotter fundamentals, Steele and other Silicon Valley analysts say that the market is better equipped to withstand a potential downturn today.

“There is a much wider and more stable foundation of technology companies than in the dot-com boom,” said Steele. “It was the dot-com boom because it was Internet-based. But now we’re looking at bridging the gap between technology and different industries. Technology is not just on the Internet, it’s made its way into business, our homes and even our clothes.”

Steele has divided technology tenants into nine sectors: software and cloud services, hardware and semiconductors, telecommunications, networking and information technology, clean tech and solar, Web sites, apps and games, social media and product design.

Of those, software and cloud services occupy 53.3 percent of the space leased to tech, while hardware and semiconductors occupy about 28 percent. Companies in each of the remaining categories occupy around 5 percent or less.

That diversity combined with an expanding biotech sector and established behemoths like Google and Facebook bode well for the overall economy to weather a slowdown, agreed Greg Martin, head of the real estate practice group with accounting and consulting firm Moss Adams in San Francisco.

“The Bay Area tech economy has matured over the years, and while there are always economic cycles to business, the diversity of the technology industry here is as wide as the diversity of the U.S. and global economy as a whole,” he said. “Plus, technology drives future business improvement and innovation.”

The current crop of young tech companies departs from the past in another way: Following a path largely blazed by Google, most companies are content to remain private rather than rush to an IPO, which provides more time for startups to beef up their operations and financial condition.

While the IPO market effectively shut out small speculative tech companies after the dot-com bust, changes to securities regulations in the 2012 Jumpstart Our Business Startups Act now allow companies to stay private longer. The JOBS Act increased the number of company shareholders allowed to 2,000 from 500 before requiring registration with the Securities and Exchange Commission.

The median age of a tech company conducting an IPO was only four years back in the dot-com boom, according to J.P. Morgan. Now it’s more than 10 years. At the same time, the number of venture capital-backed firms valued at more than $1 billion has increased to 75 from 13 in 2012, according to New York-based SecondMarket, a private securities trading platform.

“Fifteen years ago, a lot of the companies that were launched and supported by substantial amounts of venture capital were really just ideas. They may have had a business plan, but not a real product or service,” said Steve Wright, a senior vice president of the Silicon Valley Leadership Group. “This time around the venture capital community has been much more proactive in making sure there is a worthwhile product or service in which to invest.”

Wright and Steele acknowledge that concerns are mounting over multibillion-dollar valuations for some companies, particularly those without revenues that harken to the dot-com days. Yet exit strategies have evolved as well. While some companies have a path to monetization and are striving for an eventual IPO, others are focused on being acquired by established companies like Google, Facebook or Hewlett Packard that need the technology or brainpower to move into new markets, Wright said.

“Many investors don’t expect the startups to sustain themselves as stand-alone companies,” he said. “Mergers and acquisitions are a big part of the ecosystem in the valley.”

From a real estate perspective, tech companies are also making more rational decisions today, added Steffen Kammerer, a vice president with JLL in Palo Alto. During the dot-com boom, startups often leased double the amount they initially planned to occupy in anticipation of rapid and substantial business expansions subsequent to an IPO. It wasn’t realistic.

“When there was a turn in the economy, the valley was left with a bunch of excess space at inflated pricing,” he said. “And all of a sudden, there was a firestorm to get rid of it.”

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