Citing anemic demand for downtown office space, a Palo Alto developer is asking the city to remove a long-standing restriction on the space that a tenant can occupy in its Homer Avenue building.

In an unusual request, the developer Tall Tree Partners is asking the city to change the agreement that governed the development of its mixed-use building at 260 Homer Ave. for over 20 years. The mixed-use project was one of several buildings that were constructed as part of a deal that the city approved shortly after it adopted the South of Forest Avenue (SOFA) coordinated area plan in 2000.

The plan, which resulted in the construction of Heritage Park and various residential and commercial projects, followed the decision by Palo Alto Medical Foundation in the late 1990s to relocate from its historic location in the neighborhood south of Forest Avenue to its current location at Urban Lane. The two area plans that the city subsequently approved in the SOFA area are often cited as the only examples of successful area plans in Palo Alto.

The Homer Avenue building, which sits adjacent to Oak Court Apartments and across the street from Heritage Park, was completed in 2009. It consists of two residential condominiums and five office condominiums, according to the application. The development agreement that allowed its construction also came with the following clause: "There shall be no single tenant that occupies more than a third of the net usable space (i.e., exclusive of common areas and mechanical equipment areas.)"

The goal of the provision, according to the planning staff, was to foster a residential character in a neighborhood that was transformed with the addition of housing and a community park. Having various small businesses occupy the new building was deemed by the council as preferable to having one giant firm take it over. While the proposed change would not physically change the building, city planners note in a report that a larger tenant "could have an outsized presence and may affect the perceived scale of the neighborhood."

"Throughout the SOFA I and II documents, the City highlighted the importance of future development having a residential scale," the report from the Department of Planning and Development Services states.

The staff is also concerned about the precedent that the requested change would set. The report approved by Planning Director Jonathan Lait notes that approving modifications to the development standards in the SOFA area "may have policy implications that would encourage similar requests."

The property owner, meanwhile, maintains in its application that recent modifications in the office environment warrant the change. With more employees now working remotely or adopting a hybrid schedule and with commercial vacancies on the rise, Tall Tree is asking the city to provide it with more flexibility on leasing its space.

The City Council will discuss the request at its Oct. 2 meeting.

To bolster its case, Tall Tree submitted a study performed by local firm Newmark, showing vacancies on the rise in Palo Alto and elsewhere on the Peninsula. The report, which surveyed rents and vacancy rates throughout the region, found that the south Peninsula office market "took a dramatic turn in the fourth quarter of 2022 against the strong overall leasing activity experienced in the first quarters of the year." Newmark found only 49 total real estate transactions in the fourth quarter of 2022, the lowest transaction volume since the last quarter of 2020 (by contrast, in the third quarter of 2022, there were 119 transactions, the analysis found).

Newmark calculated that downtown Palo Alto has about 1.6 million square feet in its Class A office space inventory, of which 263,605 square feet are currently vacant — a rate of 17.4%. An additional 133,083 square feet falls under a "sublease vacancy" category, making about 21.9% of the city's office space available for leasing, according to the analysis. In the downtown area, the vacancy rate is about 16.57%, according to Newmark.

The market study showed Palo Alto's vacancy rate decreasing slightly in 2021 before rising in 2022, moving from 14.1% in the first quarter of the year to 14.2% in the second, 15.6% in the third and 17.4% in the fourth. This is the highest vacancy rate among the cities in the Newmark survey, a group that also includes Los Altos (15.7%), Menlo Park (12.3%), Mountain View (16.5%), Redwood City (14.5%) and the Redwood Shores business park (9.1%). It also exceeds the vacancy rate of 14.8% for the south Peninsula area, according to the study.

The study also indicated that Palo Alto is among the most expensive cities for office space, with the average asking rent for triple-net leases (which include costs like utilities, taxes and maintenance) at $7.10 per square foot. This is second only to Menlo Park, which has an asking rent of $8.41 and well above Mountain View ($6.40) and Redwood City ($5.52). In downtown Palo Alto, the rates hovered at about $9.63 per square foot in the fourth quarter of 2022, higher than all of other commercial districts in the surveyed area with the exception of Sand Hill Road in Menlo Park, which had rates of $10.78 per square foot.

"With an incredible high amount of availability and tepid demand from all sectors in the near term, look for lease economics to soften throughout the first half of 2023," the report states. "As companies slow hiring and growth, there will be a transition period to assess square footage needs and develop new and improved commercial real estate strategies."

Newmark called the significant increases in office availability and vacancy "troubling." The south Peninsula market has added more than 2.6 million square feet of availability over the course of 2022, the study found, compared to 1.2 million in 2021. The report also suggested that companies will continue to become "more particular about the quality, image and location of office space, in part to motivate their employee bases to spend more time in the office."

According to Tall Trees' application, that trend is playing out at 260 Homer Ave. A 10,000 square-foot office suite, which comprises about 31% of the building's commercial square footage, has been vacant since February 2022. While an accounting firm that currently leases about 28% of the property has expressed interest in leasing the vacant suite, building owners could not accommodate its request because of the occupancy restriction, the application states.

While the report doesn't name any of the tenants, the accounting firm in question is almost certainly Ernst and Young, an international accounting giant. The building's other tenants include the venture capital firm Matrix Partners, the investment banking firm Tidal Partners and the law firm Duane Morris LLP.

The letter states that allowing the accounting firm to lease the roughly 10,000 square feet of available office space would broadly benefit the downtown area by increasing foot traffic and supporting local services and retail demand. The occupancy restriction, however, hinders interest from tenants that "desire the flexibility to grow within the Property if their space needs change," the application states.

"While the macro forces that caused this disruption in the office and retail sectors among others cannot be solved directly by the City of Palo Alto, there are actions the City can take to help ameliorate the negative effects to the local economy, and local landlords, without compromising its own goals," states the project description submitted by Benjamin Bullock, whose firm Bullock Capital owns Tall Tree Partners I LLC.

The applicant also asserts in the letter that occupancy restriction has a "long-term effect of decreasing the leaseability and increases the likelihood of experiencing extended periods of vacancy, which has harmful economic impacts to the local economy and local landlords."

The request comes at a time when the city is taking a broader look at revising its zoning standards to account for the post-pandemic normal. Last month, the council discussed a new report from the consulting firm Streetsense that recommended a sweeping array of zoning changes, including relaxing the city's ban on chain stores, allowing residential growth in areas currently restricted to commercial use and removing an existing law that requires ground-floor retail in new commercial and mixed-use developments throughout the city.

Larissa Ortiz, managing director at Streetsense, told the council at an Aug. 14 hearing that companies now have more options than ever before to transfer operations online and downsize their space.

"Tenants are right now in the driver's seat," Ortiz said. "Palo Alto is competing in a way it has never before had to compete for tenants who are looking at other places in this market."

While the council unanimously approved the newly drafted business strategy, members indicated that they are in no rush to move ahead with some of the more ambitious recommendations for zone changes. Council member Pat Burt acknowledged the decrease in daytime employees in downtown and California Avenue over the course of the pandemic but predicted that some will return to the office.

"That's a huge transformation," Burt said during the August discussion. "Some of that will recover over time and we need to factor in that it won't be stagnant."

Council member Greg Tanaka, meanwhile, strongly supported giving downtown businesses more flexibility when it comes to tenants. Vacancies, he argued, beget other vacancies.

"That nothingness grows and spreads and it's unstoppable, unfortunately," Tanaka said.