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Office Space

While year-over-year rent growth had been in the double digits since the recession, 2016 saw a shift in that momentum. Sentiment within the local venture capital industry is cooling off as an increasing number of leaders in the industry voice concerns about high valuations. Space listed for sublease has climbed to levels not seen since 2010, as many tenants are fleeing San Francisco’s high rents by moving to the East Bay, and others such as LinkedIn and Dropbox have put space on the market as they move into newly built headquarters. With office completions expected to average a lofty 2.5 million SF annually through 2018, any slowdown in absorption from the booming levels seen from 2013−15 would put the market vacancy rate on the rise. So far, these risks haven’t stopped investors from piling into this market. Some have recently cashed out on properties purchased from 2011-13 at 30% −100% above their initial purchase prices.

NET ABSORPTION, NET DELIVERIES AND VACANCY RATE

SUPPLY

Speculative construction is in full swing throughout the market. As of March 2017, there was over 4 million SF of unleased office space under construction throughout the San Francisco metro. This equates to about 5% of the market’s current 4 & 5 Star inventory. South Financial District leads the pack, with about 1.6 million SF of unleased space, all within three projects currently underway. The John Buck Company’s Park Tower at
Transbay (a 750,000 SF project delivering in late 2018) has not yet announced any preleasing. Boston Properties’ Salesforce Tower (delivering in late 2017) has about 460,000 SF that has yet to be leased, and the Jay Paul Company’s 181 Fremont St. (which has 413,000 SF of office space delivering in late 2017) has not yet announced any preleasing. San Mateo was another focal point for speculative construction. As of the end of 2016, there was around 300,000 SF of unleased space within four underway buildings: Station 3 and Station 4 of the Bay Meadows Project by Wilson Meany, Clocktower@221 and 400 Concar Drive by Hines. As a testament of the strength of demand, however, as of March 2017 there is only around 82,000 SF of space still available.

Developers are continuing to break ground and push projects through the planning stages. This is an indication that the level of new supply completing could remain elevated beyond 2018. In mid-2016, Kilroy Realty broke ground on a 750,000 SF speculative project (Block 40 at The Exchange on Sixteenth). As of March 2017, no preleasing has taken place though there have been a couple of different biotech tenants rumored to be interested in large portions of the space. Greenland USA recently announced that it was planning to break ground soon on the 508,000 SF first phase of its Landing at Oyster Point project in South San Francisco, and San Carlos’s city council recently unanimously approved developer Windy Hill Property Ventures’ plans to redevelop a parcel on Highway 101 into a 528,000 SF office development. San Francisco’s Office Development Annual Limitation Program is also reviewing about 1.3 million SF worth of office projects pending approval within San Francisco’s South of Market submarkets. This is a clear indication that the downtown building boom could continue well into 2019.

NET DELIVERIES

RENTS

San Francisco rent growth had been in a league of its own-far stronger than in any major U.S. market-throughout much of the current cycle. Rents have doubled since they bottomed out in 2009, and are 50% above their 2007 peak. However, the increase in office construction, especially with a large portion still speculative, should cause vacancies to expand over the next few years. Meanwhile, whether the tech sector can maintain its current pace for the next five years is questionable. As a result, rent growth slowed significantly in 2016.

ASKING RENT LEVELS AND ANNUAL GROWTH

SALES

Sales prices on deals in 2016 represent the most bullish trend in the San Francisco office market. Buyers have been increasingly willing to pay up for properties that aren’t necessarily new or located in the CBD. Pricing has recently jumped both for downtown high-rises built before 1970, suburban properties, and newer product. Two high-rise assets downtown (built before 1970) recently commanded prices close to $1,000/SF, a milestone many would not have thought possible only two or three years ago. In the South Financial District, 140 New Montgomery St. (built in 1925 but renovated in 2013) sold fully leased (with Yelp as a lead tenant) to Pembroke Real Estate for $284 million ($962/SF). ASB Real Estate recently purchased 799 Market St. (built in 1968 and renovated in 1986), an 88% leased asset with Ross Stores as a ground-floor retail tenant, for $990/SF-much more than the asset’s 2012 sale price of $630/SF. This trend continued when American Realty Advisors acquired Foundry Market Square III (built in 2013) for $332 million ($1,140/SF) at a 4.8% cap rate. The 4 Star asset was fully leased to credit tenants including IBM, NASDAQ, and Neustar.

Cap rates have averaged below 5% in recent years. A handful of high-end office sales in and around the downtown core have commanded cap rates below 4% recently, including 333 Bush St. (purchased
by Tishman Speyer at a 3.7% cap rate, for $693/SF) and 250 Montgomery St. (purchased by TA Realty at a 3.8% cap rate, for $631/SF). However, both of these assets had occupancy rates between 85%-90% when sold, leaving some room for additional NOI gains from full lease-up. Meanwhile, most assets in and around the downtown core have sold at cap rates between 4%-5.1%, including 180 Montgomery St. (which sold at a 4.7% cap rate in the South Financial District), 995 Market St. (which sold at a 5.1% cap rate in the MidMarket Submarket) and 1500 Owens St. (which sold at a 4.8% cap rate in Mission Bay). Suburban assets have generally traded at cap rates above 5%. The Atrium (a 90% leased asset in San Mateo, built in 1983) sold for $376/SF, at a 5.6% cap rate. Sierra Point Opus Center (built in 2001 and fully leased) recently sold in South San Francisco for $314/SF, at a 6.2% cap rate. Finally, Hudson Pacific Properties’ $3.5 billion portfolio acquisition from the Blackstone Group closed at a 5.1% cap rate. The portfolio consisted predominately of office properties throughout San Mateo County and Silicon Valley, but it also included a few smaller retail properties and a development parcel.

SALES VOLUME AND MEDIAN PRICE

Light Industrial Space

NET ABSORPTION, NET DELIVERIES AND VACANCY RATE

ASKING RENT LEVELS AND ANNUAL GROWTH

SALES VOLUME AND MEDIAN PRICE

Apartments

San Francisco continues to benefit from a strong local market and ongoing national attention. This is a structurally tight market, although vacancies are fluctuating with the delivery of large amounts of supply. But demand has been robust enough to keep the vacancy level close to the metro’s historical average. As a result, pricing for institutional assets is already surpassing housing-boom highs. However, with some of the highest rents in the country and the continued influx of new supply, rent growth came to a halt in 2016, as affordability remains an ongoing issue in this metro. At the same time, cap rates have fallen to one of the lowest levels in the U.S.

FUNDAMENTALS

While new supply continues to put slight upward pressure on vacancies, the metro’s current vacancy level still remains exceptionally tight thanks to robust demand for new product. Not only has San Francisco far outperformed in terms of job growth during the current cycle, but apartment completions had been relatively modest until recently. As a result, today’s supply-induced vacancy expansion is coming off a cyclical low that was near tech-boom levels.

As new projects deliver, they often stabilize within 12 months. San Francisco’s exposure to the fast-growing tech sector has kept affluent renters flowing into the metro, and apartments have stayed nearly fully occupied. The prohibitively high price of homeownership has also prevented any meaningful shift from rentals. Homeownership is a luxury enjoyed by only a minority of households here, because this is one of the National Index metros where it is more economically advantageous to rent than to own. This helps to ensure stable demand growth even during good economic times, despite the fact that rents are among the highest in the nation.

Top-tier assets face the most volatility. Periods of intense construction and the propensity of renters to seek less expensive options in slower economic times can lead to vacancy fluctuations at the top of the market.
Since prerecession peaks, 4 & 5 Star vacancies have fallen more in line with those of the rest of the market. However, the high end of the market has borne the largest amount of new supply, and vacancies have trended higher than in lower-tier assets. Midlevel assets typically perform relatively well in San Francisco, as there is no shortage of demand for more relatively affordable options in this expensive metro.

NET ABSORPTION, NET DELIVERIES AND VACANCY RATE

SUPPLY

San Francisco is in the midst of a construction boom, the size of which will surpass tech-boom levels when all is said and done. More than 15,000 units have delivered since 2013, and around 7,800 more are underway as of March 2017. This is an even larger number than in 1998-2000, when nearly 8,000 units hit the market. While the amount of development hasn’t overwhelmed the market-especially in a metro with a severe housing shortage-it is heavily concentrated near the urban core. More than half of new construction underway is embedded within the South of Market and Mission Bay/China Basin/Potrero Hill Submarkets. Construction is more restrained outside of the urban core, though developers have not completely overlooked the rest of the peninsula. In San Mateo County, most of the building is focused within the cities of San Mateo and Redwood City.

Overall, San Francisco has been better insulated from supply risk than most National Index markets. Iron-fisted zoning boards, affordable housing requirements, and a lack of available land make the development process more arduous here than in the vast majority of U.S. cities, and for this reason, supply growth since 1982 has ranked in the bottom 10 of National Index markets on a percentage basis. Even with the rise in construction, inventory growth has not surpassed the national average and probably won’t. In fact, with the passage of Prop C in June, which raised the required amount of affordable units in new residential development from 12% to 25%, many residential projects that were in the early phases of planning have already made the switch from apartment units to hotel. As part of Prop C, however, the controller’s office studied the effect of the proposition for six months and has come out and deemed the new requirement infeasible which will bring up debate again. Housing regulation goes beyond local levels as well. State Senator Scott Wiener has proposed a bill that would accelerate the approval process if a city does not meet state-assigned ‘Regional Housing Need Assessment’ figures, and for a city like San Francisco, this could mean bypassing city level regulations leading to more market rate development.

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RENTS

Rent gains thus far in the recovery had been remarkable and among the best in the U.S., increasing by more than 40% from their lows in 2010. But after multiple strong years of growth, highlighted by nearly 7% gains in 2015, rents hit a breaking point in 2016, as the metro experienced slight losses for the year. Annual asking rents are now 40% of San Francisco’s median income, which is above the peak during the tech boom. Additionally, neighboring East Bay and San Jose both posted stronger rent growth than San Francisco this cycle, with San Francisco continuing to trail in 2016. Vacancies have started to feel upward pressure from supply additions, placing further competitive strain on owners. All of this cumulatively adds up to a slightly negative year-over-year growth for the metro.

SALES

New top-quality assets are commanding premiums all over the San Francisco metro. Trading of 4 & 5 Star assets is light here, and owners of top properties tend to hold onto them. With so many owners doing that, many of the top sales are of newly built and fully leased assets. For example, Greystar Investment Group sold Franklin 299 in June 2016 for around $212.7 million ($699,507/unit) to TIAA. The 304-unit 4 Star property completed in August 2015 and was reportedly 88% occupied when it sold. Such prices will likely become commonplace, or will possibly be eclipsed, as Google, Apple, and Facebook continue to expand their operations in these areas. While sales of newer assets accounted for most of the high-profile deals in 2016, a few deals involving 3 Star assets also turned heads. In February 2016, Essex Property Trust sold the 1,812-unit Woodland Park Apartments to Sandhill Property Company for $412.5 million ($228,532/unit), which is more than three times what Essex paid for the asset in 2011. In October, Pacific Urban Residential acquired the 195-unit Trailside Terrace in the San Mateo/Burlingame Submarket for $73.15 million ($375,128/unit), at a 4.9% cap rate. Grosvenor Americas, based in Washington, D.C., previously purchased the asset in 2013 for $50 million ($256,410/unit).

Investors are also bidding up pricing for smaller lower-quality assets. For instance, in a joint venture, Veritas Investments and Ivanhoe Cambridge purchased the 3 Star 48-unit asset at 665 Powell St. (near Union Square) for $24.5 million ($510,416/unit), at a 2.5% cap rate. In July 2016, local firm Lantern Group Realty acquired the 3 Star 41-unit Opera Hotel Apartments for about $14 million ($342,682/unit), at a 3.1% cap rate. This price represents a lofty premium over the previous trade in 2013, when the asset sold for $6 million ($146,341/unit).

SALES VOLUME AND MEDIAN PRICE

Retail Space

San Francisco is a perennially undersupplied retail market. High-end retailers are increasingly moving into the downtown core, where vacancies were around 2% at the end of 2016, and rents have been growing above the national average since 2013. Nonetheless, there is there is little to no retail space under construction here, as buildable land is scarce, and most developers are focusing on either high-rise office or residential projects. The tech industry continues to power above-average employment and income growth here, which has, in turn, continued to attract investors to the metro.

FUNDAMENTALS

San Francisco boasts some of the healthiest fundamentals in the country. Even with very low vacancies, new construction has remained stalled, allowing the market to stay tight. San Francisco has also maintained tighter retail vacancy rates than most other core, supply-constrained markets, such as Boston and New York.

The bulk of the vacancy recovery has been focused within San Francisco County. This includes the urban core of the metro, where the bulk of new job gains and recent office leasing has occurred. A rapidly improving labor market in the county has attracted new residents at an outsized pace. Population expanded by 1.5% annually since 2010 in San Francisco County, which was double the statewide rate. This has helped to push vacancies here down almost continuously since the mid-2000’s. With employers favoring the metro’s urban core and residential development quickly expanding, this area should continue to boast healthy retail fundamentals.

Abundant tenant demand has kept available retail space severely limited, and the local tenant base continues to shift to higher-end retailers. San Francisco’s economy is achieving what any retail landlord likes to see most in a local market: rapid growth in high-paying jobs to support continued gains in retail spending. With the metro’s retail vacancy rate around 2% (and among the lowest in the country), there simply is very little space left for retailers to expand into. Meanwhile, the number of retailers catering to lower-income demographics downtown continues to dwindle, as higher-end shops are willing to move in and pay higher rents. The Apple Store moved into their new flagship store in Union Square in May which is 45% bigger than its pervious location. Saks Off Fifth Avenue recently moved into a new 35,000 SF location at 901 Market St., and Barneys New York moved into over 18,000 SF at 790 Market St. Meanwhile, tenants continue to absorb what little space remains available in the suburbs. Living Spaces recently leased 90,000 SF at Millbrae Square, Safeway recently leased 29,000 SF at Fairmont Shopping Center in Pacifica, and Ross Dress For Less leased a 25,000 SF space in Colma.

NET ABSORPTION, NET DELIVERIES AND VACANCY RATE

SUPPLY

Despite tight vacancies and surging rents, a multitude of factors are keeping retail construction limited like a lack of available land and iron-fisted zoning boards. Available land remains scarce, most proposed projects typically come under close scrutiny by community groups, and developers are focused on building high-rise apartment or office projects rather than retail. This has meant that most of the new retail spaces hitting the market have been a part of multifamily or office buildings. The two big exceptions to this are the recently completed 6×6 (the rebranded Market Street Place) and Candlestick Point, now called Fashion Outlets San Francisco, where groundbreaking is imminent. Together, these projects total around 750,000 SF of retail space.

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RENTS

With vacancies at historical lows, rent gains had been strong from 2013 though early 2016. This has kept rent levels in San Francisco at some of the highest in the nation during this time. Rent levels and growth have unsurprisingly been driven by the core assets in the metro. Properties in San Francisco County carry a rent premium over their Peninsula counterparts of around 30% and rent growth has typically been about 100 basis points stronger, widening that gap.

ASKING RENT LEVELS AND ANNUAL GROWTH

SALES

The sales market for retail properties remains strong. On average, about 2.5% of the metro’s inventory has changed hands each year since 2012. While total sales volume didn’t match the cyclical high level reached in 2015, it still ranked among the strongest years of the current cycle. The median price/SF in San Francisco was about $500/SF in 2016, up about 20% from 2014 and almost 40% above the 2007 peak price of $360/SF. Cap rates in averaged below 5% in 2016.

One of the most notable sales in recently occurred in 16Q4, when when Acadia Realty Trust acquired the 555 Ninth St Retail Center. The 149,000 SF neighborhood center in Showplace Square traded for $140.6 million ($945/SF), and included anchor tenants Trader Joe’s, Nordstrom Rack, and Bed Bath & Beyond. A more recent trade of note was the sale os the Macy’s Mens Store in Union Square. The 263,640 SF asset was sold in 17Q1 for $250 million ($948/SF) as a sale-leaseback/redevelopment project. Joint owners Blatteis & Schnur and Morgan Stanley Real Estate Group plan to develop the space into a mixed-use, but retail-drive center. While design, renovation and leasing are taking place the Macy’s Men Store will remain in the space.

SALES VOLUME AND MEDIAN PRICE