MARKET HIGHLIGHT, AUGUST 2010

SAN FRANCISCO
Richaed Knutson, Erika Elliott, Ryan Carmichael and Joe Fabian

Technology and tourism are pulling the City by the Bay up. During the downturn, San Francisco’s multifamily sector has remained the most buoyant.

Multifamily

The city of San Francisco is not immune to the forces of gravity, but sometimes it appears that the San Francisco apartment market is. Across the country, the multifamily sector has weathered the “Great Recession” better than other asset classes. Availability of capital, both equity and debt, has resulted in relatively modest value declines compared to office, industrial and retail investments. Still, within the apartment sector some geographic markets have maintained their favored status, and this applies in particular to the San Francisco market.

Transaction volume has been relatively robust, largely attributable to the disassembly and re-sale of the former Lembi portfolio. Research indicates that just in excess of 50 apartment sales were completed in the first half of 2010, for a total value representing about $120 million. Among the most active buyers were Flynn Investments, Klingbeil Capital Management and Tribeca Cos. Expect market activity to remain level or even increase, as buyer appetite has yet to be satisfied.

The rental market also seems to have stabilized. According to Novato, California-based RealFacts, a national leader in apartment industry research, rents in San Francisco are only down modestly since second quarter 2009, but up slightly in the first half of 2010 to an average of $2,220 per unit. While occupancy is reported to be at a relatively low 94 percent, we believe this state may be a temporary condition as new condos have been recently added to the rental stock. However, as jobs return, so will tighter vacancies and higher rents. Talk in the market is that more jobs are coming soon to San Francisco. Reliable sources report that major employers with large office space requirements are active in the market. Given attractive historical lease rates and a large amount of space, there is room to accommodate new employment quickly.

Entitlement activity is at a low due to currently unfavorable conditions for new construction. The City of San Francisco’s development pipeline shows approximately 1,300 residential units under construction, more than 6,000 in some stage of the building permit process and still another 8,000 approved by the planning department. Construction activity is poised to return quickly once market demand is evidenced by quicker absorption.

— Richard Knutson is a senior vice president for C&C Apartment Advisors in Cornish & Carey Commercial’s Oakland office.

Retail

During the first half of 2010, San Francisco’s central business district (CBD), South of Market (SOMA) and Mission Bay retail submarkets have shown signs of improvement. Retailers are increasingly seeking to take advantage of premium locations at relatively lower rental rates, and landlords are committed to finding a solution to attract the right tenants to their properties. This landlord-tenant dynamic of partnership has created an environment where building owners are focused on finding the right mix of tenants for their buildings and developing creative deal structures to attract them.

While vacancy remains high in San Francisco’s CBD, SOMA and Mission Bay submarkets, the willingness of landlords to create an occupancy solution for quality tenants has contributed to the increased number of companies actively seeking space — it has more than doubled. It is anticipated that this relatively strong demand will cause a reduction in vacancies by approximately one-third in 2010.

The increased tenant activity has also impacted asking rental rates compared to 2009 when they ranged from approximately $27 to $33 per square foot; current asking rental rates range from approximately $32 to $38 per square foot. Rental rates should not fluctuate significantly through the second half of 2010. It is also noteworthy that the term of leases continues to be shorter compared to previous years. A tenant that committed to a 10-year term with two 5-year renewal options in 2008, now typically commits to only a 5-year term with one 5-year renewal option.

As disposable income has decreased, people are staying closer to home, enabling retailers with services aimed at families to thrive. Food tenants are currently the most active in San Francisco’s CBD, SOMA and Mission Bay submarkets, specifically quick, casual dining restaurants. While high-end boutiques are shutting their doors, value clothing providers like The Gap and Gymboree are expanding.

Several retailers are adjusting prices and product offerings to adapt to the different way San Franciscans now live. For example, Safeway has created several “The Market” stores in San Francisco specifically designed to fit a more urban lifestyle. Expected to open a location soon in the Bay Area, Mimi Maternity has also expanded its service line to include yoga and labor and delivery classes, as well as a maternity spa.

— Erika Elliott is a senior sales associate in Cornish & Carey Commercial’s San Francisco office.

Office

The technology and tourist-dependent industries are doing the heavy lifting, moving San Francisco out of recession, while financial services and construction continue to slow the pace to full recovery.

Office occupancy exhibited modest gains in second quarter 2010 as the market recorded 123,177 square feet of positive net absorption, bringing the year-to-date, citywide net absorption to 50,615 square feet. This positive movement was a much-appreciated respite from the 2.4 million square feet of occupancy declines experienced in 2009. Citywide overall vacancy, including sublease space, incrementally declined by 14 basis points quarter over quarter — the first overall vacancy decline since first quarter 2008. Partly causing the vacancy decline is more than 650,000 square feet of sublease space, which has been removed from the market since second quarter 2009 when sublease vacancy peaked at nearly 2 million square feet.

Leasing velocity was once again led by San Francisco’s vibrant technology sector. At the beginning of 2010, 97 technology companies were in the market looking for 800,000 square feet of space. At the mid-year point, this has translated into 58 tech tenants leasing 500,000 square feet of office space, with 35 additional firms still searching for 700,000 square feet of space.

Financial services remains sluggish, causing the CBD to finish the quarter with 165,777 square feet of negative net absorption, increasing the overall vacancy (including sublease space) in the CBD to 12.85 percent, a slight up-tick from the previous quarter’s mark of 12.55 percent.

The overall leasing velocity has stabilized rents throughout San Francisco. Conifer Securities inked a renewal at the Ferry Building at $56.50 per square foot for Class A space with water views. While this is by no means an average rent, it demonstrates the current value of top-tier space. Class A asking rates for the CBD incrementally increased from $35.50 in first quarter 2010 to $35.84 per square foot in the second quarter, with asking rates for all building classes in the CBD just under at $33.99 per square foot.

Growth will be led by the technology industries, particularly in the South of Market submarkets. While full recovery will continue to be slowed by the sluggish demand of the financial services sector, it is anticipated that that professional services (legal and consulting firms, etc.) will experience job growth, helping to solidify overall market fundamentals toward the end of 2010 and into 2011.

— Ryan Carmichael is a financial analyst in Cornish & Carey Commercial’s San Francisco office.

Industrial

The East Bay Interstate 880 corridor industrial market showed positive signs in second quarter 2010. After first quarter’s negative net absorption of approximately 1.1 million square feet, the market rebounded with 269,200 square feet of positive activity. Although the overall combined absorption was positive, the R&D sector continued its negative absorption trend while the warehouse sector rebounded significantly.

Several large transactions bolstered the East Bay industrial market: Petfood Express leased 147,500 square feet in Oakland; Containers Unlimited leased 129,920 square feet in Hayward; Nuts & Spice committed to 118,000 square feet in Union City; Door 2 Door leased 105,062 square feet in Hayward; Companion Group took 105,000 square feet in Hayward; and District Council 16 leased 90,759 square feet in San Leandro.

The recent increase in warehouse leasing activity in the second quarter resulted in a vacancy rate reduction to 12.1 percent throughout the I-880 corridor. In the same period, R&D vacancy rates rose to 27.63 percent. Asking rental rates for warehouse space are currently $0.37 per square foot, and R&D rates are $0.80 per square foot. Actual warehouse deal rates are 10 percent lower than asking, while R&D rates are off by 20 to 30 percent. Leasing activity in the third quarter is typically the lightest of all four quarters; therefore no significant change is expected in vacancy or rental rates.

While leasing activity is robust, the owner/user sales activity is picking up pace. Several sales transactions were completed in the second quarter including Smart Business Service (41,400 square feet) in Newark and New Asia Foods (32,925 square feet) and Bay City Boiler & Engineering (18,383 square feet) in Hayward. In third quarter 2010, sales activity is expected to increase considerably, largely due to reduced pricing and accessibility to capital from lenders. 

— Joe Fabian is senior vice president and manager in Cornish & Carey Commercial’s Hayward, California, office.

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