COVER STORY, DECEMBER 2011

SAN FRANCISCO
Jane Woolley, Bryan Courson, Garrick H. Brown and Whit Hughes

San Francisco remains one of the nation’s busiest hubs, demanding 24-hour services and round-the-clock care that is bolstered by its booming technology industry. With this in mind, it’s clear that the city is happy to cater to its educated workforce, providing ample lifestyle amenities and high-end residences.

RETAIL

Woolley

Despite what many might like to paint as a bleak picture for the retail climate in San Francisco, there are certain facts that remain true for the City by the Bay. The office development and rental markets adjust to the pulse of whatever technology boom is underway, and retail always aligns with this surge and earns the benefit of a new opportunity. This is exactly what we are seeing in previously unlikely areas of the city. The social media industry is driving a unique blend of entrepreneurial and savings-savvy start-ups with a mindset for not biting off more than they can chew square footage-wise.

A good portion of this activity is happening in the South of Market (SOMA) submarket, resulting in building facelifts and retail amenities lining the street level. While some building owners are caught in the “under water” category, the buyers are plentiful and keenly aware of the need to upgrade façades to attract the better restaurants.

In other areas of the city, the Potrero segment has experienced huge changes with just the presence and exponential growth of gaming company Zenga. The additional development of residential infill brought Whole Foods Market to the neighborhood in 2007 and now two major banks are contending for the corner space directly across the street, with restaurants and specialty retailers following their lead. It is all quite pleasing to see.

Early in 2011, we began a confidential search for Chicago-based Intelligencia Coffee, which purchased ECCO Coffee in Santa Rosa, and new San Francisco digs for what will be called ECCO Coffee in the Potrero Hill District. How are the deals being structured? Every one of them is unique in their own right, and no one but the trusted broker and owner/tenant knows how much skin was in the game for either party.

A similar transition is happening along the Sixth Street corridor, where many building ownerships are flipping. There is a “cleaning up” of distinct areas – we call them “pockets of opportunity” – in the turf surrounding Union Square, which has included new hotel owners and a clear expansion of the middle ground for restaurateurs. Without spreading too much of a rumor, even the famed Dottie’s True Blue Café (as seen on Food Network’s Diners, Drive-ins and Dives) will be among the line-drawing restaurants in early 2012.

Retail and restaurant owners must still be aware of certain rules of entry when doing business in certain parts of San Francisco, however. We fondly call this the looming “formula retail rule.” The formula retail rule is also known as the 11-store rule. If a retailer has more than 11 stores anywhere in the country, that retailer must go through a special public review process for final approval, which can be lengthy and costly.

Therefore, when we speak with blooming food and retail concepts with real expectations for growth, the first priority is to lock down those San Francisco units before heading out to other markets like Los Angeles or the suburbs. This has proved difficult for a number of retailers.  The San Francisco Soup Company recently topped this threshold with more than 16 cafes in the Bay Area. PETCO attempted to lease a former Walgreens in the Geary Boulevard corridor and was rejected because the neighborhood indicated they did not want a pet store. Starbucks attempted to lease a new Toyota repair facility with a small store, also on Geary Boulevard, and the effort was rejected.

The footprint for many of the larger national retailers is getting noticeably smaller. Although their attractive presence in cities like San Francisco, New York and Los Angeles develops their brand, their in-house real estate people have to think wisely about where the dollars are being spent. The private equity groups funding them are also taking an eagle eye to their investments.

The red doors of Talbots on Post are dark although they are still within the Westfield Mall. It’s true that San Francisco, like every other city, has several big spaces on some pretty main thoroughfares. However, they are not sitting idle thanks to pop-up opportunities. This option allows both landlords and tenants to try each other on for size through the holiday or other specialty shopping seasons, with each reaping a small benefit.

Most prevalent are the sweeping numbers of regional retailers and restaurants utilizing the overall economy to reposition themselves and create new market niches. They are coming through with strong financials to support relocation efforts from what might be considered B/B- locations to A/A- locations. In one of our own recent transactions we even positioned an operator to prepay 18 months of rent in advance to grab a deal. This is truly where passion meets the pavement, and it is great to see the momentum building for positive change.

— Jane Woolley, senior leasing associate, Starboard TCN Commercial Real Estate, San Francisco

OFFICE

Courson

The technology sector continues to drive the San Francisco commercial real estate office market, impacting rental rates and availability trends throughout the city. Many high-tech companies are opting for the SOMA district’s creative spaces: buildings characterized by brick and timber, high ceilings and open floor plans. Venture capital funding has armed start-ups with the means to move to SOMA, and when you pair that with the fast-growing nature of these successful tech firms you get a unique market condition in SOMA that is characterized by significantly higher rental rates and diminished blocks of large, empty space.

This SOMA premium is best illustrated when compared with space in the Financial District, which is largely occupied by more traditional companies. One year ago, asking rental rates in the SOMA market for Class A space averaged just $34. At the end of the third quarter 2011, rates increased by 41 percent to $48 per square foot. By comparison, average asking rental rates for Class A space in the North Financial District increased only 12 percent, from $36.01 to $40.50 per square foot over the same period.

As young, successful tech firms grow in San Francisco, they absorb larger blocks of space in a relatively short time span. For example, about two years ago Dropbox, a cloud storage company, leased 12,000 square feet at 760 Market Street. In the third quarter of 2011, the firm executed the largest lease of the quarter when it occupied 82,000 square feet at 185 Berry Street in the SOMA area. Similarly, Zynga leased 250,000 square feet at 650 Townsend in the Showplace Square submarket in mid-2010. Over the past 12 months, the social gaming company has agreed to occupy an additional 150,000 square feet in the same building. There are also plenty of other technology companies currently seeking space in San Francisco. They include Macys.com (200,000 square feet); Riverbed Technologies (150,000 square feet); Airbnb (125,000 square feet); Yelp (100,000 square feet) and LinkedIn (75,000 square feet).

Though office space in San Francisco’s SOMA region is in high demand, there are some spaces, such as the new building at 500 Terry Francois Blvd., that are still available.

Other submarkets in San Francisco are also beginning to experience increased demand as high rents and a lack of large, available blocks of space drive some technology companies away from the SOMA area. In the third quarter of 2011 alone, Symantec leased 67,000 square feet at 303 Second Street in the South Financial District; AECOM leased 54,000 square feet at 300 California Street in the North Financial District; and Practice Fusion leased 46,000 square feet at 420 Taylor Street in Union Square.

The outlook for the overall San Francisco office market remains positive. The overall office vacancy rate decreased in the third quarter of this year from 11 percent to 10.4 percent quarter-over-quarter. Asking rents increased quarter-over-quarter from $39.56 per square foot to $41.25 per square foot citywide. San Francisco is quickly becoming the most appealing location within the Bay Area to do business as firms seek the vibrant city community that best attracts the young workforce.

— Bryan Courson, senior vice president and manager, Cornish & Carey Commercial Newmark Knight Frank’s San Francisco office

MULTIFAMILY

Brown

Multifamily vacancy in the San Francisco Bay Area fell yet again during the third quarter of this year. It now stands at just 3.7 percent – its lowest level in more than a decade. The last time that market recorded occupancy levels nearing 97 percent was in 1999 at the height of the dot.com boom.

The region’s multifamily properties have been the beneficiaries of a number of trends. First, development has largely been absent in the region for the past four years. But while new supply has been virtually non-existent, demand has steadily risen. Despite the state of the overall economy, the Bay Area’s population has continued to grow, adding roughly 367,000 people over the past decade. Meanwhile, improving employment throughout the region is bringing back many renters who had dropped out of the market. This trend is impacting all Bay Area submarkets, with most of the region’s markets posting occupancy levels of 95 percent or higher. That being said, the San Francisco County market has led the way both in terms of occupancy and rental rate growths.

Vacancy in San Francisco County now clocks in at just 3.2 percent. The average monthly rent for all apartment types in San Francisco County currently stands at a whopping $2,568 per month, placing it only behind Manhattan in terms of the most expensive apartment markets nationwide. One year ago this number stood at $2,209 per month, reflecting a one year increase of more than 16 percent. The average rent for studio apartments currently stands at $1,967, up 23 percent from the $1,594 level recorded one year ago. But all multifamily unit types have recorded double digit rental rate growths over the past year.

It should come as no surprise that multifamily investment properties are in extremely high demand throughout the San Francisco Bay area. However, sales activity continues to be hampered by a lack of available product. Sales volume within San Francisco County topped $173.8 million during the third quarter of 2011, down considerably from the $243.6 million of deals transacted during the second quarter, with activity dominated by smaller complexes and Class B and C products. A total of 1,154 multifamily units changed hands in the third quarter, with an average price per unit of $150,663. This number was skewed downward simply because so few institutional-quality projects sold. During the second quarter, we tracked a total of 963 units that traded with an average price per unit of $253,029. The average cap rate of properties that traded during the third quarter was 5.9 percent.

Against this backdrop, developers are rushing back to the marketplace. We are aware of at least 18 major projects currently in the development pipeline within San Francisco County, and this number is increasing quickly. The projects that we are tracking will add at least 3,215 new units through 2014. But despite this surge in development, we expect vacancy levels to remain below the 5 percent mark, with strong rental rate growth to continue at least through 2012. We also anticipate strong rental rate growth to continue, as at least 18 major projects are currently in the development pipeline within San Francisco County — and this number is increasing quickly.

— Garrick H Brown, director of research, Cassidy Turley BT Commercial’s San Francisco office

INDUSTRIAL

At the conclusion of the third quarter in 2011, the San Francisco industrial real estate market appears to be poised to continue along its steady path of a market in recovery.

For the City of San Francisco, the overall vacancy rate for warehouse and manufacturing properties remains at a stable and healthy 5.5 percent. Asking rents are hovering in the range of $0.65 per square foot, per month, on a net basis, for general-purpose properties without specialized improvements. Most leasing and sales transaction activity for industrial-zoned properties in San Francisco continue to be found in a region known as The Bayview. This submarket maintains the single greatest concentration of industrial-zoned properties in the city. The Bayview, like other industrial submarkets such as SOMA and Mission Bay, is experiencing a trend in which industrial-zoned parcels are being redeveloped for other uses, such as multifamily and retail. This has resulted in a gradual year-by-year decline in the number of San Francisco properties that support industrial use. This is creating a scarcity of supply in building inventory for industrial property users, keeping markets particularly tight for more specialized uses like auto repair and R&D. Because of this inventory constraint, industrial space users must pay for the privilege of having a San Francisco address. The San Francisco industrial market continues to be buffered from market dips, despite its aging industrial building inventory, due to this constraint.

The San Francisco airport perimeter market, which is generally defined by the suburb city of South San Francisco, continues to maintain its stable market position due its 24/7 demand to serve one of the nation’s busiest airports. Industrial REITs and institutional investors that have sat on the sidelines with substantial reserves of cash since 2008 are quietly making targeted acquisitions on properties to add to their portfolios. The more specialized industrial properties, such as high through-put distribution centers and food processing facilities, are seeing multiple offers from both investors and owner-occupiers.

The vacancy rate for industrial properties in the San Francisco airport perimeter market is just above 11 percent. It is still considered a tenants’ market, and tenants have been taking advantage by locking in long-term leases on favorable terms. Asking rents for general-purpose industrial spaces now hovers in the range of $0.70 per square foot, per month, net basis, with landlords sometimes making concessions and even performing upgrades on a case-by-case basis.

Industrial property redevelopments are also accelerating in South San Francisco. Older industrial buildings are being repurposed for biotechnology firms and life science research centers. More significantly, Shorenstein has moved forward with its marketing of 39-acre site in South San Francisco, which used to consisted of about 450,000 square feet of industrial flex space. This space is being redeveloped into a new biotech research center that could support up to 2.25 million million square feet of laboratory and office space. This will reinforce South San Francisco’s claim as the biotech capital of the world.

— Whit Hughes, managing broker, Commercial Industrial Property Investments, South San Francisco

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