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San Francisco’s
Allure = Economic Stabilizer
Jeffrey Mishkin
While the San Francisco MSA has suffered some short-term economic
setbacks, the area remains extremely attractive to businesses
and residents alike. The city of San Francisco is recognized
worldwide for its spectacular physical beauty and cosmopolitan
culture. The area is characterized by its ethnic diversity,
world-class universities, cultural attractions and recreational
opportunities. San Francisco effectively serves as the administrative,
financial and services hub for the western United States.
The City by the Bay boasts a diverse economy and is home to
a wide range of businesses, including Fortune 500 companies
such as Charles Schwab, Wells Fargo, Gap and LucasFilms. In
all, more than 60,000 businesses are headquartered in San Francisco.
Tourism also plays a vital role in the local economy. In 2002,
17.3 million visitors came to San Francisco and spent a total
of $7.62 billion.
While several factors determine demand for commercial real estate
space, the primary driver is job growth. San Francisco has suffered
significant job losses during the past few years due to the
significant economic downturn, restructuring in the high-tech
sector, reduced business travel and a drop-off in tourism following
September 11, 2001. The local employment base contracted in
2001 and 2002, shedding 67,000 jobs in the 2-year period. However,
San Francisco’s employment base was expected to contract
by only 1.2 percent in 2003, and job growth of 1.9 percent is
forecast for 2004. An acceleration of economic growth will be
required to put a dent in vacancies. San Francisco’s position
as a business center and its cosmopolitan nature will ensure
a smooth recovery once the economic engines pick up speed. Commercial
real estate owners and investors recognize the area’s
inherent attributes that make it a favorable long-term investment.
Office
Similar to other markets around the country, San Francisco’s
office sector has been hit the hardest by the recent recession.
A substantial slowdown in new construction and an expected boost
in employment levels will begin to suppress office vacancy rates
in San Francisco; however, the benefits will not be evenly distributed
among submarkets. The Van Ness/Civic Center area and the North
Financial District have been buffered by old-economy tenant
bases and are expected to boast the lowest vacancy rates through
2004 — less than 17 percent. The South of Market (SoMa)
submarket, which prospered during the dot-com boom, now has
the highest vacancy rate in the region at 39.3 percent. Some
companies are taking advantage of soft conditions in the submarket.
For example, a locally based software company recently purchased
three SoMa properties that will serve as its headquarters.
Overall, owners and tenants are sensing that the bottom of the
market has been reached. While tenants still have the upper
hand, rent reductions have slowed and tenants who have been
waiting on the sidelines for better deals are moving forward
with leasing plans. Many owners, however, are trying to cap
leases at 4 years, which is when most expect measurable improvement
to occur.
Market uncertainty has hindered sales velocity. In the first
three quarters of 2003, the median price per square foot declined
to $224, from $234 in 2002 and $279 in 2001. The majority of
transactions have involved Class B and Class C properties, with
the Class A segment of the market accounting for just one transaction
through the third quarter. Medical office properties are in
high demand, which pushed the median price per square foot to
$330 in 2003, compared to $258 in 2002. Activity for this property
type has been concentrated in Marin County, primarily in areas
within close proximity to hospitals. Class A investment activity
is forecast to rise during the next year as more REITs and institutional
investors enter the market, with most seeking quality properties
occupied by credit tenants. Smaller properties with historically
low vacancy will continue to garner strong investor interest.
Despite the forecast for improved vacancy and limited construction
in 2004, effective rents are expected to drop by another 2 percent
to $23.67 per square foot. Owners will continue to negotiate
short-term leases at reduced rates in order to cut losses in
the near term. Only 500,000 square feet of new office space
was completed in 2003, down from 3.5 million square feet in
2002. Development will ease further this year, as only 100,000
square feet is introduced into the market. Vacancy reached 21.3
percent at year-end 2003, up 40 basis points from 2002. Limited
completions and a boost in employment will initiate improvement,
with vacancy forecast to fall to 20.9 percent in 2004.
Retail
While the local economy will not fully recover from the recent
economic downturn for several years, San Francisco boasts one
of the most affluent populations in the nation, which will continue
to spur additional expansion among national retailers. The retail
market is supported by strong personal income and the second-highest
per capita retail sales figure among 38 major national markets
surveyed by Marcus & Millichap. More than 13,000 retail
establishments generate approximately $7.5 billion in sales
a year in San Francisco.
One of the largest projects currently planned for San Francisco
is the redevelopment of the Emporium building on Market Street
by Forest City Enterprises. The 1.5 million-square-foot project
is expected to become home to Bloomingdale’s western flagship
store as well as a state-of-the-art theater complex, 200 specialty
stores and office space. Plans include linking the building
with Westfield’s San Francisco Centre. The project broke
ground in November with completion slated for fall 2006.
Construction activity was limited in 2003, and, although vacancy
increased 40 basis points last year to 6.1 percent, San Francisco’s
retail market remained among the tightest in the nation. Overall
rents have grown slightly despite the tough economic conditions,
but there has been some softening in rents at the top end of
the market, which has suffered due to the reduction in tourism
activity. Asking rents in the region climbed approximately 1
percent, pushing the average to $30.02 per square foot at year-end
2003.
The Bay Area retail sector has been extremely resilient in the
down economy. Retail investments in San Francisco are in high
demand and prices reflect this trend. Not surprisingly, available
retail properties are receiving strong investor interest and
multiple bids soon after hitting the market. During the next
year, buyers will continue to compete for product, as the fundamentals
remain favorable. The majority of transactions in 2002 and 2003
were under $5 million, but demand has strengthened for power
centers and regional centers. This trend has emerged in other
markets as well due to the limited availability of high-quality
grocery-anchored properties.
Multifamily
It appears the San Francisco multifamily market has finally
reached the bottom of the cycle with mild improvement in vacancy
reported during the third quarter. Subdued apartment construction
activity and job growth will ease vacancy further in 2004, allowing
owners to raise rents slightly. San Francisco multifamily vacancy
fell 10 basis points to 5.6 percent as of third quarter 2003,
and improved absorption heads the forecast for 2004, as thousands
of higher paying professional jobs are created in San Francisco,
which will help fill upscale units. Vacancy in San Francisco
is projected to dip 40 basis points to 5.2 percent as the local
job market shows improvement. At 3.9 percent, the Civic Center/Downtown
submarket reported the lowest vacancy rate at year’s end.
San Francisco will receive 650 multifamily units in 2004, a
number slightly below the 2003 total. The new developments are
concentrated in San Francisco County and North San Mateo County.
The pace of declining rents was starting to ease in late 2003;
asking rents were expected to end the year down only 4 percent
to $1,628 per month. Easing vacancy will allow owners to push
rents upward in 2004. The average asking rent in San Francisco
will increase by 1 percent to an average $1,645 per month. At
7.5 percent, the North San Mateo submarket registered the largest
year-to-year loss as of third quarter, falling to $1,324 per
month. Through 2004, concessions will be less necessary in San
Francisco, with the exception of upscale submarkets.
While transaction activity has moderated, sales prices have
continued to rise as investors focus on the long-term potential
of the region. Through the first three quarters of 2003, the
median price per unit for the San Francisco region rose 6 percent
to $155,000 per unit. Investors have shown relatively equal
interest in the San Francisco submarkets, though the majority
of sales were Class C properties, with an average sales price
of $2.1 million. A few sales above $5 million were recorded
last year, including the Class B 226-unit Crossbrook Apartments
in the Marin submarket ($27 million).
There are a number of favorable trends that will fuel demand
for multifamily housing units in San Francisco and the greater
Bay Area. Significant barriers to entry make new apartment development
difficult, thus restricting supply. On the demand side, the
area’s high cost of housing inhibits homeownership and
promotes renting. The percentage of households able to afford
a median priced home in San Francisco County was only 12 percent
in September 2003. Also, apartment demand from echo boomers,
who are entering their prime renting years, and the continuing
flow of immigrants will drive demand.
Industrial
All things considered, conditions in the San Francisco industrial
market could be much worse. The primary drivers of industrial
warehouse demand — manufacturers, distributors and retailers
— have been under pressure for more than 2 years due to
struggling economics both at home and abroad. Fortunately, the
construction cycle for industrial space is relatively short
and developers were quick to scale back on production when it
became clear that demand was faltering. The good news is that
the recent positive economic indicators promise that the market’s
future will be brighter as conditions improve and resultant
demand perks up.
Overall, the San Francisco industrial market, with its significant
development constraints, has fared better than some of its peers.
Vacancies are hovering around 6 percent and asking rents are
ranging between $0.45 and $0.95 per square foot, depending on
location and product quality.
Investment activity remains moderate, but as the economy improves,
so will the demand for industrial space. Smaller properties
are currently receiving the most attention as users look to
take advantage of low interest rates to acquire facilities.
Jeffrey Mishkin is a first vice president and regional manager
of Marcus & Millichap’s San Francisco office.
©2004 France Publications, Inc. Duplication
or reproduction of this article not permitted without authorization
from France Publications, Inc. For information on reprints of
this article contact Barbara
Sherer at (630) 554-6054.
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