MARKET HIGHLIGHT, SEPTEMBER 2005

SAN FRANCISCO ON TRACK TO RECOVERY
Greg Fogg, Rhonda Diaz and Arthus Griffith

Decreasing vacancies aren’t the only indicators that San Francisco’s commercial real estate sectors are getting hot again.

Office

The San Francisco office market consists of more than 82 million square feet of space. The north and south financial districts make up 49 million square feet, or 60 percent, of this market. In the last year, overall vacancy for the San Francisco office market has declined from 17.7 percent (second quarter 2004) to 13.7 percent (second quarter 2005). This represented the largest decline in vacancy between any four quarters since the dot-com bust in 2001. In the financial districts, vacancy averaged 13.9 percent, and in the non-financial districts vacancy averaged approximately 13.5 percent. The overall average asking rate increased for the fifth consecutive quarter to close second quarter 2005 at $28.12 per square foot full-service (annually). This is the highest average asking rate the office market has produced since first quarter 2002. While office market professionals may debate the finer points of San Francisco’s changing market environment, all agree that the trend of diminishing vacancy and increasing rental rates is well established.

Leasing activity in second quarter 2005 was sub-par compared to the previous quarters, with just 2.3 million square feet of gross absorption; however, due to an above-average first quarter performance, gross absorption totaled nearly 5.5 million square feet in the first half of 2005. Moreover, net absorption in first half 2005 was outstanding at 1.52 million square feet, approximately the same amount recorded for all of 2004. It is unlikely that the comparatively fast pace of leasing activity will remain the balance of the year, yet even with lesser demand it’s a sure bet that net absorption will achieve its highest level since the new millennium began.

The combination of both large and many average size leases led to such a strong second quarter performance. In all, there were approximately 61 deals exceeding 10,000 square feet, nine of which topped 25,000 square feet. The largest lease deal of the quarter was The Gap’s relocation of Old Navy to the Mission Bay building it had been marketing for sublease (approximately 283,000 square feet). In addition, there were numerous other large lease transactions, including: UCSF’s lease of approximately 55,000 square feet at 50 Beale Street; Interpublic Group Of Companies’ lease of approximately 53,000 square feet at 1160 Battery Street; Snapfish.com’s lease of 30,218 square feet at 303 Second St.; and Pay by Touch Signs’ lease of 29,581 square feet at 101 Second St.

The torrid pace of investment sales activity continued, with 17 buildings selling in second quarter 2005 for a combined total of more than 3.3 million square feet of office space. TMG Partners’ sale of The Landmark to American Assets was of particular interest at a purchase price of $475 per square foot.

Taken all together, the first half of 2005 has certainly been eventful. Our expectation is that while leasing fundamentals will continue to shift in favor of landlords, the oversupply of capital flooding the San Francisco market will perpetuate the high price of investment, maintaining the gap between market reality and buyer projections. In the near future, given market segmentation, the relatively high pricing associated with recently acquired assets, and continued strong demand, the upper quartile of San Francisco’s market stands to achieve significant rental appreciation.

— Greg Fogg is the managing partner for BT Commercial/NAI in San Francisco.           

Retail

San Francisco retail activity for the first half of 2005 has been brisk in both the sales and leasing arenas.

Several Union Square buildings have changed hands this year. Most recently, the Prada headquarters building at the corner of Post and Grant sold to British real estate buyer Grosvenor Group, which also owns 180 Post and 251 Post. The long-vacant building was originally purchased by Prada several years ago for $18.5 million and was to serve as a West Coast flagship. Grosvenor bought the 28,000-square-foot building for $11 million, with plans to convert it to high-end retail.

Wilson Meany Sullivan recently sold One Powell Street to SPI Holdings for an undisclosed price. Wilson Meany Sullivan spent $35 million over the last 2 years in renovations, converting the building to a 25,000-square-foot retail store (Forever 21) and 40 apartments.

Other Union Square activity in 2005 includes the pending openings of H&M, Zara, Golfsmith, Cody’s Books, American Apparel, Coffee Bean & Tea Leaf, G-Star, Joseph A. Bank, Hannspree and Chrome Hearts,  and a major expansion of the existing Louis Vuitton store. A new restaurant operator joins the square with the operators of the Aqua restaurant group taking over the Café de la Press site at the foot of the Hotel Triton.  Union Square rental rates range from $60 to $550 per square foot, depending on block, positioning and floor level.

There’s never a dull moment in the food world in San Francisco, and several new players have signed deals with planned 2005 openings such as Sammy Haggar’s Agave Restaurant and Tequila Bar, Amsterdam Supper Club, Pat Kuleto’s multi-million-dollar site on the Embarcadero, Kingfish by the ballpark, DiMaggio Restaurant’s pending opening in North Beach, and Terra of Napa’s future opening at the new St. Regis Hotel.

Other retail centers in the news were the 82,000-square-foot Mission Bay retail center sold in late 2004 to Centurion Real Estate Partners, which is reportedly entertaining resale offers. Existing tenants are Safeway, Borders Books & Music, Wells Fargo and Starbucks Coffee. Industry price estimates range from $400 to $450 per square foot for the center.

Forest City Enterprises and Westfield America continue their leasing efforts for the fall 2006 opening of the Bloomingdale’s center anchored by a 330,000-square-foot Bloomies and 333,000 square feet of specialty retail space. Century Theatres has reportedly committed to the site.

Other retailers looking at the center are those considering second store locations in the market. Many retailers view a mall location as a different market than that of a metropolitan street location. Tenant announcements have not been made, but reportedly there are several high-end designers, a major gourmet food store on the lower level (ala Columbus Circle in New York) and a bookstore all taking a serious look at the opportunity.

San Francisco neighborhood retail will be significantly impacted by the the new code, referred to as “formula retail,” requiring that chain stores with more than 11 locations apply for a conditional use permit for neighborhood review. Neighborhood voices can approve or disapprove a chain operation in these select neighborhoods, such as Fillmore Street, Union Street and Hayes Valley. Of interest on rental rates and property values will be the amount of time space remains on the market and the amount of time from deal signing to permits issuance and store opening (i.e., rent commencement). Recent neighborhood deals include East Coast boutique retailers such as the Japanese cosmetics company Shu Uemera, glassware specialist Simon Pearce and Jonathan Adler on Fillmore Street, and local favorite Home Restaurant on Union Street.

— Rhonda Diaz is a vice president for Terranomics Retail Services, a division of BT Commercial, in San Francisco.

Industrial

The San Francisco warehouse market contains a little more than 19.3 million square feet of product and comprises three primary submarkets: Mission/South of Market (5.2 million square feet); Third St. Corridor/Potrero Hill (9.6 million square feet); and Bayview (4.5 million square feet). The county’s warehouse market is one of the most successful commercial markets in the Bay Area with a vacancy rate of just 3.6 percent. A year ago, vacancy in this market was 5.3 percent. The second quarter also signified the fifth consecutive quarter of declined vacancy for the market. In all, there was just 686,211 square feet of product available at the close of second quarter 2005, the majority of which — 66 percent or 452,000 square feet —was found in the Third St. Corridor/ Potrero submarket.

In terms of available square footage, sublease space played a more minimal role in second quarter 2005 as it accounted for 117,000, or 17 percent, of the county’s total available warehouse product. After recording more than 204,000 square feet in first quarter 2002, sublease space has consistently dwindled in the majority of the quarters since. Likewise, direct space has continuously decreased the last five quarters, from more than 1 million square feet a year ago (second quarter 2004) to 569,000 square feet in second quarter 2005.

The average asking rate for warehouse product in San Francisco was $0.79 per square foot NNN at the close of second quarter 2005, a $0.05 increase from the previous quarter. The average asking rate has experienced a $0.10 increase from first quarter 2004.

Leasing activity in San Francisco has been soft, resulting in a tenant’s market. There are very few national companies looking for space compared to the East and South Bay areas. Due to this low demand, leasing rates remain flat. In contrast, the buying market has been very strong, creating a seller’s market. A few national industrial tenants have actually tried to exit out of San Francisco because of such a strong buying market. They are willing to sell their current properties in the city so that they can move to and buy or lease in the East Bay or South Bay, which are closer to the ports.

In second quarter 2005, gross absorption recorded 229,453 square feet. While this level is on or above pace compared to what has been recorded the previous quarters, it is well off the levels seen in the mid to late 1990s. Positively, however, net absorption closed second quarter 2005 in positive territory (56,442 square feet), its third consecutive quarter of positive net absorption. One reason for the limited absorption in San Francisco is the lack of large spaces available to be leased out. At the close of second quarter 2005, there were zero warehouse spaces on-line that exceeded 100,000 square feet.

The conversion of warehouse buildings to residential/condos due to the favorable economics that lead to strong demand is currently a hot issue in San Francisco. Due to low interest rates, buyers typically are owner/user-type investors. Some of the industrial users aim to buy and use themselves instead of leasing, while others intend to convert to residential/condos. A political battle on the forefront of the San Francisco industrial market deals with the issue of the Industrial Preservation Zone (IPZ). The city has been trying to preserve the industrial zones within its borders from being converted. Changes in zoning will not be allowed in the area due to IPZ enforcement. Fights over the IPZ resolution between city and residential developers will likely continue.

— Greg Fogg is the managing partner for BTCommercial/NAI in San Francisco.

Multifamily

The San Francisco apartment market remains hot. Multifamily properties of all sizes are trading at record gross rent multipliers, cap rates and prices per square foot. The primary factors fueling the boom are record-low interest rates, strong buyer demand and lack of available inventory for purchase. Many of the owners who were considering selling to take advantage of market conditions have already done so. Other owners are waiting for a significant rise in interest rates before they consider selling. As such, quality apartments of all sizes that are well marketed receive multiple offers, many in excess of list price. Currently, that trend may be beginning to change, at least for the smaller assets.

The most recent set of sales data show significantly longer marketing times and prices flattening out a bit. This is especially true for the smaller assets below $2 million. The most likely explanation is a softening of the single-family residential market. Prices for homes have flattened in response to fears that prices will drop as interest rates rise or, more simply, the bubble will pop. In turn, this has significantly increased the number of homes available for sale as owners are concerned about missing the boom (Local MLS data show a six-fold increase in listings over this period last year). The majority of the buyers in San Francisco’s 10-unit-and-under multifamily market have been either investors trading up out of smaller residential properties or owner/users looking for an alternative to the inflated single-family home market. A cool down in the single-family home market clearly translates into a slow down in the $1 million to $2 million San Francisco apartment market. The big questions are: when and how much?

The larger segment of the market ($2 million or more) has been dominated over the last 3 to 4 years by a few high-profile buyers. In most instances a large apartment offering finds the same few buyers competing to outbid each other. The logical question becomes can they and will they continue to acquire at such a vigorous rate? If not, what will happen to prices without these key players driving the market? At this point, there doesn’t seem to be a slow down in these buyers’ appetites.

In the end, San Francisco suffers from a chronic supply restriction (due to both geographic restraints and a hostile development environment), and, though this often drives apartment owners crazy, it may just prove to be San Francisco’s saving grace in a rising interest rate environment. Many brokers are confident that there remains a motivated and qualified buying pool for San Francisco’s multifamily market and that, until the supply issue changes, the boom will continue.

— Arthus Griffith is a multifamily sales associate for BT Commercial/NAI in San Francisco.

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