MARKET HIGHLIGHT, SEPTEMBER 2006

SOUND REAL ESTATE IN SAN FRANCISCO
David Klein, Rhonda Diaz, Gary Polsky and Arthur Griffith

Continued gains in San Francisco’s office market, coupled with already tight retail and industrial sectors, make the City by the Bay an attractive place to be for commercial real estate players.

Office

The San Francisco office market consists of more than 82 million square feet of product. The North and South Financial Districts make up 49 million square feet or 60 percent of the market. The city’s leasing segment continued to demonstrate solid momentum with declining vacancy and increasing rents through first half 2006. Vacancy inched downward from 12 percent during the first quarter to 11.7 percent in second quarter. Net absorption recorded a positive 262,419 square feet in second quarter. The market has absorbed a net total of 636,440 square feet year-to-date.

The second quarter of 2006 signified the 11th consecutive quarter of occupancy gains in San Francisco County. The North and South Financial Districts combined for more than 220,000 square feet of positive net absorption, accounting for 84 percent of the overall office market absorption in the county in second quarter 2006. Key lease transactions in that time include Capital Research Corporation’s expansion of 38,150 square feet at 1 Market Street - Steuart Tower, McKinsey & Co.’s expansion of 26,944 square feet at 555 California Street and FTI Consulting’s expansion of 21,032 square feet at 1 Front Street.

San Francisco’s office market has sustained rental rate growth for nine consecutive quarters (second quarter 2004 to second quarter 2006). The overall average asking rate was $32.76 per square foot full service per year at the close of second quarter 2006, up 3.9 percent since the prior quarter and up a far greater 16.5 percent in the past year. With vacancy expected to march downward to single digits in the near future, rental rates for desirable space and location will continue to increase. Due to the continued high demand for premium space, the average asking rate for Class A product in San Francisco’s North Financial District escalated past the $40 mark to $41.02 per square foot full service. Tightening supply and surging rents for premium space are expected to redirect tenants to commodity space as it becomes viable.

Developers are quietly waiting on the sideline, expecting further tightening of the market (increased demand and rent spikes) to justify profitable new office developments. Two new projects — Tishman Speyer’s 559,000 square feet at 555 Mission Street and Shorenstein’s 350,000 square feet at 350 Bush Street are expected to break ground by year’s end.

Although less brisk than 2005, sales activity during second quarter was steady. The most noteworthy transactions included RREEF’s purchase of the two-building Market Center at 555 and 575 Market Street; Beacon Capital Partners’ acquisition of the Rincon Towers on Spear Street that included 757,000 square feet of office space in two buildings, 320 apartment units and 381 subterranean parking spaces; and New York-based Resnick Development’s purchase of 215 Fremont Street that was part of a six-building portfolio sale that also included a commercial condo in Philadelphia and office buildings in Idaho, Kentucky and North Carolina.

Many lease transactions involving big companies in the second quarter were the result of expansion. This presents a strong indication that businesses are projecting stronger job growth over the near term. Specifically, the technology sector appears to be making a slow, measured comeback as demonstated by companies such as Macrovision, Zoom Systems, Hands-On Mobile and Vontu Inc.

As growth in the economy and employment continue, expect to see the San Francisco office market maintain steady absorption and rental growth through the end of the year.

— David Klein is a senior vice president and partner for NAI BT Commercial in San Francisco.  

Retail

San Francisco retail in 2006 will be known as the year of the two big B’s — Barney’s and Bloomingdales. Barney’s department store signed a 25,000-square-foot deal in Union Square and is scheduled to open in fall 2007. Bloomingdales will open this month in Westfield’s/Forest City’s expansion of the San Francisco Centre. The 357,000-square-foot flagship will be joined by a nine-screen Century Theatre and 660,000 square feet of retail. The Centre will audition many new San Francisco retailers such as American Eagle’s Martin + Osa, Abercrombie & Fitch’s Ruehl and Hollister, Burke Williams Spa, Adidas and Gap’s Forth & Towne. High-end Bristol Farms will open a 30,000-square-foot food emporium, anticipating a successful synergy between grocery and retail ala Whole Foods’ success in New York’s Time Warner Center. Westfield expects 25 million shoppers to visit the mall annually totaling expenditures of $600 million.

Union Square vacancy is approaching 5 percent. Strong sales are boosted by a high visiting population anticipated to exceed 16 million this year and extraordinary hotel occupancy. In addition to Bloomingdales and Barney’s, a Jimmy Choo will open a store-within-store at Bloomingdale’s, and a Juicy Couture flagship and London Sole will be joining Union Square. Union Square rents range from $75 per square foot on off-streets to $550 per square foot on prime corners.

The San Francisco Centre expansion has fueled investor demand for the adjacent “mid-Market” neighborhood, where rents drop dramatically to $24 to $30 per square foot. Developer Urban Realty is proposing a 205,000-square-foot retail and housing complex nearby. Expansion of the square’s boundaries into underutilized real estate will open the doors to value-based retailers such as the Target, which has been circling Union Square for years. Value retail next to luxury retail is a growing trend where perceived value, not price, is the key consumer driver. Of course, style, at any price point, is always in fashion.

While the trend of urban villages offering live, work and play within a tight metropolitan circle continues throughout the county, mixed-use has long been the lifestyle in San Francisco. Continued growth of residential and timeshares in the financial district is extending retail shopping hours and creating new opportunities for retailers. Besides the new Ritz-Carlton project outside the financial district, plans are proposed for the renovation of the Transit Bay Terminal into the “Grand Central Station of the West.” The 40-acre redevelopment will create a 24-hour neighborhood with 60,000 square feet of retail space, 3,700 housing units, 3.6 million square feet of office and 720 hotel rooms.

At Fisherman’s Wharf, JMA, along with minority partner Fairmont Heritage Place, is constructing a $50 million renovation at the former Ghirardelli chocolate factory for retail, dining and fractional ownerships. Mills Corporation gave up their long fight for approvals on the waterfront property at Piers 27-31. Shorenstein purchased the development rights to the 800,000-square-foot retail, restaurant and office project.

San Francisco cuisine continues to make its mark. Charles Phan of Slanted Door has raised the bar again with his new “Out the Door” concept: To-go, quick, clean, affordable, and really good. Another one will open at the San Francisco Centre, along with Bradley Ogden and Tom Collicchio concepts. Pat Kuleto will open Waterbar and Epic Roasthouse on Rincon Hill. DiMaggio’s Italian Chophouse opened in Northbeach, Joe’s boyhood stomping ground located across from where he and Marilyn married. New York’s Philippe Reiser will open a 4,500-square-foot club downtown, designed by Buddha-Bar designer Stephane Dupoux.

Demand for restaurant space remains high, with a low supply of space and rents and key money rising dramatically. Volumes are at an all-time high at many of the city’s food institutions. Trends: authentic, organic streetfood and taverns.

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

Industrial

The San Francisco warehouse market contains a little more than 19.4 million square feet of product and comprises three primary submarkets: Mission/South of Market (5.2 million square feet); Third St. Corridor/Potrero Hill (9.8 million square feet); and Bayview (4.4 million square feet). The San Francisco industrial market continued to show steady momentum with declining vacancy and rather stable rents in first half 2006. Vacancy decreased slightly from 3.1 percent in the beginning of the year to 2.9 percent in second quarter. This market has experienced continuous decline in vacancy since fourth quarter 2002 when it was 6.2 percent. All submarkets experienced a minor decline in vacancy during second quarter 2006. With limited industrial inventory, this low vacancy trend will likely continue as most industrial buildings have high occupancy rates. Many industrial tenants tend to remain in San Francisco and are reluctant to relocate out of San Francisco because its advantages of close proximity to target customers, suppliers, labor source, and irreplaceable and ideal spaces suited to their businesses.

The average asking rate for industrial/warehouse product in San Francisco remained stable during second quarter, dropping just two cents from first quarter to $0.75 per square foot gross. The asking rental rate ranged from $0.52 per square foot for lower-end product to $1.37 per square foot industrial gross for higher-quality product. In general, distribution businesses tend to be on the lower end of the scale, and certain production businesses tend to be on the higher end. In addition to the county’s lowest vacancy at just 0.4 percent, the Mission/SOMA submarket remained the most expensive space in San Francisco with an average asking rate of $0.97 per square foot industrial gross. The trend of office or residential conversion around the SOMA area has contributed to higher market prices for land and rent. The remaining industrial users in this submarket that can still afford high rents above $1 per square foot are high-end, production-oriented firms such as graphic design and photography businesses.

Overall leasing activity was minimal with a gross of just 62,500 square feet in second quarter, the lowest level of activity since fourth quarter 2002. The 3rd Street Corridor/Potrero Hill submarket produced approximately 37,000 square feet of gross absorption, the highest of any submarket. The overall net absorption in second quarter was a positive 31,576 square feet. All submarkets in the county posted a positive absorption in the second quarter. Both users and investors with intentions to invest in ownership or to convert to residential or retail uses remain active in this market despite the increase in the prime rate. Major sales activity continued to be for the smaller size range for industrial or warehouse properties. In fact, sales listings available on the market are inadequate and hard to find because there aren’t many owners willing to sell.

The current condition of strong job growth and declining unemployment rates keep local distribution and production businesses profitable. As a result, expect to see an increase in demand for expansion. However, tenants will have a hard time finding large industrial space in San Francisco, considering that there are only three lease availabilities between 50,000 square feet and 100,000 square feet. With no new product in the pipeline and scarce developable land, market vacancy will continue to tighten. There should be no significant changes in either direction of those important market attributes until the end of 2006.

— Gary Polsky is a partner at NAI BT Commercial in San Francisco.

Multifamily

The San Francisco apartment market has turned. Premium, high-quality multifamily properties are still trading at record prices, gross rent multipliers, cap rates and prices per square foot. However, everything else is taking significantly longer to market and sell. Suddenly, softness in price and less desirable terms are a reality for today’s sellers.

The primary factor fueling the slowdown is a rise in interest rates. Less buyer demand translates into an increasing supply of available inventory for purchase resulting eventually in soft prices. The market has not seen yet many deals close below asking price, but there is a steadily increasing supply. It appears that sellers are holding firm or offering very small reductions. The result? There are almost twice as many San Francisco buildings available for sale today as there were 1 year ago. It often takes a while for sellers to adjust their expectations in a changing market, so while an increased supply will almost surely lead to more and larger reductions, it may not happen for a few more months.

The San Francisco apartment market is most easily broken out into two segments, above and below the $2 million mark. There was a slowdown for smaller assets below $2 million, pointing to a softening of the single-family residential market. Prices for homes flattened as interest rates went up. The majority of the buyers in San Francisco’s 10-unit-and-under multifamily market had 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 translated into a slowdown in the $1 million to $2 million San Francisco apartment market. And that’s where the market remains.

The $2 million-plus market is just starting to show some signs of beginning to slow down. The causes, while interconnected, are a bit different. First and foremost, money is simply harder to come by these days. With rates up and lenders being more strict on their underwriting, it takes more cash down to qualify for deals. As the equity requirements go up, the number of buyers has dropped. In addition there are fewer owners taking profits out of the under $2 million segment and trading up into bigger, more expensive buildings. It’s early in the cycle, but the market will likely see the same increase in supply and eventually a softening in price as has already occurred in the sub-$2 million market.

In summary, a slowdown is upon the San Francisco multifamily market, but by no means is anyone predicting a crash. History has shown that even in a slowdown there remains a motivated and qualified buying pool for the city’s multifamily product. Supply will increase and prices may cool a bit, but don’t expect the sky to fall any time soon….at least not in San Francisco.

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

©2006 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.