MARKET HIGHLIGHT, SEPTEMBER 2007

SAN FRANCISCO
Nicholas Russell, Dan Wald, Rhonda Diaz, Tom Martindale and Joe Fabian

San Francisco commercial real estate is surging. Statistics indicate that retailers most certainly want to have a presence by the bay, and, thanks in large part to the single-family residential market, San Francisco’s multifamily sector is seeing increased rents and investment sales. The year started with an investment sales bang in the office sector; rising rental rates and low vacancies are backing that up. Although the Bay area’s biggest industrial submarket showed a vacancy up-tick, rental rate growth is still strong.

Multifamily

In 2007, the Bay Area apartment rental market has continued to surge while multifamily sales has enjoyed steady improvement. Due in part to the resurgence of Silicon Valley as well as shrinking development opportunities, the Bay Area is a unique apartment market. Nowhere is this growth more prevalent than in the city of San Francisco. With a population of more than 800,000 and demand on the rise, San Francisco’s multifamily rental and sales markets continue to tighten and the rest of the Bay Area has followed suit.

A variety of factors, most of which are related to the residential housing market, have contributed to the Bay Area’s significant increase in rents. With interest rates on the rise, many potential homeowners have been pushed out of the market. For those not affected by the higher rates, the recent decline in appreciation has many buyers worried about buying at peak prices. While the median price of a Bay Area home just hit an all-time high of $665,000, year-over-year existing-home sales have fallen 17.4 percent.

The current single-family housing flux has provided the apartment market with a significant infusion of renters. In the last year, rents in the entire Bay Area have increased a respectable 6.4 percent, with San Francisco reporting an impressive jump of 9.3 percent. Even more promising for apartment owners in San Francisco is the 5 percent rental growth in second quarter 2007. Although rents are being pushed throughout the Bay Area, vacancy has remained steady at 4.6 percent. The current vacancy rate represents a slight increase over the past year but is down 0.7 percent over the last quarter.

Bay Area multifamily sales have shown strong improvement in second quarter 2007. The current average transaction price of $4.58 million is nearly double that of first quarter 2007 and is accompanied by a 0.2 percent drop in cap rates to 4.8 percent. San Francisco cap rates continue to pace the Bay Area at an average of 4.3 percent.

One of the largest multifamily transactions in recent memory is the sale of the apartment component of the three-building Rincon Center in downtown San Francisco. Beacon Capital Partners retained 530,000 square feet of retail and office space while selling 320 apartment units to New York-based Capital Properties for $143 million. In a more typical deal, AIMCO purchased the Leahy Square Apartments from Interstate Equities Corp. in April. Located in Redwood City between San Francisco and San Jose, the 110-unit Leahy Square Apartments traded for $23 million at a low 4.43 percent cap rate.

The Bay Area multifamily market is healthy and appears poised for a strong second half of 2007. The rental market is thriving due to an influx of new renters, and demand for multifamily investments is greater than the supply. The Bay Area can expect to see cap rates remain low — less than 5 percent — and prices continue to rise.

— Nicholas Russell is a member of NAI BT Commercial’s Multifamily Division in San Francisco.

Retail

With vacancy rates declining, and rents and sales trending up, the greater San Francisco Bay Area retail real estate marketplace is surging, thanks to both a resurgent tech-led local economy and San Francisco’s position as a world-class destination.

San Francisco’s position on the world stage puts it on the “A list” for investment buyers, and retail properties have been among their top targets. Similarly, the strength of foreign currencies against the dollar has fueled a boom in tourism and spending in San Francisco, further enhancing sales results for its local, national and global retailers.

In the City by the Bay, the opening of the Bloomingdale’s-anchored Westfield Center has only strengthened the storied Union Square retail submarket, dispelling early concerns that the 1 million square feet of space would hurt Union Square’s traditional “high-street” retailers. On the contrary, the Westfield/Forest City joint venture, doubling the size of the existing, Nordstrom-anchored San Francisco Centre, created a new geographic dynamic with the increased foot traffic on Market Street. The shopping district’s traditional borders are expanding farther east towards the financial district and the Ferry building and south towards the Moscone Convention center.

Union Square has seen an upsurge in investment sales activity, including the late-July, $70 million sale of the Ann Taylor building on Post Street by Festival Companies. Underpinning continued investor interest are increasing rents in the $200 to $400 per square foot range and falling vacancy approaching 5 percent throughout Union Square. Top 2007 retail transactions include a De Beers jewelry store at the long-vacant site at Post and Grant, Skechers at 200 Powell, Fresh beauty products at Grant and Sutter, and rouge & blanc, from the Aqua restaurant group, on Grant Street. A 63,000-square-foot Barneys New York will open in fall 2007.

San Francisco’s other major retail submarkets have also performed well, with low vacancies and increasing rents in the Waterfront/Fisherman’s Wharf and the Stonestown Mall areas. San Francisco’s surrounding markets are on fire as well, fueled by county-by-county vacancy rates below 5 percent. Close in to San Francisco, big box retailers such as The Home Depot and Lowe’s Home Improvement Warehouse, spurned by the city’s restrictions on national chains, draw San Francisco customers to shopping centers in South San Francisco, Colma, Daly City, San Bruno and Emeryville.

Suburban infill has become the hottest trend for retail development in the Bay Area’s close-in established communities. In Silicon Valley, Cousin’s Properties has developed The Marketplace, a power-promotional center that has brought the nation’s dominant power and promotional retailer virtually to the heart of San Jose. H & M recently signed a deal at San Jose’s Santana Row, and Valley Fair, across the street, plans a future 560,000-square-foot expansion. In Sunnyvale, a joint venture of Sand Hill Properties and the RREEF Funds has acquired the long-underutilized Sunnyvale Town Center for a major renovation. In Palo Alto, San Francisco-based Ellis Partners is completing its renovation of Town & Country Village at the doorway to Stanford University. Plans are also under discussion for an additional 240,000 square feet at Stanford Shopping Center.

In San Francisco’s suburban markets, rapid population and housing growth has been answered by many exciting retail developments. In Vacaville, the historic Nut Tree has been redeveloped into an exciting lifestyle retail complex reintroducing to Interstate 80 travelers and local residents the family-centered entertainment and dining destination that in the past made the property a Northern California retail icon.

Not only is the increased population of the suburbs fueling retail, but mature communities there are supporting significant revitalization of older properties. Expect more “high-street” retail in Union Square, and downtown San Francisco will see continued strong activity and attraction to international shoppers and retailers. Value and big box retailers will continue to search in San Francisco and populate the suburbs to serve inherent demand.

— Dan Wald is a partner in the NAI BT Investment Services Group and Rhonda Diaz is a vice president at Terranomics Retail Services, both in San Francisco.

Office

The San Francisco commercial real estate market is expanding rapidly. With the Blackstone/Morgan Stanley property sales and demand driven by the technology and biotechnology sectors, dynamics are strong in both office leasing and investment activity. Average rental rates for Class A office space in the central business district (CBD) have risen to $41.25 per square foot, a 14 percent increase compared to second quarter 2006, when the average was $35.98 per square foot.

Coupled with rising office rental rates, the vacancy rate for Class A space in San Francisco’s Financial District is at its lowest point since the dot-com bust, at 9.5 percent. As a result, office and retail developers are making their move into the market. Downtown San Francisco currently has six projects under construction with a total of 1.8 million square feet estimated to be delivered by the end of 2008. The three biggest office developments are: Tishman Speyer - 555 Mission Street; Morgan Stanley - 400 Howard Street; and Shorenstein Properties LLC/ SKS Asset Services - 409 & 499 Illinois Street. Another 17 projects, totaling 3.2 million square feet, have been approved. Alexandria Real Estate Equities accounts for four projects totaling 962,900 square feet, with an estimated completion by year-end 2009. All of Alexandria’s developments are earmarked for biotechnology usage.

With availabilities tightening in San Francisco, especially in the CBD, most future projects are focusing on the South of Market and Mission Bay districts. It is estimated that more than 10.4 million square feet will be in planning and under construction by the year 2010, with the primary focus being in those two districts. Of those, there are eight projects located in Mission Bay and more than 15 developments designated for the South of Market district. Without any significant office space delivery in the market until the end of 2007, coupled with multiple buildings continuing to change hands citywide, expect to see office space rental rates escalate in the immediate future.

2007 started with a bang as the headline investment of 10 properties sold by Equity Office Properties to Blackstone Group LP set a record sale price of $2.5 billion ($675 per square foot). Yet another multi-asset portfolio purchased by Broadway Real Estate Partners, involving four properties totaling $800 million ($516 per square foot), closed in May. The expectations for both the office leasing and the investment sectors remain high for the balance of the year. For the rest of the year, rental rates should remain in an upward trend and vacancy rates will continue to decline until more office space can be delivered to the market.

— Tom Martindale is senior vice president and regional manager for TRI Commercial/CORFAC International.

Industrial

As 2006 concluded, the Bay Area warehouse/distribution market trends seemed clear. With more than 10 quarters of declining available inventory and rising rents, strategists pegged 2007 as the year for dramatic rent spikes. Three of the four major Bay Area markets continued the trend, however the largest, the Interstate 80/880 corridor, added 1.4 million square feet to the available inventory or 1.9 percentage points to the overall vacancy. The Bay Area markets consist of San Francisco County (12 percent of the market), San Mateo County (19 percent), Santa Clara County (21 percent) and the I-80/880 Corridor (48 percent).

The I-80/880 corridor tends to drive the warehouse/distribution activity for the Bay Area. At the end of 2006, the vacancy bottomed to a record low of 4.4 percent. Since then, vacancy has increased to 6.4 percent, yet asking rents increased by 12.5 percent. Quality property is in scarce supply; however large blocks of space were added to the inventory in 2007. In Richmond, Navistar vacated 242,720 square feet; in San Leandro, Levitz is leaving 240,170 square feet, Sear’s 311,000 square feet; in Hayward, Owens Glass Company is leaving 394,000 square feet. All of the companies mentioned have consolidated to other locations throughout the country. Although these are larger blocks of space, most are not capable of handling modern warehouse/distribution tenants and are speculated for a change in use or will require significant modifications.

Large vacancies have affected the market statistics, which is why we must look past the numbers. Excluding the Navistar building in Richmond, there are no vacancies greater than 100,000 square feet from Oakland to Richmond. From Fremont to San Leandro, there are only four buildings greater than 100,000 square feet that can be categorized as B quality or better. Beyond the I-80/880 corridor, only two exist in Santa Clara County and two in San Mateo County. The market is a lot tighter than the numbers suggest and this is evidenced by the significant renewals that have been completed this year. Rather than test the market, the following companies already completed lease renewals in the I-80/880 corridor: Excel Direct (78,000 square feet) and Everett Graphics (82,000) in Oakland; Cost U Less (81,000) in San Leandro; Sara Lee (84,000), Iron Mountain (147,000) and Brook Furniture (129,000) in Hayward; Spicers Paper (135,000) and Keebler (78,000) in Union City; and Corporate Express (164,000) in Newark.

Several companies relocated in the first part of 2007, thus leaving slim pickings for others: Pacific American Group (206,000 square feet), DHE (185,000) and Bobac Trucking (184,000) in San Leandro; Dealer Tire (144,000), East Bay Logistics (154,000) and Jaco Environmental (84,000) in Hayward; LA Specialty (130,000) in Union City; Special Dispatch (76,000) in Newark; and Alphaville (67,000) in Fremont.

It was mentioned earlier that asking rents are up 12.5 percent. Deal rents have not followed as aggressively, however that trend is about to change. Excluding the Sears and Levitz buildings from the San Leandro statistics, the vacancy is a stunning 2.6 percent. Likewise, in Hayward, if Owens Glass is excluded, the vacancy would be 2.4 percent. While San Mateo and Santa Clara counties’ vacancies continue to trend downward, it may take the I-80/880 corridor a few more quarters to adjust, however don’t let the numbers fool you.

— Joe Fabian is a partner specializing in San Francisco Bay Area industrial properties for NAI BT Commercial.

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