MARKET HIGHLIGHT, SEPTEMBER 2008

SAN FRANCISCO
Jeffrey Mishkin, Mark Mason and Chris Economou

Persistent demand and high barriers to entry are keeping the City by the Bay healthy.

Multifamily

While the national economy has faltered during the last year, the San Francisco metro has maintained solid growth, though signs of cooling are emerging as the year progresses. Buoyed by strong renter demand and high barriers to entry limiting supply additions, apartment vacancy in the metro area continues to remain extremely tight, which has given owners sufficient leverage to implement aggressive rent gains in recent quarters. Although employment growth is forecast to ease this year, a thriving tourism industry has boosted expansion in the leisure and hospitality segment, which, combined with healthy professional and business services payroll gains, has helped to offset losses in the struggling banking and financial sectors. Additionally, the increasing number of high-tech companies electing to open locations in the city’s downtown core, particularly in the South of Market area, has supported rental demand among young professionals seeking an urban living environment unmatched by some surrounding metros, along with brief commutes. As such, occupancy levels will remain elevated in 2008, though rent growth is expected to ease slightly from the gains recorded last year, as owners will be wary of pricing residents out of the market altogether.

By the numbers, job growth is expected to slow this year, as employers are forecast to create a total of 10,000 positions in 2008, a 1 percent rise, though down from 20,900 jobs added last year. Apartment inventory will stay in check this year, as there are no new projects slated for delivery in 2008. Last year, developers completed 750 rental units. A slowdown in employment expansion is expected to slightly ease renter demand, though no new additions to supply should keep vacancy relatively steady at 4 percent, a modest 10 basis-point rise. In 2008, tight conditions will enable owners to leverage healthy rent hikes, though at a more reserved pace than in recent quarters. Average asking and effective rents are forecast to expand 5.7 percent to end the year at $1,967 per month and $1,865 per month, respectively.

In the multifamily investment arena, sales velocity has lagged during the last year, as more conservative underwriting practices have limited some highly leveraged buyers. Additionally, some owners who are steadfast on pricing may find that the gains achieved last year will not likely persist, and adjustments in seller requirements may be necessary in order to close transactions. Meanwhile, buyers will take a more reserved stance when approaching potential investments, aiming for high-quality assets in a flight-to-safety approach. Cap rates have slightly risen to the mid- to high-4 percent range during the last 12 months, and are expected to modestly inch up by year’s end, as sellers strive to narrow the expectations gap. 

— Jeffrey Mishkin is the first vice president and regional manager of the San Francisco office of Marcus & Millichap.

Hospitality

A strong local economy and a steady flow of tourists have sustained a strong San Francisco hotel sector. Occupancy will remain very healthy during the next few months, although the effects of a weak national economy on travel will suppress room demand. As a result, increases in the average daily rate (ADR) will wane, producing a slower rate of room revenue growth than recently registered in the market, which consists of Marin, San Francisco and San Mateo counties.

Currently, a favorable balance of demand to supply in the market is pushing up occupancy. Through May, year-to-date occupancy of 71.1 percent was 130 basis points more than in the corresponding period a year ago. So far this year, a 3.5 percent increase in rooms sold to guests (or demand) was partly offset by a 1.6 percent advance in the number of rooms available. A few factors are driving room demand in the market, and probable changes in those demand generators in the coming months will affect hotel performance.

For starters, the market remains a top tourist destination. While a weak economy is crimping domestic travel, favorable currency valuations are bringing in tourists from Asia and Europe. Asian economies remain robust, while those in Europe are starting to weaken, indicating that room demand driven by foreign tourists may waver in the months ahead.

Also, passenger volume was up 8.2 percent at San Francisco International Airport during the 12-month period ending in May. Planned cutbacks in service among several airlines will likely have an adverse affect on hotel bookings, however.

Additionally, employment growth in the three-county region was strong through the early part of this year, supporting room demand related to business travel. Recently though, employment growth has started to slow. Staff reductions at local employers are a symptom of a softer business conditions and will weaken business-related room demand.

Despite the likelihood that fewer rooms will be filled in the months ahead, demand will remain strong enough during the balance of the year to support additional gains in the ADR. The rate of growth will be less than recently recorded, however. The ADR of $152.87 year to date through May was 6.5 percent greater than in the same period a year ago; it is expected to fall to the 5 percent range by year’s end.

Higher rates and steady demand elevated room revenue 10.2 percent during the first 5 months of this year. Combined with only a small increase in the number of rooms available, revenue per available room (RevPAR) of $108.73 was 8.5 percent greater than in the same period a year ago. Slackening demand will lower RevPAR growth over the balance of the year, although it will remain firmly in positive territory.

*Smith Travel Research provided occupancy, ADR and RevPAR data for this column.

— Jeffrey Mishkin is the first vice president and regional manager of the San Francisco office of Marcus & Millichap.

Retail

San Francisco’s high barriers to entry and demographic strengths are forecast to support one of the tightest retail markets in the country this year, though regional economic challenges will weigh on consumer spending.

In 2007, consumer demand supported retail sales growth of 5.4 percent; however, as payroll expansion moderates and equity spending further diminishes, retail sales are not projected to reach the robust levels attained in recent years. As a result, a measured rise in vacancy will be recorded in some property types.

San Francisco’s prime, street-level retail space continues to attract high-end national retailers, with both De Beers and Barneys New York acquiring space in Union Square during the past year. Despite the additions of these retailers, there is still a fair amount of vacant space available, even in the better areas of the city. Supply-side pressures, meanwhile, will remain modest as many builders target redevelopment opportunities due to the region’s land constraints. As new construction slows and occupancy levels remain near historical highs, owners should retain sufficient leverage to implement healthy rent increases.

By the numbers, job growth will slow from last year’s accelerated pace as many firms reduce expansion plans. In 2008, local employers are forecast to add approximately 10,000 workers, a 1 percent gain. Last year, employment growth measured 2.2 percent. Retail development is slowing in San Francisco. Builders are expected to bring

300,000 square feet of new space online in 2008, down from 370,000 square feet last year. Completions will expand total inventory by less than 0.5 percent this year, roughly 40 percent below the metro’s 5-year annual average.

Despite reduced construction activity, decelerated retail spending will contribute to a rise in vacancy. The vacancy rate is expected to end 2008 at 4.3 percent, up 30 basis points from last year. Asking rents are forecast to climb 2.4 percent to $34.38 per square foot this year, while effective rents advance to $31.79 per square foot, a 2.3 percent gain. Last year, rent growth was more significant, as asking rents rose 3.8 percent and effective rents gained 3.7 percent.

A flight to safety among buyers should help to prop up investor demand across the San Francisco metro area. While leveraged investors are projected to take on a diminished role due to higher debt-service coverage ratios, equity-rich fund and foreign buyers will remain the primary demand-side drivers, targeting ground-floor retail properties beneath residential space. Nevertheless, deal flow will likely continue to trail off in the months ahead as the inventory of listed properties remains limited. Tightened lending requirements may push cap rates modestly higher, though healthy revenue growth should keep prices near their current range. Looking ahead, well-located, anchored strip centers along commuter routes such as Highway 101 are expected to capture the attention of buyers.

— Mark Mason is a senior director of the National Retail Group in the San Francisco office of Marcus & Millichap Real Estate Investment Services.

Office

Fundamentals in the San Francisco office market are expected to reach more sustainable levels in 2008, following a year of robust leasing activity. Office tenant demand is easing in the metro, which has been relatively insulated from the economic turmoil that the rest of the country has endured over the last year, with some employers scaling back expansion plans. Continuing losses in the city’s banking and financial sector have been offset by a thriving technology industry, led by Google’s recent move to 200,000 square feet of sublet space formerly occupied by Gap. Climbing rental rates and an increase in sublease space from financial companies in distress, however, have left some prospective tenants and those with expiring leases seeking more affordable options. Combined with elevated completions, this will likely force owners to curtail rent growth. Nevertheless, rent gains will be among the highest in the country, ending the year up nearly 50 percent from 2004. Conditions will also remain tight, as vacancy is forecast to record only a mild increase.

By the numbers, metrowide employment growth will be more subdued this year, as payrolls are forecast to increase by 1 percent or 10,000 new jobs, down from the 20,900 positions generated in 2007. Employment in the office-using sectors will also slow with the net gain of 2,000 positions in 2008, compared with 9,000 jobs last year. Developers are expected to complete approximately 1.4 million square feet of competitive office space this year, a 1.6 percent increase in inventory and up significantly from the 336,000 square feet that came online in 2007. Heightened deliveries and easing tenant demand will place upward pressure on vacancy, which is expected to rise 30 basis points to 9.7 percent by year-end 2008. Throughout 2008, owners will likely pull back on the rate of rent growth, though gains will still be among the highest in the nation. Asking rents are forecast to increase 6.3 percent to $42.68 per square foot, while effective rents will end the year at $36.44 per square foot, a 6 percent rise.

Local sales activity has slowed in recent months as the marketplace recovers from a buying frenzy in 2007. More cautious investors are now approaching potential purchases with the underlying assumption that the still-strong market has begun to level out and will not attain the growth attained in previous years. Underwriting, meanwhile, has become more conservative, making it difficult for some deals to be completed. Sellers steadfast on achieving 2007 prices are finding that assets are no longer trading in that range, and those who are motivated to sell may be required to accept cap rates in the mid- to high-6 percent range in order to close deals.

Looking ahead, buyers will likely target assets in the South Financial District, where a bulk of the new development is occurring in an effort to create a downtown live/work hub. Opportunistic investors may look to the South of Market area, where a number of tech-related companies have recently leased space and rental rates continue to lag behind the metro average.

— Chris Economou is an office investment specialist in the San Francisco office of Marcus & Millichap.

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