Brokers Wrangle With Evolving Future of Bay Area Real Estate Investments

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By Alice Yin

Convening panels from the Bay Area’s top investment sales and leasing brokerage firms, The Registry hosted its fourth-annual Mid-Year Broker Forum earlier this month in Redwood City to discuss the present market and assess its drivers entering the second half of a very dynamic and active year.

The investment panel, which took to the stage first, began its discussion with an examination of co-working businesses like WeWork, a company that is trying to innovate in this sector by matching empty office space with budding businesses. The New York-based office co-working firm is one of many that have sprouted since the Great Recession across the country. Drawn by the variable, and what seems to be affordable, pricing to rent an office or even a desk, tech startups and individuals have found such space an appealing alternative to standard, longer-term lease arrangements.

[contextly_sidebar id=”QkVolByugzgdJG89NcL34wqteha0VN6x”]“It’s the wave of the future. It’s collaborative. It’s creative. It’s what everybody’s looking for now,” said panelist Kyle Kovac, senior managing director of commercial real estate brokerage Newmark Cornish & Carey.

Operating from locations including San Francisco and Berkeley, the lessee business snatched up a chance to rent shared workspace during the economic crisis that left many commercial buildings deserted. The question, however, is if its success is here to stay.

Russell Ingrum, vice chairman and managing director at commercial real estate firm CBRE Group, Inc., was skeptical. He sees the primary user group as a generation that will eventually grow up and prefer traditional, fixed office space. When one converts the rental price of a desk in such places, she is often realizing the per square foot cost can be more than double the asking rent for standard office space.

“It’s got to be in the realm of fads. It’s relatively new,” Ingrum said. “The concept appeals to millennials who are commitment-phobic.” The question about its survival will be really tested as the market goes through another downturn, he added.

However, Kovac said that as long as people still need a place to go to work, WeWork will stay “as full, if not more full.”

While the focus on co-working was addressing a relatively new phenomenon in the Bay Area’s commercial real estate space, the main point was to highlight one of several themes that could have a strong impact on the office market overall.

Another significant trend was that of increasing valuations of San Francisco’s office buildings—primarily driven by the foreign capital-chasing deals throughout the region.

JLL’s Menlo Park-based Managing Director Erik Doyle said the money is “coming from every door.” Believing that this stage is just an early phase, he suggested San Francisco’s cap rates could drop even lower. Typically, he said, there is one global region that seems to be more prominent in its efforts to acquire real estate around the Bay Area. Today, that demand is coming from all corners of the globe, according to Doyle.

Currently, the city’s office buildings are at a 3 percent cap rate, said panel moderator Luis Belmonte, a partner in San Francisco-based real estate development company Seven Hills Properties. According to a recent CBRE study, San Francisco leads the nation with lowest cap rates for office buildings.

The prime yield and cap rates in the U.S. make investing here a safe alternative, Kovac said. He predicted that San Francisco is certain to see foreign capital driving a stake in development next.

“What you’re seeing is partnering with local developers to get into the market from the ground up, which really we haven’t seen until recently,” Kovac said. “I think that’s going to continue being a trend.”

Greg Cioth, managing director at real estate investment banking company Eastdil Secured in San Jose, said special note should be given to foreign capital presence from Asia. Capital from the East is flooding in, but Cioth maintained that there must be a premium associated with these investments.

However, Ingrum upheld the notion that cap rates in San Francisco and the Bay Area are not entirely out of order. They are justified, he said, as “the low cost of capital is really affecting the core end of space.” He predicted that people have a couple years to get in and out of the real estate market before prices fall.

“If your rent is 40 percent below market, it should trade at a tighter cap rate than New York, where you’re at or maybe even slightly above [market],” Ingrum said. “The valuations are rational, I think the low cost of capital is really affecting the core end of the space where you’re getting unlevered IRR sub 6 percent. That makes sense in an environment when bonds are trading in 1 or 2 percent.”

Adding to that sentiment, Belmonte explained, “There’s an interesting point being made here in terms of where we are in the capital world and in general … non-single family real estate in the grand scheme of things is about 10 percent of the investment universe. So you need to watch carefully what’s going on in other segments. If the stock market starts trading at 16 or 17 times, and the bond market starts trading at 3 on the short end and 6 on the long end, it changes our whole world. You’ve got to remember at all times we are in competition with other products in the capital structure.”

The panel also touched on the crunch for San Francisco developers under Proposition M’s cap on new office development. Belmonte pondered its enforcement and where construction would push to as a result.

“San Francisco has some real issues that they need to address right here because there’s more demand than there is supply,” Ingrum said.

“[San Francisco is] going to be the most important city in the U.S. by far in the next 25 years,” said Doyle of JLL. The prominence of technology in every sector of the global industry will keep Silicon Valley and greater Bay Area an important economic driver of the world, he added. Dealing with a growth restricting regulation, such as Prop M, will be challenging, the panel agreed, even through the market does not seem to be reacting to that challenge quite yet.

“The interesting thing is that the issue of Prop M is clearly in front of everyone in developer and investment side, [but] that hasn’t caused valuation issues on residual land value, yet. It’s something that’s looming that people are somehow getting comfortable with it, but land values haven’t adjusted to offset that, at least I haven’t seen it,” said Steven Golubchik, a senior managing director in the San Francisco office of HFF.

The panel scrutinized San Francisco’s model up against New York City. Belmonte said the city, with its rent-control legacy and transit-first evolution, is becoming more similar to Manhattan. Ingrum added that while San Francisco doesn’t want to mirror the metropolitan giant, it is land-constrained and must consider growing vertically.

“The valley is run down from airport to other airport,” Doyle said. “Most cities [along the Peninsula] are reluctant to get vertical density … that could end up shooting them in the feet.”

San Francisco has, however, stepped up from being a secondary city—as it was in the last business cycle—where capital would eventually spill into, Golubchik said.

“It’s a top-tier city worldwide and people are looking at it on a national and international basis,” Golubchik concluded.

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