San Francisco remains the hottest city in the nation for commercial real estate, with office rental rates surpassing dot -com era prices this quarter. No slowdown is in sight for the near future, as rapidly growing technology companies continue to expand throughout San Francisco. Leasing activity is already at record levels, and San Francisco is on pace to finish the year with over ten million square feet of gross absorption. With tenant demand exceeding the nearly four million square feet of office space currently under construction, competition is high. Investment sales activity is increasing as well, as buyers hope to see how high this peak will rise, and are willing to buy at lower cap rates to take advantage of this upswing.
Employment – San Francisco’s unemployment rate fell even lower in the third quarter of 2014, down an additional 0.3% to 4.5% for August. The San Francisco area has experienced job growth of 3.3% over the past year, or 35,500 new jobs. Construction sector employment rose the fastest at 12.1%, due to the office and residential construction booms. In terms of overall number of new jobs created, professional services and technology jobs lead the pack, with over 12,000 since August 2013. There is no greater sign of San Francisco’s economic strength than this statistic: On average, six new high-skill/high-wage jobs have been created every business hour for the past year. The spillover to the office real estate market is noticeable. Companies need space for their employees, so as job growth continues, the San Francisco office market will grow to meet this need.
Sublease Space – Sublease space is typically a leading indicator of slowing real estate market growth. As bubbles in the market start to burst, tenants tend to put excess space on the market to improve their bottom line, giving a precursory look into how the companies within a local economy will affect real estate trends quarters into the future. Historically, increases in sublease space usually precedes slowing market growth by three to five quarters.
Many have had a close eye on office sublease space in San Francisco, as the market grows at unprecedented rates. The most worrying statistic is that sublease space, as a percentage of total office space for lease, has increased by 49% year-over-year. This figure on its own would be cause for concern; however, this increase is mostly due to a tightening in the direct leasing markets, as the total square footage of sublease space is increasing at a pace that is far below the levels leading to the last downturn. With no signs of a pending downturn and barring a “Black Swan” event, we anticipate the market will continue to grow to record levels for several quarters to come. The sublease metric, and many other leading indicators, will be monitored for any sign of slowdown, but all signs are pointing to continued growth.
Rental Rates – While rental rates for the office market are always detailed in our reports under Office Leasing, this quarter they have warranted their own category. Asking rental rates for Class-A office space currently average $55.12 per square foot city-wide. This number is artificially lower than the rate at which transactions are actually occurring, as choice real estate is often marketed without asking rates and closes in the mid-$60’s and upwards, per square foot. That is an important number, as this is very likely to be the last quarter where average rental rates are below the dot-com era peak of $67.20 per square foot. The office market’s strength will continue, causing rates to rise to record-setting heights.
Uber Lease – Uber has been no stranger to our Notable Leases list, as they have moved seven times since their founding in 2009. This quarter they inked a new deal for their eighth move, this time as developers. In a partnership with Alexandria Real Estate Equities, Uber will develop two buildings totaling 422,980 square feet in Mission Bay, which is enough space for 2,000+ employees.
Mission Bay’s recent building boom has been due almost exclusively to life science companies, making Uber the first major tech tenant to plant their flag in the submarket. The site at 1455 and 1515 Third Street was purchased from Salesforce.com, which no longer needed the land for a headquarters campus. Construction is set to begin in January, with delivery scheduled for late 2016. Uber plans to remain in their current Mid-Market offices after completion of the campus, which will put them near 1M square feet of occupancy in San Francisco.
Direct asking rental rates for Class A, B and C buildings currently average $55.12 per square foot, $42.84 per square foot and $39.29 per square foot, respectively. Year-on-year rental rates for Class A buildings are up 7%, year-on-year rental rates for Class B are up 10%, and Class C buildings are up 14%. There are no obvious signs that this rapid rental growth, which started in 2011, will stall anytime soon.
Net absorption (the change in occupied space) for San Francisco overall was a positive 211,196 square feet in the third quarter. While the third quarter did not see as many large leases over 100,000 square feet as the previous quarter, many mid-sized deals were inked: Moody’s KMV with 69,242 square feet at 405 Howard, Perkins Coie with 55,695 square feet, and Prosper Marketplace with 41,618 square feet at 221 Main.
The vacancy rate in the second quarter fell another 20 basis points, to 7.2%, making it even more of a landlord’s market. With much of the office space being developed already pre-leased, and record-breaking leasing activity, this number will continue to drop.
The investment sector outpaced the first and second quarters of 2014, with approximately $3.3B in sales volume, aided by the closing of multiple deals that were pending in the second quarter. Some of the major buildings sold in the third quarter include: 50 Beale for $395M ($597/SF), Foundry Square II for $390M ($774/SF), 650 California for $309M ($647/SF), 100 California for $182M ($667/SF), 60 Spear for $107M ($800/SF), and Waterfront Plaza for $88M ($296/SF).
The $3.3B in deal volume is comprised of 24 San Francisco market office properties. A total of 5.2M square feet transacted with an average price of $596 per square foot, which is a 37% increase in average dollars per square foot since the beginning of the year.
Correspondingly, the average cap rate for San Francisco office investments further compressed to 4.1%. A majority of investment sales in the third quarter are in the 3% cap range, with the lowest deal at a 2.5% cap rate at 100 California. By contrast, the national office cap rate average is 6.8%. Investors clearly continue to prefer office buildings in premier markets and are willing to pay more to acquire them.
Spotlight: Prop M.
Prop M is a law instituted in 1986 that limits new large office development in the city at 875,000 square feet each year, with unused allocations accumulating from year to year. The law’s main intention is to ensure that office development does not displace existing tenants in order to accommodate new growth. Twice before has this development cap come into effect, most recently during the dot-com boom. This year should be the third time that the Prop M limit has been met, as the current availability under the Prop M allocation has been exceeded by pending projects. There are 1.1M square feet of pending projects in excess of the 2.1M square foot remaining allocation of available space, which means that 3.2M square feet of office development projects are going to fight it out to build in a city with a rapidly shrinking vacancy. In addition to the pending projects, there are 7.7M square feet of office projects in the pipeline that have not yet submitted applications under Prop M. Given the current state of allocations, it would take a decade for these office projects to be completed under Prop M.
Prop M’s effects will be felt over the coming quarters, as vacancy tightens and the laws of supply and demand come into effect. Competition will increase, prices will rise, and tenants will be displaced out of San Francisco. This has already caused some tenants and developers to get creative, as we have seen with Uber this quarter. Uber is rapidly expanding, but there is a shortage of large blocks of space on the market. One of the main reasons Uber landed in Mission Bay is that their development site was already approved under Prop M for the previous owner, Salesforce. If the market keeps growing at the same pace and construction is unable to provide adequate supply, many tenants will be displaced.
Notable Leases Signed
- Uber: 422,980 s.f .- 1455/1515 Third St
- Google: 242,640 s.f. – 1 Market
- Moody’s KMV: 69,242 s.f. – 405 Howard (renewal)
- Perkins Coie: 55,695 s.f. – 505 Howard
- Prosper Marketplace: 41,618 s.f. – 221 Main
- 50 Beale: $395M or $597/s.f.
- Foundry Square II: $390M or $774/s.f.
- 650 California: $309M or $647/s.f.
- 100 California: $182M or $667/s.f.
- 60 Spear: $107M or $800/s.f.
- Waterfront Plaza: $88M or $296/s.f.