Kidder Matthews San Francisco Office 2nd Quarter 2014

San Francisco remains the hottest city in the nation for commercial real estate. The 714,000 square foot Salesforce lease at 415 Mission Street (formerly known as Transbay Tower and renamed Salesforce Tower) signed during the second quarter is the largest office lease in San Francisco history. Massive pre-leasing deals such as this, along with continuing investment and redevelopment activity, show that both tenants and institutional investors still see value and potential upside in San Francisco despite the huge market gains of the past few years. It is clearly their belief that the market fundamentals are strong enough to support current rents and sales prices into the future.

Market Drivers

Employment – San Francisco’s unemployment rate continues to drop from 4.8% in December to 4.4% in April. The unemployment rate hasn’t been this low since 2008. The number of jobs in the City is currently at an all-time high (623,000) and the number of employed city residents is also at a new high (466,500). The City is expected to add even more jobs in the near future. California’s unemployment rate dropped substantially from 9.0% in May last year to 7.6% in May 2014. The national unemployment rate fell from 6.7% in February to 5.9% in April.

Unentitled Land – With ‘soft’ and centrally located development sites already being developed, and development friendly zoning changes to Western and Central SOMA, developers have been giving SOMA lots of attention. The extensions of Caltrain to the Transbay Terminal along with the Central Subway have added even more value to these highly sought after properties. With some developers desperate to get hold of a piece of land, many are willing to spend the money and time to get the entitlements for larger projects.

Alexandria Real Estate Equities bought the collection of industrial properties and warehouses at 500 Townsend for about $117 per buildable square foot, or $50M. The properties make up 1.23 acres of developable land, which Alexandria plans to develop with labs and biotech facilities. Alexandria wants to expand life science facilities and labs beyond Mission Bay and use this plot of land as their bridge into SOMA.

We are keeping a close eye on the sale process of 701 3rd, a 13,750 square foot parcel in SOMA, and 424 Brannan, a 21,348 square foot parcel, both unentitled lots. They are estimated to fetch about $170 per square foot of land. Each of these sites is suitable for over 100,000 square feet of mixed-use residential or office. Just like 500 Townsend, these plots also have a way to make some income while going through the entitlement process; 701 3rd has a McDonald’s and 424 Brannan is currently a parking lot.

It is also speculated that the change in the Central SOMA Plan, which could allow for a development up to 200 feet, will cause 645 5th to come on to the market. This is currently owned by the Bay Club as tennis courts. The parcel is zoned for residential use and although Bay Club has not mentioned its plans for the properties, it will be highly pursued by developers.

Salesforce Lease – Salesforce’s record 29-floor, 714,000 square foot office lease at 415 Mission is the largest lease signed in San Francisco history. The lease and building improvements are worth an estimated $1B; the magnitude of the transaction will put Salesforce’s name on the preeminent building in San Francisco. This was a rare opportunity that Salesforce jumped on, thus creating “Salesforce Tower”.

Salesforce’s plan is to create an urban campus in the middle of the South Financial District. By 2017 this campus will be comprised of their leases at 415 Mission, 350 Mission, 50 Fremont, 101 Spear and their current headquarters, 1 Market. In total their campus will comprise over 2.1M square feet in the South Financial District (the equivalent of more than four Transamerica Pyramids).

Office Leasing

Direct asking rental rates for Class A, B and C buildings currently average $52.69 per square foot, $41.99 per square foot and $38.05 per square foot, respectively. Year-on-year rental rates for Class A buildings are up 12%, year-on-year rental rates for Class B are up 14%, and Class C buildings are up 15%. 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 775,110 square feet in the second quarter. The second quarter saw four leases over 100,000 square feet commence: Salesforce with 228,721 square feet at 101 Spear, NeuStar with 144,000 square feet at 505 Howard, LinkedIn with 134,539 square feet at One Montgomery and Medivation with 127,165 square feet at 525 Market.

The vacancy rate in the second quarter fell from 8.2% in the first quarter to 7.4%, making it even more of a landlord’s market.

Norwest Venture Partners set the high water mark for the second quarter and almost set a city-wide record with a five-year, 2,000 square foot lease at $117 per square foot at 123 South Park in Rincon/South Beach. This deal was still a bargain compared to the rents in VC country on Sand Hill in Palo Alto.

Investments

The investment sector has been able to keep up with its first quarter sales pace of $1.8B in sales volume, recording $1.7B in the second quarter, with multiple deals pending. Some of the major buildings sold in the second quarter include: 22 4th for $354M ($965 per square foot), 225 Bush for $350M ($629 per square foot), 55 2nd for $276M ($728 per square foot), 221 Main for $228M ($590 per square foot), 888 Brannan for $190M ($447 per square foot), and 33 New Montgomery for $147.5M ($610 per square foot).

The $1.7B in deal volume is comprised of 20 San Francisco market office properties. A total of 3.6M square feet transacted with an average price of $539, compared to $434 in the previous quarter, which is a giant 24% increase in average dollars per square foot over just a 90 day period.

Correspondingly, the average cap rate for San Francisco office investments decreased to 4.2% from 4.8%. By contrast, the national office cap rate average is 6.0%. Investors clearly continue to prefer office buildings in premier markets and are willing to pay more to acquire them.

Spotlight: Prop B.

Prop B. passed on June 3rd and will require voter approval of all projects which exceed current zoning height limits of 40 feet or higher on Port of San Francisco controlled land. This will affect much of the highly sought after real estate along the 7.5 waterfront miles controlled by the Port. The passage of Prop B will directly reduce the number of potential new condos and apartments in San Francisco – further limiting the housing supply in this housing starved city. By reducing potential development, Prop B will correspondingly reduce the amount of affordable housing – either through direct units or payments by developers to the city.

Two major redevelopment projects that are currently in the works will be effected by Prop B: the San Francisco Giants plans to redevelop Seawall Lot 339 and Forest City’s plan to redevelop Pier 70. Prop B makes these and any future development projects exceedingly difficult because developers no longer only have to win approval from the city but they have to spend millions to campaign for their project’s approval by the general public, which has been increasingly anti-development.

Notable Leases Signed
• Salesforce.com – 714,000 s.f. – 415 Mission
• LinkedIn – 450,029 s.f. – 222 2nd St.
• Dolby Laboratories – 70,365 s.f. – 100 Potrero
• Lyft – 65,494 s.f. – 2300 Harrison
• Braintree – 63,285 s.f. – 123 Townsend
• IBM – 53,323 s.f. – 425 Market
• Credit Karma – 47,182 s.f. – 760 Market

Notable Sales
• 22 4th – $354M or $965/s.f.
• 225 Bush – $350M or $629/s.f.
• 55 2nd – $276M or $728/s.f.
• 221 Main – $228M or $590/s.f.
• 888 Brannan – $190M or $447/s.f.
• 33 New Montgomery – $147.5M or $610/s.f.

West Coast Commercial Real Estate News