San Francisco Investment Demand to Stay Strong in 2015

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San Francisco Panorama 3By Joe Gose

Commercial real estate prognosticators across the board remain bullish on 2015, declaring that an abundance of low-cost capital will continue to boost property markets around the world.

[contextly_sidebar id=”26XJisG59sIldsonSbHcLtA18eKQ26y4″]Some, however, like Chicago-based LaSalle Investment Management, a real estate investment manager with $50 billion in assets under management, are warning that because it is late in the cycle, investors should exercise caution in anticipation of a downturn in a few years.

But the firm’s investment guidelines and other indicators suggest that the San Francisco Bay Area will continue to attract an outsized share of commercial real estate capital. Among other recommendations, LaSalle advised buyers to focus on investment themes inherent to the Bay Area: secular trends like technology or urbanizing markets that will be less exposed to a downturn, and sustainability.

“As I look at it, any forecast that says there should be caution is based upon looking backward and not necessarily looking forward,” said Russell Ingrum, the San Francisco-based managing director for the capital markets office practice at commercial real estate firm CBRE Group, Inc. “If you look forward, it’s hard to see anything troublesome.”

San Francisco’s commercial property prices have increased roughly 90 percent since the market bottomed in 2010, according to the January 2015 Moody’s/RCA (Real Capital Analytics) CPPI, a commercial property price index that measures price changes in repeat sales. That is about 18 percentage points more than the CPPI recovery in the United States as a whole. The technology boom has fueled nearly 300,000 new jobs in San Francisco over the same period, according to the Moody’s/RCA report.

Additionally, like last year, foreign real estate investors continue to rank San Francisco as the third most desirable market in the world behind New York and London, according to the latest annual survey conducted by the Association of Foreign Investors in Real Estate, which was released in early January.

The fact that few, if any, of the most coveted San Francisco office buildings are for sale has not soured interest, Ingrum said. Many structures have already traded or are controlled by owners uninterested in selling, but buyers are getting creative in order to increase their exposure to the city or establish a foothold in it.

“There’s a whole lot more demand for trophy properties than supply,” he said. “But buyers still want to be downtown, so maybe they’ll take a little more risk on a location they wouldn’t have wanted originally or take an older building that’s in need of renovation. We will see more of that this year.”

In some cases, high property prices require investors to accept lower returns than desired during the first couple years of ownership. But Ingrum wagers that buyers will be “pleasantly surprised” over time as lease rates climb. CBRE reports that asking rental rates for office space in San Francisco grew 14.2 percent to an average of $63.24 per square foot in 2014, thanks to 17 leases for more than 100,000 square feet each and pre-leased construction deals.

Plus, Class A office properties fetched an average sale price of $641 per square foot, the brokerage said. That’s still well below the replacement cost of around $950 per square foot, Ingrum noted.

“The cost of new supply is always the governor,” he said, “and as the cost of new supply goes up, developers are going to require higher rental rates for compensation.”

Some lenders such as life insurance companies, however, are wondering if the upward trajectory in rental rates can continue unabated, suggested Eric Von Berg, a principal in the San Francisco office of commercial mortgage banking firm Newmark Realty Capital, Inc. Thus, underwriters are beginning to more closely scrutinize debt service coverage ratios and other standards in the event office rents or hotel room rates drop, he said.

“When a hotel can charge $400 a night, that’s one thing,” Von Berg said. “But lenders are saying, ‘Let’s see what the deal looks like if we took rates back to 2008. What would the numbers look like then?’ So there is some concern.”

The potential that the market could run out of office space given Proposition M’s looming construction restrictions in the city also is generating some anxiety, Ingrum said.

“Price becomes the best allocator of scarce resources, so if we run out of space, prices will go up,” he added. “But if they shoot up too high too fast, tenants are going to start making alternative choices.”

West Coast Commercial Real Estate News