San Francisco Vacancy Continues to Climb as More Sublease Space Hits the Market

Newmark, San Francisco
Courtesy of Sebastien Gabriel

By Meghan Hall

As the end of 2020 nears, those in the commercial real estate industry are keeping a close eye on the San Francisco office market, which has seen its vacancy rates rise and rents slowly decrease amid extended work from home orders. But for those over at brokerage firm Newmark Knight Frank, San Francisco’s rising vacancy rate is really a story of two different perspectives: direct space and sublease space.

“[The market] has definitely changed dramatically from a year ago; it’s a completely different landscape than we had” explained NKF Research Director Andrea Arata. “There is definitely a lot more sublease space on the market.”

At the end of the third quarter, San Francisco had 85.5 million square feet of office inventory and a vacancy rate of 10.3 percent, a 750-basis-point increase year-over-year. During the third quarter of 2019, office vacancy in the city sat at around 2.8 percent. San Francisco’s availability rate has also increased, rising to 17.7 percent.  Availability has increased by more than 1.5 million square feet for the fourth quarter in a row, to 15.5 million square feet. At7.5 million square feet, sublease availability has increased five-fold since the same time last year, a number that NKF predicts will continue to grow.

For Arata, it was important to note that companies were placing space on the market, not because they were in distress, but with the hope of perhaps making some money on a space they were not currently able to use—a far cry from the dot com era when office vacancy shot up as companies floundered.

“It’s a very different market than during the dot-com bubble,” said Arata. “Right now, a lot of tenants putting space on the market, they’re good credit tenants. They’re good public companies.”

Arata added, “If you have a bunch of companies, and they’re not there; they’re working remotely. If they put the space on the market as a sublease space because they’re not using it, I tis a way of taking it off the books for a little bit. But it doesn’t mean  that all of these companies are actually in a dire situation and that they need to shed the space.”

San Francisco also experienced one of its largest drops in absorption in history, at a negative 2.2 million square feet during Q3 and a year-to-date total of negative 5.9 million square feet. Leasing volume came to about 375,000 square feet, not including renewals. As of the end of the quarter, 2020 leasing accounts for just 26 percent of the leasing volume over the same quarter in 2019. However, in a potential bright spot, tenant demand increased by 10 percent during the third quarter.

As a result, rents have begun to slowly dip, with overall asking rents decreasing four percent over the past quarter and down just 6.1 percent from Q3 of 2019. Rents now sit at about $80.98 per square foot, and $87.23 per square foot for Class A office space. Sublease space overall are about 7.7 percent lower than direct rates, coming in at $74.78 per square foot. Class A sublease space offers an even larger discount of 11.5 percent and rates of $79.08 per square foot.

“I think r rents came in higher than we expected, but part of it could just be that direct rents just haven’t fallen yet,” said Arata. “When comps are traded, [landlords and tenants] can start adjusting a little bit. But there’s not a lot of things trading right now…Once those comps start coming out, we could see a bigger drop.”

Direct rental rates have held thus far because for the biggest landlords, noted Arata, vacancy has held relatively stable as a result of reliable, credit-worthy tenants, while sublease space is likely to offer more flexibility in pricing. And, while the rates reported represent what landlords and brokers are officially asking for, NKF also stated that there is plenty of anecdotal evidence that there may be more wiggle room than meets the eye. Landlords are also more likely to offer concessions to fill direct vacancies prior to dropping rents.

When the market is expected to recover—or when recovery can even begin—is unclear. NKF believes that a vaccine or daily testing protocols will need to be in place before workers can return to the office fully.

“Looking across the country at major markets and the past few events, San Francisco was one of the first to be hit hard and one of the first markets to bounce back, if not the first market to bounce back,” stated Arata. “San Francisco has this fascinating history, being at the edge of things. I think in the long-term the SF market is going to be just fine…It might be rough between now and that point, but long-term the market is not disappearing.”

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