S.F.'s second gold rush

Mark Ritchie, president of Ritchie Commercial Real Estate in San Jose, refers to this era as California's second gold rush. The state is enjoying a wave of economic prosperity, and no area is more prosperous than Ritchie's own backyard. The area stretching from the Golden Gate Bridge to San Jose's Santa Teresa Valley is unquestionably the most prosperous in the state, and perhaps in the nation.

Statistics for the state as a whole are impressive. According to the state Department of Finance, California added 537,000 residents between July 1997 and July 1998, bringing the population to almost 34 million. The agency expects at least as much in-migration this year.

Employment is the major draw. Figures from the state Employment Development Department (EDD), show California enjoyed 38 consecutive months of record-breaking employment gains through June.

The San Francisco-to-San Jose region has matched or bettered the state on virtually all fronts. Its unemployment levels, for example, range from 1.9% in San Mateo to 3.6% in San Francisco. Many businesses cannot find qualified employees. According to Joint Venture: Silicon Valley Network, a Santa Clara-based business and government coalition, Santa Clara County will be short 160,000 employees this year.

Fortunately, business is strong enough to support good salaries and bonuses. According to Marcus & Millichap Real Estate Investment Co. in Palo Alto, half of Northern California's most profitable companies are located in Silicon Valley, an imprecisely defined area running roughly from south San Jose to Redwood City along the west side of San Francisco Bay, with an extension up the east side to Fremont. Whatever its exact boundaries, the latest data from the U.S. Department of Commerce reveals that in 1996, Silicon Valley accounted for 6% of the nation's export total of $494.5 billion.

Not surprisingly, area incomes are high. The most recent report from the state Franchise Tax Board reveals the five richest counties in the state are all in the San Francisco Bay area. Santa Clara and San Mateo counties rank second and fourth, with 1997 annual median incomes for joint tax returns at $80,253 and $66,904, respectively. San Francisco ranks further back in 17th place, since half the workforce resides outside the city in the counties ranking one through five.

As recently as 1994, two industries dominated the local economy, with the two neatly split geographically: high-tech in Silicon Valley and finance in San Francisco, with San Mateo County (generally referred to as the Peninsula) a mix of the two. Today the industries are the same, but their makeup has changed and the geographic distinction has disappeared.

Where computer and computer component manufacturing used to provide the majority of high-tech jobs, software, multimedia and Internet-related companies now dominate. Where banks and stock market firms formerly overshadowed all other kinds of finance, today they share position with venture capitalists, credit card issuers, REITs and financial advisory firms. And though finance has barely spread into Silicon Valley, high-tech and all its offshoots have definitely come to San Francisco.

Economy drives RE The changes have substantially altered both the real estate landscape and the real estate market. The rise of the software and programming end of high-tech has had a particularly significant impact. To begin with, it has created much greater demand for office buildings in Silicon Valley. Concomitantly, the amount of manufacturing space has declined to the point that brokerages such as San Jose-based BT Commercial Real Estate no longer include it in overviews. Research and development space has replaced manufacturing in importance.

Meanwhile, in San Francisco, a former warehouse and light industrial zone loosely known as Multimedia Gulch has grown to rival the traditional Financial District as the city's primary economic engine. In addition, a growing proportion of Silicon Valley and Peninsula high-tech companies are creating their own campuses combining office and R&D functions in one place. Many own or lease more than 1 million sq. ft.

What is most remarkable about the overall change is its rapidity. Rents in Multimedia Gulch doubled in the past two years. In late-1997, Los Angeles-based McCarthy & Cook Inc. and New York-based Blackstone Group bought China Basin Landing, a 728,000 sq. ft. office building at the nether reaches of downtown San Francisco. The acquisition loan, recounts Ed Cook, a partner in McCarthy Cook, was underwritten on the assumption of $24 per sq. ft. gross rents. A mere 18 months later, the property gets $45 per sq. ft. gross on five-year leases.

The rate is comparable to those paid for Class-A space in the Financial District, traditionally the city's economic hub. According to CB Richard Ellis, the average Financial District Class-A rent for the second quarter of this year was $48 per sq. ft.

McCarthy asserts the area around China Basin has even supplanted the Financial District as the number one office submarket. He points out the area had 345,000 sq. ft. of positive absorption for the second quarter, compared to 197,000 sq. ft. of negative absorption for the Financial District. "Eighty percent of new leases were for high-tech firms in [Multimedia Gulch]," he says.

A more challenging kind of rapid change, says Bill Allen, vice president of Newport Beach, Calif.-based Carlyle Realty, is tenants' explosive growth. It is not uncommon for high-tech companies to double and triple in size in a single year, and 30% to 50% growth is common. But, of course, companies can shrink as fast as they grow.

In a market with low vacancies and limited construction, it is extremely difficult to meet such fast-changing needs, Allen observes. "You get huge swings in demand," he says. "It puts a lot of pressure on the market. Both leases and development take a long time, but companies fortunes can change overnight."

The frenzy can be a landlord's or broker's nightmare, he says, but he notes it also creates significant real estate repositioning opportunities on a continuous basis. "If you can handle it, the rewards are substantial," he observes. "If you can't, it's disastrous."

Space at a premium The scenario for all categories of properties in the area is very similar. The office, R&D, warehouse/distribution, retail and multifamily markets all boast vacancy rates in the 5% and under range, according to all the major brokerages. When asked if retail vacancies in the area are low, Matt Alexander, a vice president in the San Francisco office of the Dallas-based Staubach Company just laughs. He says space is so hard to come by, the vacancy rate might as well be zero.

Rents are also up. According to Los Angeles-based CB Richard Ellis, average annual Class-A office rents have risen to $48.68 per sq. ft. in San Francisco, $43.44 per sq. ft. on the Peninsula and $39.96 per sq. ft. in Silicon Valley. Select submarkets do even better. Rents along Palo Alto's Sand Hill Road are in the $60 range.

According to Terranomics Retail Brokers in San Francisco, retail addresses in San Francisco's Union Square get up to $300 per sq. ft. annually, while neighborhood rents average $24 to $36 per sq. ft. John Cumbelich in the Walnut Creek office of CB Richard Ellis also puts Peninsula and Silicon Valley rents in the $24 to $36 per sq. ft. range, but in general they run $18 to $24 per sq. ft.

In Allen's opinion, the market's greatest attraction is the high barriers to entry. Buying in is difficult due to high purchase and maintenance costs; developing is difficult due to a shortage of land and subsequent high land costs combined with severe building restrictions.

The various barriers to entry have made the three-county area one of the most expensive investment markets in the nation. Both land and buildings command high prices.

Last fall Newport Beach-based Koll Development landed what brokers termed a good deal when it bought a 45,000 sq. ft. site in downtown San Jose for $9 million, or $200 per sq. ft. The site had approvals for a 300,000 sq. ft. office tower. Also, a 32,000 sq. ft. downtown San Francisco site sold for $21.8 million, or a whopping $681 per sq. ft. It had approval for a 50-story apartment tower.

More recently, locally-based Spieker Properties paid a slightly less stratospheric amount for 15 acres in Redwood Shores, the Peninsula's premier office location. The $35 million sales price works out to $535 per sq. ft.

Not all property is so expensive, however. Veritas Software Corp. recently paid $35 million for a piece of land - but it got 19.6 acres in Mountain View. Brokers consider the $40 per sq. ft. price an exceptional bargain, given that Mountain View is fast becoming one of Silicon Valley's prime corporate addresses.

According to Ray Garland, vice president in the San Jose office of CB Richard Ellis, low interest rates have prompted many retail owners to refinance rather than sell. With lower payments and rising rental revenues, the promise of elevated returns is attractive, he says. Given the prospect of little new development, properties should enjoy significant appreciation in the next few years, he adds.

"You have current owners who are enjoying the fruits of ownership," he explains. "They can wait until buyers become aggressive and drive up prices," he explains.

Nonetheless, significant sales have occurred in the past 12 months. According to the San Francisco Business Times, more San Francisco office properties have changed hands since December than in any equivalent period in history. Recent Class-A building sales have averaged more than $300 per sq. ft., and virtually nothing rentable trades below $200 per sq. ft. in the Financial District. A smaller percentage of Peninsula and Silicon Valley properties have traded, but prices there too have spiraled upward.

By far the biggest transaction in any category, apart from portfolio sales, was Boston Properties' late-December 1998 purchase of the Embarcadero Center, the six-building, 4 million sq. ft. office complex that is arguably San Francisco's most prestigious business address. The Boston-based REIT paid $1.23 billion.

Coming in second was the $300 million-plus July purchase of Parkmerced, San Francisco's largest residential complex, by a partnership of Carmel Companies and the J.P. Morgan Strategic Property Fund. The 144-acre development has 3,500 apartments and 60,000 sq. ft. of retail space. The sellers were Sierra Towers Corp., Fresh Meadows Associates L. P. and the Leona M. and Harry B. Helmsley Charitable Trust, all of New York.

The largest retail transaction was Los Angeles-based Westfield America's $152 million buyout of Maryland-based Rouse Co.'s 50% interest in Valley Fair, the largest mall in Silicon Valley.

Apart from the Embarcadero deal, REIT purchases in the city have been rare of late, but foreign, primarily European, investors have made a splash. German investors have purchased more than 2.5 million sq. ft. of local office space in the past six months.

REITs have been more active outside the city, where many commercial parcels are slated for business parks with 1 million sq. ft. or more of space. As an example, San Francisco-based AMB Properties bought a 21-building office/R&D compound in Menlo Park for $100 million.

Minimal new development is on tap. The three markets combined will see some 2 million sq. ft. of office space added this year, but more than three quarters of that is preleased. According to Grubb & Ellis, 1.04 million sq. ft. will be completed next year in San Francisco, but half of that space is already committed. G&E reports preleasing of 40% for the 1.2 million sq. ft. planned in the city for 2001.

The Construction Industry Research Board in Newport Beach reveals industrial/R&D development in San Mateo and Santa Clara counties is running about half of last year's level, with about 89 million sq. ft. of construction through April. All but 3.4 million sq. ft. was in Santa Clara County. Office construction was down by 71% in Santa Clara County. Retail was down further yet, dropping 80% in San Francisco. O

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