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There's a healthy stability in San Francisco real estate

San Francisco is No. 1. At least that's what the 1999 edition of Emerging Trends says.

Because The City by the Bay offers a true 24-hour environment and enjoys a super-tight Class-A office market, it is the city for real estate investment, the report says. However, new construction and an increasing vacancy rate have some believing the San Francisco real estate market has peaked.

Now the question is: How long before the inevitable downturn arrives? National Real Estate Investor recently gathered a group of local real estate experts to find out just that.

NREI: Julien J. Studley Inc.'s San Francisco office recently released its third-quarter 1998 Studley Report & Spacedata. Chris, can you give us your take on the state of the local office market?

Chris Lovell: I think overall, it's very healthy. Certainly, the rental rates that are being achieved are profitable for the landlords, which is terrificbecause I think everybody is trying to make more money - maybe they're making a little bit too much money right now. I hear people use terms like 'rental leveling out' or 'stabilize.' I don't know that stabilization is an accurate term in discussing rental rates because that implies that that's where it is, and that's where it's staying, and I don't think that it ever is any place very long or stays very long. There has been an increasing vacancy rate for the last four quarters, and I don't think that that's questionable. I think everybody agrees with that, and paradoxically or not so paradoxically, rental rates have continued to rise over the last four quarters as well. So, I think the stabilization concept is just really the top of the downward trend. The rentals are going to have to go down a little bit simply because, not only is the vacancy rate higher than it was a month ago and a year ago - and it's going to continue to go up a little bit - but because I don't believe the economy is going to continue to grow at a rate that is going to absorb the amount of new space that's coming on line because of renovations of existing buildings and because of new buildings and because of space being vacated by existing tenants. I think next year there will be 2 million sq. ft. of new space and another 2 million sq. ft. in 2000. That's a lot of space for San Francisco. I personally think that a vacancy rate that hovers between 8% and 10% is a very healthy vacancy rate. It maintains rentals at a price that is profitable to a landlord and is also a fair price to a tenant.

NREI: Mark and Monica, your companies are heavily involved in the leasing market. What do you see happening the the Bay Area?

Mark McGranahan: The analogy we've been kicking around the office is that as we head into the so-called 'flu season' - everybody's getting their flu shots - landlords are making the deals while they can because the rents are high and concessions are low, and I think there's a lot of uncertainty. It's still unclear, if BofA, post-NationsBank, decides to put a bunch of space on the market - that's what drives rental rates down on sublease space. While landlords are trying to make profits, sub-landlords are trying to minimize losses, and they get desperate. That drives our market down. It has traditionally, and I think it will again if indeed BofA and Wells Fargo, post merger, put a lot of space on the market.

NREI: Let's ask BofA. How much space will the bank put back on the market?

Bill Herrera: Well, I'm not on the facilities side of the bank, so I really don't know. The expectation is that it will be a considerable amount of consolidation, most of which will happen right here in San Francisco as we move our corporate headquarters to Charlotte. A lot of the functions that were done here will be moved there, but the amount of space, I don't know. Possibly as much as 1 million sq. ft. I keep hearing that number.

Monica Finnegan: I think to sort of complement some of Mark's comments, you also take a look at the demand, and we happen to be the leasing people for 101 Second, which is a new construction building, and for 1 Market, which is a rehab. We're seeing a lot of the tenant activity that's in the market area right now, and we're tracking 2 or 2.2 million sq. ft. of tenant activity, whether that means renewal and going out to the marketplace to see what kind of opportunity you can get out here, or whether is an actual new requirement. But, I still feel - this is just sort of the intuition thing and also backed up with some of the facts - I still feel it's pretty strong. There's still some strong demand, and the demand hasn't necessarily all been settled down and fulfilled yet. One other thing, we just finished our third quarter statistics, and we were doing a third quarter '97 vs. '98 comparison. Rents jumped 34%, according to our statistics, from third quarter of '97 to third quarter of '98. So that's a real steep, not unnatural, but a real steep jump compared to what has historically happened. So, even if we do stabilize rents, by all the other measurements, it's still been a healthy run. We still should have a pretty healthy run from there. San Francisco, in my mind, is probably got much more infrastructure, rehab and redevelopment and development going on than in, I would say, almost any other city in the U.S. If you take a really good look at everything that's going on: rehab, ballpark, the bridge rework, the Presidio, Mission Bay, all of the things that are going on, it's pretty phenomenal, and it makes it feel very, very strong not only within San Francisco, but around the Bay.

NREI: Ed, what are some of your observations from the suburbs?

Ed Hagopian: At Bishop Ranch, we're the largest supplier of office space in Contra Costa County, and the vacancy rates - probably for the first time in many, many years - have been single-digit in all of the markets. Our vacancy rates in Contra Costa County for prime, Class-A space have been running around 3%. And in the last three years, we built and leased up over 1 million sq. ft. What you have, probably for the first time since the 1970s, is a huge disparity in downtown office rents vs. some of the suburban office rents - not Silicon Valley, not the Peninsula - but in Contra Costa County and Alameda County. We have a substantial disparity in rents. Now, tech has been driving the south part of the suburban markets. Tech has been driving some of the San Francisco decrease in vacancies, especially South of Market. And with the slowdown, I don't know what's going to happen. But, our market in Contra Costa County is extremely healthy, and right now we have half a million sq. ft. under construction.

I spent 20 years in downtown San Francisco, and I've been in the East Bay now for 10 years, and it's very, very interesting having the experience of spending the majority of my career in the urban center and then going to the suburbs. You reach a point where a tenant is not going to pay $50 a sq. ft. to go South of Market. There are a limited number of trophy buildings: 101 California, the Bank of America Building, the Embarcadero Center - buildings like that that can command the high rates. But when you start looking at a $25 a sq. ft. disparity in rents, those tenants are going to look at their options. And I don't think the tenant that's going to pay $45 a sq. ft. necessarily wants to be South of Market. What you have is new industries that have gone South of Market that are, in all due respect, they're startups. They're non-credit. They're not the type of companies that historically we as owners would invest a lot of capital in and take those risks. So, they're paying those rents because that's the space they have, and that's the only space they can get.

Finnegan: I also think you have to keep in mind there is, with the Gen-Xers if you will, some sort of synergism and some sort of recruitment issues and some sort of connectivity to different kinds of businesses. So, maybe not all will end up looking at East Bay as an option because that might not fit the synergism that they're looking for. But, I think you will find some that will look at both areas.

Geoff Sears: We own about 3 million sq. ft. between the Bay Bridge and Richmond-San Rafael Bridge. We have a whole menu of different project types there including a Class-A building that we'll complete in April. We certainly see the East Bay kind of operating as a mirror to San Francisco in that if you take Oakland to Richmond, it's got the full range of product type. Oakland has more sort of plain vanilla high-rises, 10-years-old but certainly serviceable. Emeryville and Berkeley, where we own a lot of product, are probably a mix of products: a lot more rehab and lower-scale that might be more commensurate with South of Market, and then Richmond is more on the industrial and office mixed inside. We see a lot of tenants looking over here, over where we are from San Francisco, because you can offer rents that are 30% or 40% less expensive and still try to meet those things that, you know, if you like a funky, eclectic environment, Emeryville-Berkeley might serve you. If you want sort of a typical high-rise environment, you can go to Oakland. Transit is still there. There are still services. I think it really gets back to the quality of life, because at some point someone says whether it's a $15 premium or a $20 premium, 'What amenities, what quality of life am I buying for that extra premium?' One of the problems that The East Bay has had is it hasn't had a big inventory. I mean, Berkeley and Emeryville have had just about zero availability, so it hasn't offered people the opportunity to come and look over there. That's not the case anymore. We're building things; other people have property over there. And now that there are places to look, I think we're getting a lot of interest and that will just happen slowly.

NREI: There was a story on Page One in the Oct. 27 New York Times about Silicon Valley losing some of its momentum because of the Asian crisis, with the manufacturers of hardware and chips not having as big a market over there. Has that affected the local real estate market?

John Diserens: That Silicon Valley is a problem that's waiting to happen; it's not going to wait too long. I think that's tenant-driven in the Valley. They're taking a large amount of space on the assumption that their expansion will continue, and that is a sublease market that's just starting to emerge that will have impact on a number of landlords and tenants.

John Herr: You know, I agree that the economy is having an effect on the Silicon Valley, but one of the things that balances the effects of Asia is the diversification of the Valley today. It's not just a PC-, hardware-based economy. While semi-conductors and semi-conductor-related industries are very soft - and that's what's really contributed to that big increase in sublease space - there's a balance in that Internet, Internet-related and communications-software companies continue to be strong. And so, there's anecdotal evidence as well as statistical evidence of a balance in strength. But the end result is flat, and it's affecting leasing and investments differently.

Paul Lee: I second that. I think the multimedia portion of the high-technology industry is undergoing a tremendous, explosive growth, and it's a continuous trend. It's not only affecting the South Bay, Peninsula and East Bay, but it's happening right in the heart of San Francisco. The traditional boundary between North of Market and South of Market is blurred, very blurred, in large part due to the current market's tightening position and the definition of a tenant, 'a credit tenant.' When you look at 101 Second, you look at 199 Fremont, you look at the two major lead tenants - a financial services tenant, that as an industry is about one-third of our city's industry component. These folks are there because they're looking for cutting-edge technology, buildings that offer state-of-the-art safety systems that many of the Class-A trophy buildings here in downtown, quite frankly, don't have.

If I may just add a little bit of my self-observation of the Asian market influence on the investment side here. While the high-tech, software-dominant industry is being affected by the Asian problem, we see its effect on the city's investment sales to be predominantly capital-driven. If you look at the current plus-or-minus 16 buildings that are either widely marketed, quietly marketed or to-be marketed, about five of them are Asian owners selling. They represent about one-third of the value of the property. Why are they selling? If you look at individual property, it is because of what's happening back home, not what's happening here in the city. It has a little bit of effect, but the traditional discrepancy between a buyer and seller's expectation, narrowed down probably to its height three or four months ago, and with what I would call 'The Dallas-ULI Effect,' instantly, you're getting back to this blip, and there's this 10% automatic discount. But, we on the investment side, see this imbalance to be an aberration. We believe as of the first of next year, given the underlying strength of the San Francisco economy, there is no reason why we need to take this inverse movement.

Lovell: So you're saying that sales prices are going to rise?

Lee: No. I'm saying that the sales prices took a temporary dip in the last month [October 1998]. We can point to at least two properties that are currently under contract, that, had they been on the market two months earlier or two months later, it would be a different price.

Herr: I think in every submarket there's been a lot of deals that have fallen out in the last 45 to 60 days, and it's short-term. There is a ULI Effect; there's confusion. This is really relating to investment. And there's all of a sudden a lot of capital on the sidelines waiting to look, and they're looking to the spread to try to understand what's going to occur and be ready to take advantage.

Lee: It's a wait-and-see attitude.

Gary Faber: I want to get back to downtown San Francisco. It is moving South of Market. I think some of us resist that, but to have service companies and accounting companies moving there is a sign that they want to be located where the future is. And where is the growth in San Francisco? It is only in South of Market. It really offers an entire mix of uses, a diversification; I like that word. Whether they're high-tech or whatever, it's a live-work environment. That's really the vision for South of Market: residential and commercial and retail. That's the future of it. It's nowhere else in San Francisco but South of Market.

NREI: Let's hear the multimedia and high-tech perspective from Dennis.

Dennis DeAndre: I was kind of laughing because I am actually the typical person you're talking about. We're an office that occupies about 7,000 sq. ft. We're an expanding multimedia company, and we're a venture-capital-backed company. The great majority of the money that flows into the expanding industry flows through Menlo Park. You have the majority of the talent - not only from a lower-level programming side of it, but also from a startup managerial, experienced side of it - coming from Sunnyvale all the way to San Francisco. I'm from the East Bay; I'm from Berkeley. I actually grew up in Contra Costa County, and I'd love nothing more to move my office to where I think the quality of life is very good here, which is Contra Costa County, and the rental rates are certainly lower there. I think that it's extremely difficult to start a multimedia company anywhere outside of the Sunnyvale-to-San Francisco marketplace. I think that if you're looking at what's going to happen in the future, I don't study the Bay Area marketplace - our system that we run is a North America-wide system - but if you want to look at the expanding marketplace, that's the multimedia marketplace. Capital going into the multimedia marketplace is expanding, and the expansion that's going into the venture-capital pool of investments is going to fuel it not just today, but it's going to fuel it for the next three to four years. So, you can anticipate that multimedia companies will expand. They'll die, but they'll continue to grow, too. And if you're looking for talented management, if you' re looking for money, the farther you go from Menlo Park, the more difficult it is to run a company. I think that the amount of money that you have to pay for and the quality of office space that you can get in Sunnyvale is a complete joke. At the same time, if that helps me attract a much more valuable vice president of marketing or vice president of business development, you can bet that I'm going to locate in Sunnyvale. We have an office in Burlingame and San Francisco right now, and it's interesting riding up here in the morning because I work out of our Burlingame office. There is a commute that leaves San Francisco in the morning; there is no commute that comes into San Francisco in the morning. It's been like that for about two years as far as I can see. So, I think that you definitely seeing a turnaround. We work in the commercial industry, but I'm coming from more a perspective of a tenant.

NREI: Gary, how's it going at 199 Fremont?

Faber: It's going very well. We just made an announcement [the week of Oct. 25] that the Fremont Group will be locating in the top seven floors of that building - 80,000 sq. ft., so we're 55% there, and we're looking forward to really 80% by the end of year. That's our goal.

NREI: When will the it be finished?

Faber: April of 2000 is when PricewaterhouseCoopers will be the first to move in. Fremont Group being on the top floor, probably will not move in until September 2000. I'm very happy to say we're not trying to make a Dec. 31, 1999, deadline. It's just one more challenge that would just be impossible for us.

Lee: Gary, I would be curious to hear you comment about the very healthy rents that you were able to achieve.

Faber: Very healthy rent, and the proposals that are out there - that's why I have used the word 'stabilize,' because I do want to go back to this ULI Effect. I was very disappointed when I was [at the Fall Meeting in Dallas] because the emphasis was on what's going in the capital market and the international markets, but when you look at the fundamentals of real estate, the supply and demand, we're not the early '80s; we're not any of these previous markets. We are in a 4%, and we're still agreeing that 8% vacancy is kind of a healthy vacancy. I use that broad term 'stabilize.' Real estate people don't like to be stabilized. They like to be either up or down; it's kind of part of the drama of being in real estate. But really, it's that equanimity or that stable range that really is the health that we're all looking to achieve, and I say we're there now. And we will be there for the next few years.

Finnegan: We're healthier now this time around than the last 10-year-ago crunch, or something like that. The real estate industry is much more healthy than when the so-called recession hit last time. We're dealing with a credit crunch more so than a real estate overbuilding, so they're shouldn't be as much dip-down.

Herrera: And the point is that the credit crunch is driven by the capital markets, and not the fundamentals of real estate, as you say. Our loan portfolio - I don't have any classified credits, and that's a very unique situation. Either we're too conservative or something. But I think that speaks loudly that we don't have any criticized assets, yet we're approaching the market with a lot of skepticism and concern about what's going to happen.

Diserens: We have our analyst call [Oct. 28], actually, and one of the issues that comes up each quarter is this issue of growth in earnings and the impact on acquisition volume. This year, we'll do about $1.3 billion in acquisitions, and next year I think that will go back to a normal level of about $500 [million]. And that's largely driven by cost of capital, which ultimately gets to the real estate market; it just does because with fewer dollars chasing, that deal is going to end up moving your pricing. Similarly, on the demand side, it's about earnings; it's about companies' earnings and their ability to grow their business, the same as our ability to grow our business. The fact is earnings are stabilizing. Maybe that's the term we use too much, but certainly slowing. Corporate earnings are simply slowing, and that ultimately drives the demand side for space - whatever type of space: office, retail, industrial. They are just simply facts. To sort of isolate that from the real estate business is just a temporary phenomenon, and it ultimately is going to affect it. Our pricing on acquisitions in the last month has dropped 50 basis points on cap rates across the board, across product types and across the country. We are finding both on the buy side and on the sell side that the number of buyers is largely halved, at worse halved. So it really is happening. If it hasn't crept dramatically into the office market, it will more so. And I think it's going to be there for the next 12 to 24 months. A 1% inflation market and a 1% growth in earnings market, it's just reality. We think it's going to stay there certainly through the next 24 months.

NREI: One last question: When will this market peak, if it hasn't already?

Faber: I think it has peaked.

NREI: Down in L.A., they say the best is yet to come.

Sears: Well, that's what they always say.

NREI: Thank you all for coming.

Roundtable Participants

Dennis DeAndre President and Founder LoopNet Inc.

Bill Herrera Regional Vice President Commercial RE Services Group Bank of America

John H. Diserens Managing Director/Retail AMB Property Corp.

Paul P. Lee Managing Director Sonnenblick-Goldman Co.

Gary A. Faber Vice President Fremont Properties

Chris A. Lovell Senior Vice President

Julien J. Studley Monica Finnegan Managing Director CB Richard Ellis

Mark S. McGranahan V.P./Managing Director Cushman Realty Corp.

Edward Hagopian Senior Vice President Sunset Development Co.

Geoffrey B. Sears Wareham Development

John S. Herr Senior Vice President CarrAmerica Realty Corp. Moderator:

Tony Wilbert Editor

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