Vacancies tight, rents rising say SF market leaders

San Francisco's real estate movers say good economic times portend steady growth ahead. Editor's Note: Normally when you hear about 2% vacancy levels and a lack of land you also hear despair and cries for help. Not so in San Francisco, where office vacancies are generally at their lowest level in a decade and rents have climbed to nearly $40 per sq. ft. on average.

We wanted to hear more about this happy circumstance diectly from some of the area's leading real estate minds, so we gathered them for an early breakfast at the Westin St. Francis Hotel recently for a chat. Here's what we heard.

NREI: What are some of the drivers behind the city's new vitality?

David Wall: We've had in this city for the last eight to 10 years, Proposition M, which was limited growth of only 450,000 sq. ft. a year. In the '80s when it was adopted, only so many projects would be approved in a year. We're one of the last ones, on a site at the corner of Howard and Field, that will be built. We have not really had any new construction of any kind. We've just been absorbing what we have. Finally the economy's turned around and we are getting a tremendous amount of growth internally and we're finally seeing in-migration, which I think last year was about a million sq. ft. of various multi-media firms, publishing companies and other companies coming into the city. We're seeing vacancy rates of probably less than 2% now in the institutional grade real estate. And we have a mayor that's pro-growth and would really like to see projects come out of the ground. It's a little easier to work with the city today.

Richard Pogue: The real driver of San Francisco is Silicon Valley, and will continue to be in my opinion. If you look at where jobs are being created and which sectors jobs are being created in, it's the high-tech and the multimedia and, as David pointed out, in the South of Market area. Historically, San Francisco has been the heart and soul of the Bay Area, but it's not that way anymore. When you look at the Bay Area, you've got to look at all of the seven major counties that make up the Bay Area. What is attractive to San Francisco is the housing, the restaurants, the hotels, all of the things that make a 24-hour city.

Wall: When we were dusting off our plans for our project, we studied certain Silicon Valley firms and the demographics indicated the average age was 28 years old, and more than 50% of the people who work in Silicon Valley live in San Francisco. To us, that showed that it was only a matter of time before many of those executives and people who live here in San Francisco ultimately are going to be officed here.

Jeff Mishkin: To underline what Mr. Pogue said, we're seeing renters actually moving up to San Francisco from the Silicon Valley to get relief in available rentals, and that combined with the existence of vacancy decontrol has just fueled a tremendous interest in the city.

NREI: What are corporations doing here -- expanding, contracting?

Steve Polito: Probably a little of both. We've had a large increase in the number of site location studies for out of the area, largely driven by the competition for the labor pool. Space is a problem. In the Silicon Valley, the vacancy is 2% or less depending on the area you're looking at. The bigger problem is the labor pool. Clients are competing for the workforce and finding themselves in the position where they're being forced to look outside the Bay Area. It's the tolerance for the commute. More people seem to be looking for the shorter commute.

In the corporations, we're also seeing with the mergers a consolidation that's bringing about a smaller space requirement. The vacancy is tight and as these people shake out their consolidations or mergers, they're going to be shedding some large blocks of space. The real question is you don't know exactly when.

Ed Hagopian: Hopefully when their leases expire, right?

Polito: You also see a lot of the corporations in the Valley that are buying space to build their own campus. If they build their own campus, they're going to be vacating space. Collectively they could put a fair amount of space back on the market.

James Ida: Not only are prices rising on land, but you also have companies warehousing it, which they really haven't done. You've got major corporations that are taking 50-and 100-acre parcels.

Jeffery Sears: You still need to focus on the quality of life. Because Silicon Valley is a fundamentally intellectual capital business. All those smart people probably have a lot of places to choose where they're going to live and yet it's not going to be adjacent to other smart people and foster creativity. So one thing to keep in mind is the quality of life here is very good.

NREI: Let's tackle the office market. Absorption is up to about 1 million sq. ft. in the first half of 1997, rents have risen from the high-$20 range and could hit $40 next year. What are the dynamics behind this growth?

Michael La Horgue: The main factor now is there is simply a lack of supply. There just isn't space. We have a number of buildings where tenants who want to expand in the building can't. People who want to come into the property just can't. We've always been able to move people around, help people grow and shrink, but right now we're really stuck.

NREI: Doesn't that signal a need for new construction?

La Horgue: I don't think so. There's that kind of vacancy in a number of cities across the country. Around the country we see more development in the suburbs, when things get tight in the financial districts or the downtown areas, whether it's a Charlotte or a Nashville, or any number of places, you've seen the development out of town. That's going to happen more here as well.

There aren't that many great sites to build on in San Francisco. If you had heart of the financial district sites to be built on, you'd see them being built on right now.

Rich Robbins: If REITs start buying sites you'll see speculative building. For traditional builders with traditional financing, it will take us at least 70% preleasing before we start developing.

Hagopian: If you understand San Francisco being a very finite land mass and if you look at the history of the city, the great land sites for future development are gone. The Bank of Americas, the Embarcadero Centers, I don't think you'll see anything built of that size. (Today) you're talking about something that's 200,000 to 400,000 sq. ft. which really doesn't impact the market per se. What's happened is the city has grown tight. The big companies down in the Valley have bought 50- to 100-acre parcels and they're sitting on them, so it doesn't leave a lot of opportunities. Fortunately where we are, out in Bishop Ranch and San Ramon, in the last 18 months, we've built roughly 800,000 sq. ft. of speculative office space. We've been very fortunate to lease most of it up, but it's interesting to note that the growth comes from within that market, that being the 680 corridor, some growth coming from the Silicon Valley and some from San Francisco, but not in the quantities that we would like to see in the 100,000 to 150,000 sq. Ft. requirements.

Frank McDowell: As opposed to a lot of cities, the CBD of San Francisco is a very difficult market to relocate out of, mainly because of mass transit. We took a look at it a year or so ago, we have a relatively modest downtown employee base, but what we found is when we looked at our people, we would have disrupted the commute patterns of 80% of our staff, who either live in the city or use mass transit that would not have been available as an alternative.

We anticipate that we would have to restaff 50% to 60% of our employee base in a very tight labor market, and that's not a very attractive alternative.

Thomas Kasten: The last time we saw a market like this, with this kind of absorption and rent increases was in the early-'80s, and rents got in excess of $38 on an average in the financial district. The market was driven by several large tenants -- Itel, Bank of America, the phone company, British Petroleum. They were all taking every bit of space they could and warehousing it. The complexion of the San Francisco market has changed. San Francisco has become more of a boutique city. The average size has gotten smaller, many of these back-office kinds of functions have gone out of town. In the early-'80s there was a big discrepancy between rental rates in the city and on the peninsula, and the other suburban markets. Nowadays, in Palo Alto, Walnut Creek and Bishop Ranch, there isn't nearly as big a delta between San Francisco rents and suburban rents.

Hagopian: I disagree with you on that Tom. The disparity in rents has grown significantly and that really does impact occupancy costs. For example, I think typical rents in San Francisco are conservatively $30 to $40, while rents in our product are in the $24 to $26 range, so you're talking $10 a sq. ft. differential on a substantial office requirement. That disparity I don't think will continue to grow. I don't think you're going to see rent levels just go off the charts. I think they've pretty much peaked out, simply because there's no inventory to turn over.

La Horgue: You've got to raise your rents, Ed! (laughter)

Kasten: In the early-'80s though, Ed, if you recall, if average rents were $38 then and let's say they're $32 now, which is what our research says they are, the rents in the suburbs were nowhere near what you're talking about. They were low.

Hagopian: They were $12 to $18.

La Horgue: What Tom is saying is it may not be your particular product or your area, but the suburbs as we know it, where people were always running to after the urban decays, are no longer an alternative for many of these users because the rent thresholds are very close to or higher than what they are in the city.

Hagopian: We all kind of go by the heartbeat of San Francisco. Our philosophy has always been as San Francisco goes, so goes the suburbs. But I think in the past few years, you have created independent markets that now thrive on their own tenant base.

La Horgue: Not only that, the rents in San Francisco haven't been this high for very long. It's onlyrecently that rents in San Francisco have spiked the way they have.

Robbins: A lot of the companies that we deal with are far more interested in the quality of life, how far are they from affordable housing, the potential for mass transit. A lot of companies, in particular I think some have mentioned the average of what we call the 'juice freaks' about 28-30 years old, they don't work typical hours, they earn between $60,000 and $500,000 every year (laughter), they can go to work with their dog, it's in Emeryville and Berkeley and anywhere they want it to be because with the technology and communication systems today you're not a slave to a location. Yes, San Francisco will dictate to some degree, but to a larger degree, people ignore what's going on there. We're more concerned with corporate strategic alliances which may take decision-making away from the Bay Area.

NREI: How is the downtown being affected by the new developments in the South of Market area, for example?

Kasten: The Yerba Buena project is one of the hottest non-office markets in San Francisco, and San Francisco already is one of the most desirable tourist locations in the country. I think it's just going to enhance that. The Sony project with 16 cinemas and the children's center with ice-skating rinks and more hotel rooms are going to make that whole Moscone Center experience even more desirable than it has been in the past. It's going to be seen in retail sales and major hotel sales. There is a lot of hotel development going on right now, some adaptive reuse. 500 California Street has just sold at a price of about $190 a sq. ft. for a hotel site as opposed to an office building. One Market, the old Southern Pacific headquarters, is most likely going to be another hotel.

NREI: Who are the players right now in the investment arena?

La Horgue: Zell is the biggest buyer in San Francisco.

Dan Cressman: I think it's safe to say if you go down the laundry list of all the logical investors who have all attempted to come into the San Francisco Bay Area, be it downtown and suburban markets, if it's the Class-A or trophy properties it's the usual cast of characters and they just go from one party to the next. When you get into the B category, it opens up. The assets are smaller, but it opens it up to a whole other cast of players and we're seeing a continued interest by the offshore buyer, but domestics are paying more than anybody right now.

NREI: Are they bidding up prices?

Cressman: I wouldn't say 'bidding up' per se, but prices are continuing to rise. There is still plenty of profit potential. We've seen a number of properties that have doubled escrow.

Kasten: Investors are buying on projections rather than actual revenue streams at this point. There was a point earlier this year when rents were going up $1 per foot a week. We have just heard that the $60 barrier has been broken. Those are numbers we haven't seen in 15 years. The projections and the expectations that trend is going to continue has really spurred the investment marketplace. We've never seen investment activity like we've got right now.

Ida: We've purchased in Silicon Valley. Twenty-five percent of our deals in the past year have been in the Bay Area. They've all been in Silicon Valley. It's about $150 million worth of product primarily, smaller campuses.

NREI: Joe, to whom are you lending?

Joe Cunningham: When we look at the trend nationally, San Francisco is particularly strong. As you see rents moving up from the mid-$20s to the $40s and above, that's now going to mean that new construction will pencil and people will start doing spec development. It's hard even in San Francisco to do that, but developers have a great way to get municipal approvals and build. If the numbers are there and the economics are there, people will build it.

Our company began securitizing a $120 million offering in 1993. In the commercial real estate that we've loaned on, we've never had a default. It's not because necessarily we're that smart, but we've been on the right side of the market, and nationwide we've watched rents rise, we've watched absorption improve, vacancies have dropped. Combine that with greater liquidity with REITs and securitized lending and it's a very attractive environment.

Wall: In the early-'90s, pension funds, REITs and institutions owned maybe 5% of institutional-grade real estate. And maybe today, it's about 10%. I hear people talk that by the year 2000, REITs will own 50% to 60% of institutional-grade real estate. What's your opinion?

McDowell: I think there's going to be a huge surge, but again, you're talking about a $3-trillion market. We're seeing a trickle of institutional holdings being securitized, but the entire REIT industry is still smaller than Wal-Mart.

Cressman: The table is set now in San Francisco for this market to eclipse anything we saw in the '80s. The reason for that is it is transforming from a national stage to an international stage.

NREI: How does San Francisco grow with its limited land area?

Cressman: It's always what you can't have that makes it more interesting.

Hagopian: If you look at the San Francisco Bay Area compared to other regional or international markets, it's still a relatively inexpensive place rent-wise to conduct your business. And I think everybody's in a consensus here that it's one of the finest places to live in the world.

Dan Cressman, PrincipalM Whitney Cressman; Jeff Mishkin, Manager-San Francisco office, Marcus & Millichap; Joe Cunningham, President, Liberty Mortgage Acceptance; Frank McDowell, CEOBRE Properties; Ed Hagopian, Senior Vice President, Sunset Development Co.; Richard Pogue, Senior Executive Vice President, CB Commercial; James Ida, Senior VP- Acquisitions, TriNet Corporate Realty Trust; Steve Polito, Regional Partner, E&Y Kennethal Leventhal; Michael La Horgue, President, Shorenstein Asset Group; Rich Robbins, President, Wareham Development; Thomas Kasten, Senior Vice President, Grubb & Ellis; Geoffrey Sears, Vice President, Citicorp Real Estate; David Wall, Executive Vice President, Fremont Properties.

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