The market will be defined by
continued very strong volume of
leasing activity, increasing rents
and dwindling availability of space,
says Colliers’ Collenette.

SAN FRANCISCO-San Francisco is a top-performing office market—followed by New York City and Houston—based on factors including vacancies, job growth and projected rents, according to the National Office Property Index. Rental rates soared during the first quarter, increasing by 7.5% over fourth-quarter 2011, as strong absorption and decreasing vacancies continued to put pressure on rates.

Class-A rental rates across all markets averaged $48.87 per square foot, up from $44.56 in fourth-quarter 2011, according to Colliers International’s first-quarter office report for San Francisco; class-B rates rose from $38.18 to $40.29 during the same time period. Class-A financial-district rental rates rose from $43.56 to $49.65 during that time, while class-B rates in this submarket rose slightly from $36.03 to $36.85.

Demand and rent growth are being driven largely by technology growth—specifically, social media, search engine and cloud computing companies such as Twitter, Zynga, Salesforce, Yelp, Google and LinkedIn, Colin Yasukochi, VP of research for the Northwest region at Jones Lang LaSalle, tells GlobeSt.com. The demand for scarce class-A space, particularly in the South of Market submarket, is strong and shows no signs of stopping soon as these companies seek large blocks of office space to house young engineers and technology workers flocking to the bustling, 24-hour city.

“A couple of things driving the trend are the demand for those kinds of services and products as well as the work environment that is uniquely provided here in San Francisco,” Yasukochi explains. “We have a vibrant, urban marketplace, and many technology tenants are young and want an active lifestyle and an exciting, amenity-rich city, which San Francisco certainly provides. We have seen those demands play out in our marketplace, and they have moved our market fairly dramatically from its low point in early 2010.”

Rent growth has increased by nearly 40% off those lows overall, rising up to 60% in SOMA, Yakusochi continues. Colliers’ report indicates that vacancies are down from 15.2% in early 2010 to 12.2% at the end of the first quarter. Both SOMA East and West saw vacancies decrease by more than 2% since fourth-quarter 2011, and Potrero East and West saw vacancies decline substantially to 8.8% and 5.8%, respectively.

“There’s both concern about bubble-type activity and lots of hype about more,” Chris Economou, asset manager for PMI Properties, a private real estate fund that owns and operates office buildings dedicated to technology and digital media tenants such as TechCrunch and Yammer, tells GlobeSt.com. PMI is a client of Marcus & Millichap, which just released its national office report revealing San Francisco as a leading office market.

Economou’s focus here is the SOMA submarket, where supply is especially constrained, forcing some technology companies seeking large blocks of space to take it in institutional buildings in the financial district, even though they’d rather be in SOMA, he continues. And there’s also the matter of rapidly rising rental rates in SOMA, some approaching $45 to $50 per square foot, driving tenants to less desirable submarkets.

 “There is space left in SOMA, there are buildings with availability, but the companies that are expanding need a place to go that is economical,” Economou tells GlobeSt.com. “The financial district is becoming expensive as well, because that supply is being swallowed up.”

The market experienced positive net absorption of 333,391 square feet during the first quarter, fueled mostly by SOMA East and the financial district, according to Colliers’ report. Absorption continues to be driven by technology companies, which are adding space at an extraordinary rate, regardless of their current company size. However, whether all these companies will stay in line with their growth projections and occupy the space that they have leased remains to be seen due to a phenomenon taking place here called space hoarding.

“A lot of space is being leased by some of the major technology companies, who are taking quite a lot more than they need,” Alan Collenette, executive regional managing director with Colliers International, tells GlobeSt.com. “It’s an offensive maneuver for the future so they don’t get caught with rising rent and nowhere to house their employees.

Space hoarding represents a reverse turn from the 2000 .com boom and bust, during which tenants had vast amounts of “shadow space”—leased space that was not occupied after downsizing. “It’s an undocumented market, several million square feet of empty space that originally was leased and occupied, but is now empty, even though they were still paying rent on it,” Collenette continues. “Now, it’s nothing as large, but extra space is being leased to main-name companies wanting to protect themselves.”

Construction here was flat for the quarter, but expected to increase as demand for large blocks of space continues throughout the year. Cost of construction in this market is roughly $650 per square foot, Yakusochi tells GlobeSt.com. Also, a new trans-bay terminal currently under construction in the south financial district is adding to the momentum in this submarket.

The investment market has drawn players from across the country, particularly for buildings housing technology companies, and pricing for existing assets is beginning to exceed replacement costs. Investment sales volume continued the positive momentum of 2011, with approximately $280 million in downtown San Francisco transactions realized in the first quarter, according to Colliers’ report. Prices continue to rise for class-B properties as witnessed by notable sales that closed this quarter including 222 Sutter St. for $53.8 million, 1 Beach St. for $36.5 million and 717 Market St. for an undisclosed price near $400 per square foot.

“We’re optimistic about the office market,” concludes Economou. “Companies are a little more conservative this time around as opposed to what we saw in the 2000 bubble, but we’ll see a good market next year.”