SAN FRANCISCO—Rising levels of employment, surging and robustrates of new leasing activity, and a near-record number ofinvestment sales recorded at the end of the third quarter in theSan Francisco office market have resulted inpositive conditions not seen since before The Great Recession. Thisis according to the recent third quarter survey report fromColliers International.

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Overall vacancy levels continued to plummet andstood at 7.5% at the end of the third quarter,compared with the 8.3% recorded during the second quarter and wellbelow what Colliers calls the “10% tipping point,” which signals abalanced market, a threshold broken one year ago.

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“San Francisco and the Bay Area have become the literal centerof the world's knowledge-based economy,” said Colliers'Alan Collenette, regional executive managingdirector for the firm's brokerage operations in San Francisco. “The24-hour heartbeat is right here, downtown. Having graduated, inhalf a generation, from everyone's favorite tourist destination toa global economic powerhouse, San Francisco has no competitionamongst other US cities, with the exception of New York.”

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Collenette continued, “The big names have to be here now toattract employees, so Twitter, Google, LinkedIn,Salesforce and others are devouring space in the city, andin their slipstream are the V.C. companies, the law firms, ad firmsand other service sector companies that depend on the high-techindustry for their livelihoods.”

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To underscore the fact that tech companies are the main drivingforce in the market, adding more jobs and growing spacerequirements in the city, the third quarter was the 17thconsecutive three-month period of positive net absorption, withthree-quarters of a million square feet snatched up, the reportnoted.

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“Additionally," added Collenette, “the city is on pace to exceedthe market's historical annual average of 7 million square feet oftransactions. The San Francisco market experienced 13 leases over100,000 square feet closed in 2012 and, the following year, themarket recorded eight leases totaling more than 100,000 squarefeet”.

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This year, the report noted, the city at the end of the thirdquarter, has already recorded 11 transactions totaling more than100,000 square feet with two of those closing during the currentquarter. Meanwhile, overall non-weighted class B rents increased inthe third quarter by 6.6%, to $54.47 per square foot. Non-weightedclass B rents have surged by 31% over the past two years.

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There were a total of 16 office saletransactions closed during the third quarter for acombined value of nearly $2 billion. Incomparison, during the first half of 2014,Colliers recorded 22 office sales for a total of $2.55 billion. In2013 the total sales volume was $2.38 billion. Collenette predictedthat investment sales volume for the San Francisco market willremain strong for the rest of 2014.

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With nearly 782,000 square feet absorbed at the end of the thirdquarter, the market has experienced over 2.5 million squarefeet of growth, the report noted. Again class A assetscontinue to benefit from the large leasing volume in the market ofover 1.9 million square feet, which accounts for approximately 77%of the positive absorption in the market year to date.

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“If all deals currently in escrow and on the market close, totalvolume will surpass $5 billion with the number of transactionsclose to 50,” said Collenette. “This is well above the historicalaverages of $2-$3 billion seen in San Francisco over the last 14years and chasing the historically strong years of 2007 and 2012with $9.8 billion and $6 billion in sales, respectively.”

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On the jobs front, state data furtherreinforced Colliers' optimistic outlook for employment during theremainder of the year and into 2015 for the Bay Area. According tothe California Employment Development Department (EDD), the numberof full-time workers in San Francisco grew from466,500 to 476,600.

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Reflecting these strong local employment trends, leasingactivity continued to be strong during the third quarter with morethan 1.5 million square feet leased, Colliers noted, andnon-weighted class B rents continued to surge during the quarter,up by 31% over the past two years.

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In terms of new construction, two build-to-suit properties weredelivered to the market during the third quarter: 50-60Hawthorne Street is 56,000 square feet, pre-leased toAthenahealth, and Market Square South at 1Tenth Street, totals more than 338,000 square feet.Twitter had pre-leased more than 90 percent of the property.

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In its report, Colliers said it expects 521,000 square feet ofrenovated and new space to be delivered to the market during thefourth quarter with a large portion of that space alreadypre-leased. Given the current deal velocity being experienced inthe market, San Francisco will absorb this new space easily, thecompany predicted.

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Among the region's submarkets, SOMA Easttightened this quarter as its vacancy dropped to 5.1 percent, downfrom 8% just one year ago. The Yerba Buenasubmarket experienced a significant decrease in its vacancy rate,as well, during the quarter, dropping over four percentage pointsto 6.1%. This submarket continues to benefit from technologycompany spillover from the SOMA submarkets.

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“Despite many large tenant requirements being filled this year,demand in this market continues to remain strong with nearly 5million square feet of office space in play among 124 tenants,”said Collenette. “If all of these tenants' requirements were met,this would equate to a net absorption of over 1.2 million squarefeet. While the likelihood that 100% of these tenants will securetheir stated space requirements is doubtful, this does provide anindicator that there will be robust leasing activity well into 2015and, perhaps, beyond.”

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The Yerba Buena and Civic Center/Mid-Marketsubmarkets fueled large net absorption gains this quarter,experiencing over 251,000 and 116,000 square feet of positive netabsorption, respectively. A significant amount of the occupancygrowth in Yerba Buena can be attributed to Riverbed Technologymoving into 168,000 square feet at 680 FolsomStreet and Athenahealth's occupancy of the entire buildingat the newly renovated 50-60 Hawthorne Street.

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This positive net absorption helped to shrink the Yerba Buenavacancy nearly 4 percentage points to 6.1 percent. Meanwhile, keycontributors to the Civic-Center/Mid-Market submarket were Twittermoving into approximately 76,000 square feet at 1355 Market Streetand Rocket Fuel occupying nearly 25,000 square feet at 1455Market Street, Colliers noted.

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While overall weighted rental rates for class A assets reflecteda decrease for the quarter, annualized rents are up over17.4%, Colliers disclosed. The decline in weightedClass A rents for the third quarter can be attributed to tenantsthat had leased large blocks of space in newly constructed, orcurrently under construction, buildings, pushing class A weightedrents in the second quarter to highs not seen since the tech boomin 2000.

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Looking at overall class A weighted rents with the newconstruction removed in the second quarter would reduce the overallclass A rents to $61.81 per square foot and wouldhave translated into a 7.1% increase in the overall Class Aweighted rents for the third quarter.

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This year the city has recorded 11 transactions greater than100,000 square feet with two of those completed in the thirdquarter. Google leased nearly 243,000 square feet at 1Market Street and Dodge & Cox renewedand expanded for 111,000 square feet at 555 CaliforniaStreet. There were three other large renewals this quarterwith Fenwick & West, Moody's,and Jones Day taking 90,000, 69,000 and 61,000square feet, respectively.

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Despite his optimism, Collenette also sounded a cautionary note:“The good news for investors and for landlords is obviously drivingup the cost to businesses of operating in San Francisco. Althoughrent is typically under 10% of a company's overhead, eventually,the incremental increases have an effect on bottom lines. Equallyconcerning is the cost of housing for San Francisco workers, withrents and home prices having risen 30% in two years.”

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Added Collenette, “This puts heavy pressure on wages. Additionalitems such as gross receipts tax and the former payroll tax combineto make other parts of the country tempting for companies that havethe inclination to outsource or relocate. It is not reasonable toexpect that this utopian environment for building owners can besustained indefinitely. Whether the correction will be dramatic andsudden, or gradual and shallow, depends as much on fate and luck asit does on analytical science.”

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David Phillips

David Phillips is a Chicago-based freelance writer and consultant with more than 20 years experience in business and community news. He also has extensive reporting experience in the food manufacturing industry for national trade publications.