High Prices, Growing Income Gap are Bay Area Headwinds

SAN FRANCISCO—At Urban Land Institute’s recent Emerging Trends event covering the Bay Area, local real estate experts added color and detail to the annual study’s findings, including perspective on ever-rising office values, the shortage of housing and “hand-to-hand combat” in retail. An opening presentation of the ULI/PWC jointly produced report set the stage with research on the Bay Area’s rebound in rankings from a year ago.

In 2018, San Francisco ranked 41st in investment prospects and rocketed to 12th place this year while the San Jose/Silicon Valley market jumped from 26th to 13th this year. The Oakland/East Bay market, #30 overall, was the number one market for investing in office in the study’s buy versus hold versus sell rankings.

According to the study, the “Bay Area market’s robust economy seems to have overcome concerns such as high costs, lack of housing affordability and NIMBYism expressed a year ago. Yet its high price structure and growing income gap are still headwinds.” However, panelists saw glimmers of opportunity amid an increasingly top-heavy market.

“Most things seem pretty fully priced in the Bay Area,” according to Melinda Ellis Evers, managing principal of Ellis Partners LLC. “With San Francisco office vacancy below 5%, there’s more focus now on how to manage your rent roll. Cap rates for CBD office are in the 4s with a path to mid-5s with some packages showing starting caps in the 3s. With prices around $1,000 a foot, it requires a shift in perspective. But if you are a long-duration investor, $1,000 a foot looks ok given strong fundamentals and significant pressures on building costs.”

As for retail, opportunities have opened up with regard to events, experiences and social media, and walkability continues to be a focus.

“It’s real hand-to-hand combat,” said Ellis Evers. “We are curating (shop) spaces like never before, with a huge focus on events and social media, and the walkable urban vibe is very important. Still, in the Bay Area, I think there are opportunities because we’re not over-retailed like so many other markets.”

When the conversation turned to design trends, Ellis Evers says there has been a lot of change to “the box we are all building”.

“Flexibility has become a really important attribute, to be able to accommodate new configurations and amenities,” she observed. “Some of the things we’re seeing are side core designs, larger floor plates, the addition of stairs, bathrooms and/or elevators to accommodate more density and a premium on outdoor space.”

Gayle Starr, advisor with Bridge33 Capital, said lenders are both disciplined and choosy.

“Debt liquidity is strong though the large lenders have remained disciplined,” she said. “Many of the life lenders have had a robust year so they are becoming more picky as we approach year end and are full with office and some with multifamily.”

Amy Price, managing partner with BentallGreenOak, said rising costs bring about some positives, contrary to common wisdom.

“Rising construction costs are a real concern but there are a couple of positives that come with rising costs as well,” she said. “First, higher costs limit supply and keep a check on the market. They also act as a catalyst for innovation as we look for new ways to build what we need.”

So what else underpins Bay Area prospects?

“Investors want to be in the innovation markets, where there’s strong underlying demand fueled by the technology industry and related to that, it’s where highly educated Millennials want to live,” Price added. “All that skews to favor the West and the Bay Area.”

According to Rob Hielscher, managing director of JLL, there are many factors that point to increasing values.

“Values could keep rising because of the massive amount of capital on the sidelines and investment allocations that are still underfunded in real estate, combined with extremely liquid debt markets and a relatively limited supply of investment properties for sale,” he said.

Foreign investments has shifted in recent years. Although investments from China and Germany have decreased, investments from Canada and Singapore have increased.

“We are seeing international capital migrate into ‘18 hour cities’ such as Nashville, Austin and Denver where higher yields are available,” Hielscher added. “Alternatives to office have also seen tremendous growth in foreign investment, with data centers, life science and medical office all experiencing foreign investment growth of over 30% during the past 12 months. Multifamily still has relatively low foreign penetration but that is expected to rise.”

In terms of pricing in the Bay Area, Hielscher expects further price increases in markets such as Oakland and San Jose, which are seeing burgeoning tenant demand and a significant increase in investment.

“There’s a building in Oakland being marketed at $1,000 a foot,” he said, to which a panelist interjected, “That’s offered.”

The audience chuckled at the retort.

“Yes,” Hielscher answered, “and I’ll make a bet it gets that.”