How Sustainable Is San Francisco's Tech Boom?

Real Estate San Francisco is part of the Forum LOCAL series of features in Real Estate Forum magazine. This is an HTML version of an article that ran in Real Estate Forum. To see the story in its original format, click here. 

It seems that almost every day in the San Francisco and Silicon Valley area, another big deal has just been signed—or is just about to be. With LinkedIn signing a lease for the entire 26-story building under construction at 222 Second St., Google's 372,000-square-foot renewal at Hills Plaza, and other tenants like Twitter, Dropbox, Trulia and Practice Fusion, tech companies are dominating the area's leasing activity this year. 

According to Reed Payne, EVP of brokerage at Kidder Mathews, tech has carried the economy out of the recession. And in the past, Payne says, this heavy dependence on a single sector, especially technology, has led to extreme highs and lows.

But sources assure Real Estate Forum that it is no longer the case here in San Francisco. While some people are making comparisons to the heady days before the dotcom bubble burst, Payne says that today's technology sector is structurally different from those days. “More companies are valued by their actual revenue creation, and as more people come online around the globe, the size of the potential market seems almost boundless. Investors and analysts are hoping that this new depth and breadth within the technology sector will forestall a major crash similar to the early 2000s.”

Markus Shayeb, SVP of tenant advisory at Transwestern's San Francisco Bay Area office, agrees, noting that when looking at the current tech boom in San Francisco commercial real estate, this time around—compared to 2000—there are far more companies with stable, revenue-generating business models. “There have been acquisitions by fairly large firms with big balance sheets, such as LinkedIn…For the most part, these are not risky tenants: They are high-value firms any landlord would love to have.”

Compare that to 2000, when investors threw money at any company that was on the Internet. “We call the firms from both periods tech companies, but today's tech firms cater to a diverse mix of institutional investors and service all types of industries—payroll, medical records, insurance, you name it,” Shayeb says.

If you have a large business-analytics company, for example, you won't be harmed if anything happens to an overvalued social-media firm, explains Shayeb. “Because there is so much diversity and various revenue models, we don't have a 'too big to fail' situation as with the banks in 2008 or the 2000 tech bubble. Landlords can feel secure about that.”

Mark Gedymin, senior advisor at TRI Commercial/CORFAC International, says that this tech sector boom is highly likely to continue simply because of the amount of innovation that is happening. “The industries behind it have an untold number of applications for their respective technologies,” Gedymin explains. “It is not just gaming and social media we are talking about. It's robotics, artificial intelligence, big data, curation, analytics.”

Another reason for tech's sustainable run, Gedymin tells Forum, is that “many of these companies are profitable, unlike the dotcom era.” However, he warns, “if for whatever reason venture capital vanishes or we have some sort of disaster, all bets are off.”

The better question, according to Amber Schiada, director of research for the Northern California and Rocky Mountain region at JLL, isn't whether it is sustainable; it is about how long this boom will last. “We are moving through a business cycle, and tech growth will inevitably peak and slow at some point. While tech growth is significant in markets like San Francisco, the Silicon Valley and New York, it's still got room to grow in smaller, emerging markets like Atlanta, Portland, and Chicago. Additionally, the tech industry will always exist, but it will continue to innovate. So, while tech is largely focused on cloud computing, social media and software as a service today, those may not be the innovations of the future.”

When asked about whether there is enough quality space available in the city for the demand projected by tech firms, Shayeb said that six months ago, he might have said yes. “That product is now dwindling. Look at 350 Mission. Its 451,000 square feet was entirely taken by Salesforce before it was built. When Dropbox moved into 333 Brannan, it took a total of 180,000 square feet, and it has committed to over 450,000 square feet. Many buildings that are completely pre-leased are not even under construction yet. Transbay Tower won't be delivered until 2016.”

What is important to ask, Shayeb continues, is where is the rental-rate pain threshold for more traditional businesses? The answer, he says, depends on how far out of the city they are willing to relocate. “Oakland and South San Francisco are likely targets…If they're paying $40 per square foot in the city, and it's $30 out there, they may stay in the city, but if the city is in the average of $70 and it's $30 out there, it's not even a question. They will move.”

Currently, Shayeb explains, there is space in the range of $28 to $30 per square foot in Brisbane in South San Francisco. “The neighborhood doesn't have dim sum restaurants on every corner, but the price is right,” he says. “Research shows that buildings within a five-to-10-minute walk of BART with good views can command up to $68 per square foot, per year, while buildings a greater distance from transit and the city core are in the $30 range.”

No doubt, this is a good time to be a crane operator in San Francisco, with dozens of projects coming out of the ground and more planned, notes Gedymin. Yet the vast majority of the cranes, he says, are in the sky for residential developments. “We've got several million square feet of office product pending delivery but it is hard to say if it will be enough to satisfy demand when companies like Salesforce commit to about half of one of the new Transbay Towers—as it recently did—and this while the Transbay Center is still only a hole in the ground and a couple years or more from completion.”

But the other dynamic here, Gedymin explains, is the huge demand from the 10,000-square-foot to 60,000-square-foot occupiers for creative space, and that space, he says, just isn't available. The solution for some is to “create” that space themselves. “I did a recent deal with a tenant that leased space at 201 Mission St., which is a traditional office building, and they ripped out the false ceilings to increase volume in the room and exposed the concrete and HVAC piping to get the type of space their employees want.”

Julia Georgules, manager of research at JLL for Northern California, agrees that the availability of top tier, creative space is declining, with a current availability rate of about 9.2% or 580,000 square feet as of Q1 2014.

“The pipeline of development is currently only 50% pre-leased, which means that approximately two million square feet of new supply will be available to companies looking for state-of-the-art, open office space. While there are currently 2.8 million square feet worth of technology tenants in the market, this figure represents tenants from all stages of business growth,” she explains. And, like Gedymin, she says that not every one of these tenants is in the market for premier, creative office space. “Many of these tenants are still in the very early start-up stage and require less within an office.”

On the infrastructure front, explains Georgules, the amount of time it takes to approve projects and actually construct buildings is an issue being addressed by the city. “Actual supply relief is still several years away. The city is making great strides toward accommodating a higher density, but these projects take time and resources, neither of which are unlimited.”

The problem, according to sources, is housing. “Housing has always been and always will be an issue in San Francisco,” says Gedymin. “Of the 28 projects with 50 or more units that are currently under construction—and this doesn't count approved or in design/planning stages—approximately 6,500 residential units are pending delivery between now and 2015. It's a drop in the bucket compared with demand. And the numbers don't take into consideration affordability.”

Most of the new product is market rate, Gedymin continues. “Only people with high-paying jobs will be able to live in these new residential buildings. San Francisco will remain a city that relies heavily on commuters to come to work here in the day and go home at night.” 

Shayeb explains that “the average software engineer is making $140,000 a year, which sounds high. But if you're spending $4,000 a month rent on a 1,200-square-foot apartment, there's not much left over.”

And forget about it if you're a family of four, he explains. “People who get married and have kids end up moving out. At some point, these high-paying jobs become less attractive.”

On other hand, Shayeb says, “you have to question some recent projections of the high number of jobs coming. If you look at all the commitments of lease expansion, our research shows it translates to upwards of 20,000 additional jobs—an enormous figure that doesn't seem possible, given the city's current infrastructure and housing.”

SIDEBAR: Silicon Valley vs. San Francisco

What is the difference between the tech companies taking space in Downtown S.F. and the huge campuses being built in Silicon Valley?

Julia Georgules, Manager of Northern California Research, JLL: The difference between San Francisco and Silicon Valley is simple: one market is urban, while the other is suburban. Companies—not only in San Francisco, but in other major urban markets across the country—are locating in these markets to access the talent pool. This talent pool wants to be located in areas where they can live and work, with access to cafes, restaurants, outdoor activities and cultural events. Because this is about the people, San Francisco will continue to attract and retain companies hoping to capitalize on this vibrancy. Conversely, Silicon Valley will remain the high-tech capital of the world as it offers both the talent pool, proximity to competitors and venture capital and the ability within real estate to expand into significant office space. More often than not, the two markets are not competing with the other, but working together.

Markus Shayeb, SVP of Tenant Advisory, Transwestern: As with all office-space needs, the difference is employee driven: Where do they need their talent to work? It's a difference of size and youthfulness. There are older, mostly larger firms whose clients are all around the world and don't need their employees to be in San Francisco to service customers in India. There is also the generational issue: If you're a more established company such as Hewlett-Packard, a large share of your employees can live and work in the suburbs. But the younger companies seem to believe they must be in San Francisco.

A lot of the demand in the city is from companies that have grown to more than 200,000 or 300,000 feet, such as Dropbox. Salesforce started out at about 100,000 square feet and is now using over 1 million feet. But this dynamic will evolve. Once your company achieves a certain size, you can carve out your accounting department, for example, and move it to, say, Texas, where costs are lower. The current peak demand in San Francisco comes from the 50,000- to 200,000-square-foot tenants tripping over each other for prime space.

Mark Gedymin, Senior Advisor, at TRI Commercial/CORFAC International: The question is not whether tech companies should or will locate in one market or the other because usually the big players want to be in both. It has been well documented that Silicon Valley firms have opened numerous satellite offices in San Francisco. Google, Yahoo, Microsoft and others all have a major presence in the city now. And Google recently acquired a robotics company on Potrero Ave., which is a client of mine, and further expanded their footprint in San Francisco. While engineers and programmers are frequently cited as reasons to have a presence in San Francisco, a lot of people forget that many highly qualified executives want to work and even live in the city, versus the valley.

Assuming demand for space continues at or near this pace, and space continues to be constrained, what alternatives will companies consider? Will they be drawn away from San Francisco?

Gedymin: With companies under pressure to stay in San Francisco to attract and retain the workforce they need, many of them stay and just pay going rents, because they have to. Dropbox, Yammer, Yelp and others aren't leaving San Francisco. However, during the recent run-up, essentially a new submarket was created when the city established a payroll tax incentive for the Mid-Market area, and Twitter was the first big anchor tenant to relocate to Mid-Market. The submarket has since grown to include approximately four million square feet. With average class A rents trending toward $60 a foot, we expect to see some firms, likely non-tech, leave for the East Bay.

Amber Schiada, VP and Director of Research, NorCal and Rocky Mountain Region, JLL: Although new construction is quickly being consumed, and existing supply for creative space is also on a downward trend, there are likely going to be several blocks of space placed on the market when Schwab relocates a significant portion of its headcount to Texas and once Salesforce begins to consolidate its operations in the Transbay area. It's important to remember that the start-up component of this industry still requires a lesser quality space. Often, these small start-ups are not generating revenues to command premium space. Pricing, however, could present a challenge for smaller, non-revenue generating technology tenants. As San Francisco's office supply continues to decline, pricing will continue to increase. For smaller companies, this could force some to look to nearby Oakland, Emeryville, or Pleasanton where tech hubs are emerging.