Google, Tech Deals Drive Hot Q3

SAN FRANCISCO—Rising levels of employment, surging and robust rates of new leasing activity, and a near-record number of investment sales recorded at the end of the third quarter in the San Francisco office market have resulted in positive conditions not seen since before The Great Recession. This is according to the recent third quarter survey report from Colliers International.

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

“San Francisco and the Bay Area have become the literal center of the world's knowledge-based economy,” said Colliers' Alan Collenette, regional executive managing director for the firm's brokerage operations in San Francisco. “The 24-hour heartbeat is right here, downtown. Having graduated, in half a generation, from everyone's favorite tourist destination to a global economic powerhouse, San Francisco has no competition amongst other US cities, with the exception of New York.”

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

To underscore the fact that tech companies are the main driving force in the market, adding more jobs and growing space requirements in the city, the third quarter was the 17th consecutive three-month period of positive net absorption, with three-quarters of a million square feet snatched up, the report noted.

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

This year, the report noted, the city at the end of the third quarter, has already recorded 11 transactions totaling more than 100,000 square feet with two of those closing during the current quarter. Meanwhile, overall non-weighted class B rents increased in the third quarter by 6.6%, to $54.47 per square foot. Non-weighted class B rents have surged by 31% over the past two years.

There were a total of 16 office sale transactions closed during the third quarter for a combined value of nearly $2 billion. In comparison, during the first half of 2014, Colliers recorded 22 office sales for a total of $2.55 billion. In 2013 the total sales volume was $2.38 billion. Collenette predicted that investment sales volume for the San Francisco market will remain strong for the rest of 2014.

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

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

On the jobs front, state data further reinforced Colliers' optimistic outlook for employment during the remainder of the year and into 2015 for the Bay Area. According to the California Employment Development Department (EDD), the number of full-time workers in San Francisco grew from 466,500 to 476,600.

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

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

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

Among the region's submarkets, SOMA East tightened this quarter as its vacancy dropped to 5.1 percent, down from 8% just one year ago. The Yerba Buena submarket experienced a significant decrease in its vacancy rate, as well, during the quarter, dropping over four percentage points to 6.1%. This submarket continues to benefit from technology company spillover from the SOMA submarkets.

“Despite many large tenant requirements being filled this year, demand in this market continues to remain strong with nearly 5 million 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 square feet. While the likelihood that 100% of these tenants will secure their stated space requirements is doubtful, this does provide an indicator that there will be robust leasing activity well into 2015 and, perhaps, beyond.”

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

This positive net absorption helped to shrink the Yerba Buena vacancy nearly 4 percentage points to 6.1 percent. Meanwhile, key contributors to the Civic-Center/Mid-Market submarket were Twitter moving into approximately 76,000 square feet at 1355 Market Street and Rocket Fuel occupying nearly 25,000 square feet at 1455 Market Street, Colliers noted.

While overall weighted rental rates for class A assets reflected a decrease for the quarter, annualized rents are up over 17.4%, Colliers disclosed. The decline in weighted Class A rents for the third quarter can be attributed to tenants that had leased large blocks of space in newly constructed, or currently under construction, buildings, pushing class A weighted rents in the second quarter to highs not seen since the tech boom in 2000.

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

This year the city has recorded 11 transactions greater than 100,000 square feet with two of those completed in the third quarter. Google leased nearly 243,000 square feet at 1 Market Street and Dodge & Cox renewed and expanded for 111,000 square feet at 555 California Street. There were three other large renewals this quarter with Fenwick & West, Moody's, and Jones Day taking 90,000, 69,000 and 61,000 square feet, respectively.

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

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