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SAN FRANCISCO-Amid the devastation that has struck San Francisco Bay Area office markets over the past 30 months, there are signs of life, says Dan Mihalovich, a 21-year leasing veteran and principal of Mihalovich Partners.

In the company’s mid-3rd Quarter 2003 analysis of the market, Mihalovich reports net positive growth to date of 492,000 sf in the city; 39,000 sf in San Mateo County; and 289,000 sf in Santa Clara County. “After 10 consecutive quarters of repeated onslaughts of new space being dumped on the market by failing tenants and struggling landlords, many tenants have finally risen to the occasion to do the economic thing—respond to rapidly declining rental rates and enormous incentives from the landlord community.”

This does not mean a recovery is in full swing, says Mihalivich, as “the weight of total vacancies remains painfully obvious.” Asking rental rates in every Bay county, for both direct and sublease space, are lower than in Q2, and asking rates in the city, even during a period of impressive absorption, are down 6% since Q2, according to the report. “Landlords will find the levels of activity refreshing, but hardly satisfying,” says Mihalivich.

“We will need to document consistent net positive absorption overall before we conclude that a ‘trend’ exists,” concludes Mihalovich, explaining that the East Bay region is still in negative growth territory. “For the moment, it is encouraging to see tenants’ levels of confidence improving to the point that positive growth exists at all.”

“Economic forces never sleep”, adds Mihalovich. “Our markets have reacted and are continuing to adjust not only to the dot-com demise, but to 9/11, the stock market crash, the war on terrorism, the $38 billion deficit and junk-bond rating of California–rising unemployment, massive macro forces which have brought rental rates back to levels of the early 1980s. Market function, in this kind of economy, also dictates shutting down new construction or renovation of office projects.”

Mihalovich says his report predicts trailing vacancies—the millions of sf available in the Bay Area within the next 12 months, declining from 55.55 million sf in Q2 to 54.22 million sf today. “We should see some stabilization, at which point the combination of contributions of new space by landlords and tenants is more readily absorbed, during the next 6-12 months,” says Mihalovich.

As for landlords, “the pressure to perform is as real as ever, and rates of return on leasing are as close to zero (or less) as ever, too.” The good news is that many city buildings are in strong hands, owned by institutional money. The bad news is net returns are made more difficult to capture based on soaring operating costs in California, with skyrocketing insurance premiums pushing tax and operating expenses in class A buildings into the range of $16-$22 per sf per year.

“Landlords, in today’s market, must lure tenants with compelling concessions, while simultaneously negotiating to shift the risks of rising costs to their tenants,” concludes Mihalovich. “More sophisticated, better credit and better-represented tenants are able to avoid assuming such risks. So, the pressure on the landlord community continues.”

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