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Part 2 of 2-part series

[IMGCAP(1)]SAN FRANCISCO-Although it is difficult to predict just how long and severe the current downturn will be, one thing we do know is that any economic times such as these become a test of sector resilience. And as discussed in part one of the two-part Bay Area market overview on GlobeSt.com, the technology market is faring well, and is expected to lead the recovery out of the current recession. The same cannot be said for other sectors in the Bay Area.

Office SlowdownSublease is a word we are hearing more and more in the Bay area’s office sector, as the amount of available space is becoming a major factor in the local leasing market. Since this time last year, the ratio of available direct space to available sublease space has increased from 15% to nearly 30%, a CBRE report states. “As this ratio continues to increase, overall asking rates will fall as well in order to compete.”

In Palo Alto, Google’s sublease at 395 Page Mill Rd. represented nearly 225,000 square feet of newly available space in Q4 alone, as the company consolidated Googlers into existing office.

[IMGCAP(2)]Also, three construction projects were completed in the quarter and contributed to the increase in overall vacancy of 180 basis points, according to the report. The largest was the completion of the South tower of the Centennial Towers project, totaling more than 300,000 square feet of available space in South San Francisco. The five-building project at Clearview Way in San Mateo was also completed, with roughly 75% of the 270,000-square-foot project available for lease.

[IMGCAP(3)]New product delivery in 2008 also included Tishman Speyer/Morgan Stanley’s speculative 552,000-square-foot office building at 555 Mission St.; Morgan Stanley’s 335,000-square-foot office building at 400 Howard St. that was 100% pre-leased to Barclay’s Global Investors; and RREEF/McCarthy Cook’s 175,000-square-foot addition to185 Berry St.

Not all projects reached the completion stage. Beacon Capital Partners broke ground and then immediately halted construction of a 290,000-square-foot speculative office building located at 535 Mission St., and RREEF/TMG delayed delivery of a 500,000-square-foot office renovation/addition located at 680 Folsom St. Also, Broadway Partners were scheduled to deliver vertical expansion to two properties, 100 California St. and 120 Howard St., however neither project will move forward as planned, according to Jay Sternberg, a senior vice president in the San Francisco office of Colliers International.

[IMGCAP(4)]On the transaction side, the market has come to a screeching halt with no significant acquisitions being transacted in the area. Tomas Schoenberg, a senior vice president of investments at the Swig Co., a San Francisco-based private real estate investment firm, attributes this to several factors: the wide gap between sellers and buyers expectations combined with the lack of acquisitions data points on which to determine fair market value which has created a pricing imbalance; a lack of debt financing; the focus on distressed assets on the part of equity capital; and risk aversion. “The institutions that historically provided capital for acquisitions and development are either unable or unwilling to commit capital to new transactions,” he says. “The result of all the above has been capital markets paralysis,” he adds that “Until the downward spiral of the banking and financial services industries can be stopped and a gradual return to stability can be reached, the real estate investment market will continue to stagnate.”

[IMGCAP(5)]Sternberg’s comments can be backed up by these examples, where properties brought to market in 2008 failed to close. Examples include: One Sansome St. and 50 Beale St., owned by Broadway Partners; 555-575 Market St., owned by RREEF, and interests in high-profile assets 101 California St. and 120 Kearney St. Sternberg did note, however, that he foresees an increase in sales velocity in 2010 as the bid-ask spread tightens and the equity markets begin to cycle equity through the system.

There is still some hope from local developers. In a recent interview with GlobeSt.com, San Francisco-based Myers Development Co. chairman and CEO Jack Myers said that “we think that the worst of all that’s been going on is behind us, and [we] have an abiding belief and respect for the Peninsula market. While these are disappointing times when it comes to leasing the market, the fundamentals over time are pretty solid.” (To read the full story, visit http://www.globest.com/news/1316_1316/sanfrancisco/176030-1.html).

[IMGCAP(6)]While activity has been down, like in most areas throughout the country, owners are becoming more realistic with regards to pricing and offering incentives and are even open to taking commitments for future occupancy in their buildings. “In order to attract a dwindling pool of tenants,” Swig Co.’s Schoenberg states, “desperate landlords are starting to offer significant concessions.” Other landlords are offering bonus commissions, he adds.

Schoenberg’s comments were echoed in Cushman & Wakefield Inc.’s Q4 ’08 report, which said that the current environment has forced landlords to rethink strategies and lower asking rents in order to maintain building occupancy. “Tenants have definitely taken the upper hand in lease negotiations and will continue to hold an edge throughout 2009,” the firm forecasts. “The next 12 to 18 months will expose a variety of space options for bargain hunting tenants.”

Going forward, Sternberg predicts an increase in sublease space and bankruptcies with continued downward pressure on rental rates, with dramatic write-downs in property values “as macro-economic events continue to plague the market.” And while it remains unclear how long the declining market conditions will last, with its mix of high-tech and traditional businesses, Sternberg says the Peninsula market remains well positioned to weather the storm.

Industrial, Strong Foundation[IMGCAP(7)]The Bay Area industrial market experienced significant corrections during 2008 as uncertainty in the overall economy resulted in a substantial decrease in demand. So says Mike Smith, a senior managing director of CB Richard Ellis’ Bay Area region, based in the San Francisco office. “As a result, subleases and short-term renewals have become much more common, with tenants hesitant to make long-term decisions.”

The biotech firm Beckman Coulter recently put a five building R&D/Flex complex in Palo Alto on the market for sublease, representing more than 260,000 square feet of newly available space. Also in Palo Alto, construction was completed on the 78,000-square-foot R&D/flex building located at 3420 Hillview Ave. The project broke ground in the fourth quarter of 2007 and was 100% occupied upon completion by SAP.

And although activity did remain slow in the fourth quarter, a few transactions were completed including Biotech firm Portola Pharmaceuticals’ 24,725-square-foot lease of R&D space at 270 E. Grand Ave. in South San Francisco and SDV International’s 21,522-square-foot lease of warehouse space at 415 E. Grand Ave.

The increase in available space has begun to put downward pressure on asking rates as well, Smith notes, with the overall rates experiencing the first decreases since 2003. “The uncertainty in the overall economy remains the largest concern for the market in 2009,” Smith says, however, he adds that “The Bay Area is better prepared to react quickly to any signs of sustained economic strength.”

The combination of the Easy Bay’s ports and infrastructure, the Peninsula’s significant biotech presence and Silicon Valley’s global reputation in technological innovation will provide a strong foundation for growth in a market recovery, Smith says.

Limited Development Helps RetailThe Bay Area retail market is seeing a progressive downward trend similar to most other retail markets across the nation as a result of low consumer confidence, job losses, dwindling international tourism and business travel.

Business credit is tight at all levels and publicly-traded equity shares in retailers have been affected such that occupiers have been seriously challenged in their ability to capitalize for expansion, says CBRE’s Smith. Home equity lines of credit—the source of capitalization for many “mom and pop” shop tenants—have been withdrawn or sharply reduced, preventing new entrepreneurial store openings and forcing some existing shop tenants out of business, Smith says. “Most of the recent closures have been for the larger box and junior anchor tenants.”

Prime retail neighborhoods such as Union Street for example, have experienced several store closings. Prominent stores that have enjoyed record sales in the past include many international luxury brands, but as these brands have become ubiquitous locally, and international tourism and consumer spending has fallen, it is likely landlords will lack the ability to increase rents in 2009, a CBRE outlook says.

While retail vacancy across the Bay Area started 2009 within the 2% to 5% range, CBRE anticipates a significant upward swing in all submarkets moving forward through the year. “However, due to the barriers to entry in the local retail submarkets, there was limited development over the course of the last cycle,” Smiths notes, adding that with limited additions of supply, the Bay Area should fare much better than other national markets on a relative basis.

Smith expects vacancy rates to remain in the mid-to-high single digits. “We believe 2009 will be a challenging year for retail landlords, who will face increasing vacancies and will be unable to increase rents,” he says. “Instead, in an effort to hold asking rental rates, landlords may end up accepting lower effective rents by offering larger concession packages.”

On a positive note, the city has many high-rise residential deliveries that may buoy retail sales into 2009 as resident density increases. There are more than 4,500 residential units currently under construction, with another 12,000 units approved, and 35,900 units under review.

Approximately 188,000 square feet of retail space is under construction including Trinity Place, a 60,000-square-foot 100% pre-leased facility. In the past four quarters, only 86,360 square feet of retail has been built in San Francisco, according to the CBRE outlook. Construction completions include 27,000 square feet of storefront retail on San Francisco Avenue, and 11,400 square feet on Geneva Avenue.

Significant leases recently include Ross absorbing 47,000 square feet, Ford Motor moving into 36,000 square feet, Sports Basement signing to 93,500 square feet, and the Sports Authority moving into 50,007 square feet.

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