Economic Woes Stall San Francisco's Strong Growth

Midway through 2008, the national economic slowdown is beginning to have an impact on the San Francisco office market. According to NAI BT Commercial, one of San Francisco’s leading commercial real estate brokerage firms and a member of NAI Global network, the market experienced negative net absorption, slower leasing activity and decelerated rent growth. The impact of bankruptcies, downsizings and financial instability contributed to slower leasing activity, negative net absorption and a deceleration of rents.

Technology companies in the South of Market area continued to demonstrate strong demand for expansion space, but it was not much of an offset to the occupancy losses caused by businesses vacating more office space than they absorbed. The market added more than 1.2 million square feet of total availability in the second quarter of 2008, and the market-wide vacancy rate increased 140 basis points to 11.6% after approaching single digits in the first quarter. Both combined North and South Financial Districts saw a modest increase in vacancy, the vacancy rate outside the Financial Districts increased sharply.

More than 800,000 square feet of the availability in Non-Financial Districts is attributable to several new and rehabilitation projects in the Mission Bay/China Basin and Rincon Hill/South Beach submarkets. Additionally, 204,771 square feet of new sublease space came on the market in the second quarter with Folger Levin & Kahn LLP, Pay By Touch, Sharper Image, Design Within Reach, California Pacific Medical Center, Vontu Software and AON Corporation contributing to the surge.Following flat absorption in the first quarter, the 334,813 square feet of negative net absorption is the weakest absorption San Francisco has seen since the fourth quarter of 2003.

Several large leasing deals were signed this quarter, mostly in the form of renewals and expansions, including: California Public Utilities Commission's renewal of 140,781 SF at 1155 Market Street and McCann-Erickson Worldwide’s renewal and expansion of 112,000 SF at 600 Battery Street. However, weighed down by rising uncertainty and growing concerns about the direction of the economy during the first half of 2008, San Francisco’s large tenants seem reluctant to commit to long-term leases while cautiously considering future growth. According to NAI BT Commercial, approximately 10 companies are currently looking for blocks of space 100,000 square feet or larger and 15 companies are looking for blocks of space between 50,000 square feet and 100,000 square feet. Seventeen of the 25 tenants seeking large blocks are technology companies and law firms.

Overall leasing activity has steadily decreased since the fourth quarter of 2007.  Gross leasing activity totaled 1.75 million square feet in the second quarter of 2008, compared to 1.85 million square feet in the prior quarter. Leasing activity in the Financial District Core – North & South – accounted for almost half of the overall gross market figure.

Amidst worries over bankruptcy and layoffs, the San Francisco office leasing market saw continued strength of High-Tech and Advertising Agency/Brand Imaging sectors. A number of growing technology companies opened new or expanding offices in the South of Market area (SOMA) during the second quarter. The list included LoopNet, Inc., AKQA, AbsolutelyNew, Next Internet, Meraki Networks, Jawbone, Atlas, Yipes, and Acteva. Advertising Agency/Brand Imaging firms opening new or expanding offices included McCann-Erikson Worldwide, Comcast Spotlight, Anthem Worldwide, Schawk, Inc., and Dogtime Media.

Rental rates remained steady overall as rent growth continued to decelerate. The average asking rate market-wide, $41.44 per square foot full service, posted its first minor decline after 16 consecutive quarters of rising rates and still represents an 8.8% increase over a year ago. The average asking rate for Class A space in the North Financial District stood at $52.46 per square foot full service, followed by Class A space in the South Financial District at $49.28 per square foot full service.

Sales volume for large downtown Class A assets nearly vanished this quarter following an all-time record in 2007. Only one newly built, Class A office building changed hands--500 Terry Francois Boulevard (291,000 SF) sold for approximately $149 million or $521 per square foot. Driven by a weak U.S. dollar and unique opportunities of solid real estate fundamentals, long-term macroeconomic growth and political stability, international investors will likely continue to pursue San Francisco high-profile trophy assets later this year and in 2009. Mirae Assets, a unit of South Korea 's biggest mutual fund sponsor, Mirae Asset Group, is in contract with Broadway Partners for the purchase of One Sansome Street.

Despite softness in the leasing market, San Francisco seems better able than other major markets to endure the impact of national economic woes due to its diverse industries and labor talents, particularly its solid technology sector. As market conditions weaken, NAI BT Commercial expects vacancy to moderately rise and rental rates to further soften, creating greater negotiating leverage for credit-stable tenants.