WEST OFFICE MARKET
San Francisco
Market conditions strengthened in the first quarter on continued positive momentum.
Vacancy declined for the third consecutive quarter on positive net absorption. More than 178,000 square feet of vacant space was newly occupied by tenants during the quarter, pushing vacancy down by 70 basis points to 22.7%.
Gross leasing activity maintained an impressive pace, with 1.8 million square feet changing hands. However, the number of transactions did slow considerably from 156 last quarter to 123 this quarter on a 30% jump in the average transaction size to 15,000 square feet.
There also has been a sharp decline in the amount of available sublease space. It’s down by more than 50% from a mid-2002 peak, which places unleased and still vacant sublease space in more stable hands.
Combined, this positive momentum once again kept rents stable at $27.76 and $20.34 per square foot for class A and class B, respectively, compared to last quarter.
There are some cautionary notes that could temper the seemingly bullish mood for near-term recovery. Widely anticipated, but not yet arrived, job growth is needed to sustain demand.
There are pending net reductions of space among several large tenants. And it’s unclear what impact rising interest rates will have on business activity.
Yet, generating significant positive momentum from mostly internal tenant movements and repositioning is a major confidence-building step forward. Thus, until signs of convincingly sustainable job growth appear, expect uneven performance.
Market Assessment
The San Francisco office market has performed consistently well in the past three quarters. Vacancy is down 1.4 percentage points from its peak, net absorption is up to nearly 650,000 square feet and rents are now holding firm.
Market fundamentals are moving in the right direction, except jobs, which are needed to sustain the budding recovery.
Vacancy rates have continued to edge downward on positive net absorption. The pace of decline is better than anticipated. Class A vacancy peaked at 23.5% in the second quarter last year and it’s now 22.7%. Class B space has experienced a more rapid decline in its vacancy rate. It peaked at 26.5% in the first quarter of 2003 and it’s now 22.7%.
Overall, asking rents are firming but not yet rising. However, it’s important to note that effective rents are creeping up and narrowing the gap between asking and taking rents.
Sublease space has declined by more than 50% from its peak in mid-2002 to 3.3 million square feet.
Although gross leasing activity has maintained an impressive pace, a concentration of large transactions may result in future volatility.
The top 10 transactions represented 53% of the total space leased this quarter, versus 33% last quarter and 40% a year earlier. This, of course, is representative of a rising average transaction size, which now stands at nearly 15,000 square feet.
Forecast
There’s a seemingly bullish mood for near-term recovery based on improving market indicators.
Consistent vacancy declines on solid, positive net absorption, strong leasing activity, firming rents and diminishing sublease space all point to further improvement ahead.
However, the widely anticipated,but not yet arrived,job growth is needed to sustain demand and keep the budding recovery on track. Combined with pending net reductions of space among several large tenants and the impact of rising interest rates, there’s still uncertainty regarding the pace and sustainability of recovery.
Thus, until new job growth makes an invigorating return, expect uneven performance.
Challenges
A common misconception made by tenants seeking office space is that the 14.3 million square feet of vacancy translates into plentiful, high quality leasing opportunities at historically low rents.
It’s an easy conclusion to reach, but breaking the office market down into sub-sectors provides a more realistic picture. View, small suite and north of Market Street creative space are sub-sectors of relative strength, and commodity space weakness.
However, there appears to be a premature movement to correlate these strengths, which are still just pockets of the broader market, with a reason to push up overall asking rents.
Knowing the market and its dynamics will provide opportunity for some and challenge to others.
