Western Region Office Market
SPECIAL REPORT: Commercial Real Estate
San Francisco’s office market continues to deteriorate.
After peaking in the third quarter of 2000, there have been five consecutive quarters of negative net absorption, rising vacancy and falling rents. This is unprecedented in both velocity and size of change. From its cyclical low point in the third quarter, vacancy has increased to 21% from less than 2% two years ago.
During this period, class A and B rents have fallen nearly 60%, from $80 and $69 per square foot to $34 and $24 per square foot, respectively.
As dramatic as these statistics may seem, negative net absorption has been the driving force to the precipitous market decline. Previous downturns were largely driven by new supply and had continued to show some positive demand, which at least temporarily interrupted the downward trend.
In the 1991-1992 recession, only two consecutive quarters of negative net absorption were recorded. Looking further back, the last peak in vacancy occurred in 1987 at just less than 17%. This peak coincided with the end of a 10 million-square-foot building boom from 1984 to 1988 that was caused by the looming passage of Proposition M, an office development growth control regulation.
The current market cycle also had a big building boom that will add 8.3 million square feet when complete, though it’s been characterized by speculative leasing and the resultant 8 million square feet of negative net absorption to date.
These two forces have combined to pull the market out of balance from both the supply and demand side and pushed vacancy to historic highs.
Although far from positive, the emptying of the new supply pipeline and an anticipated return of more positive economic conditions later this year should bring an end to the net absorption red ink and rise in vacancy.
The key to a potential recovery will be a sustained, multiyear period of employment growth. With only 800,000 square feet of gross leasing activity during the first quarter, it’s clear that businesses remain skittish about their office space needs.
It took seven years for vacancy to return to single digits after its 1987 peak and even more time for rents to show improvement. Three years before vacancy reached that peak, class A rents were $35 per square foot. By 1985, class A rents had declined to $25 per square foot, where they remained for nearly 10 years.
Could rents again remain down for such an extended period of time?
It’s certainly possible. In 1987, 17% vacancy represented 9 million square feet; 21% currently represents more than 13 million square feet, and that number is expected to grow. And the amount of sublease space has not peaked yet,with an average term of five years, it remains competitive to direct space.
If history is any guide, rents are likely to remain in a holding pattern until the market begins a sustained recovery and reaches a greater supply/demand balance.
The office investment sales market is very quiet.
The only investment sales during the first quarter involved small, non-institutional investment grade properties. There are owners looking to sell and even more buyers looking to buy; however, the bid-to-ask pricing gap between them remains too wide.
Owners of high-occupancy buildings with credit tenants, above-market rents and limited near term lease rollover are faced with buyer pricing economics that more closely reflect lower current rents and higher vacancies. The bid-to-ask pricing gap in a situation like this could be as much as $100 to $150 per square foot for class A buildings.
Owners have opted to collect above-market rents rather than sell at what they view to be discounted valuations. This situation will right itself once market rents and higher vacancies push owners’ income and internal valuations closer to buyer expectations later this year and into 2003. Until then, most investment activity will likely be limited to small, situation specific and owner-user deals, with the possibility of a few preemptive plays for distressed properties.
Forecast
The San Francisco office market is expected to reach a peak in vacancy and bottom in rents by year-end. Should the economy stabilize and show signs of improvement during the second half of the year, as widely anticipated, negative net absorption from businesses shedding excess office space should, for the most part, come to an end. And by year-end the nearly 2 million-square-foot pipeline of new space should be virtually empty.
The combination of these factors points to a coming peak in vacancy. With the amount of space on the market stabilizing, lease rents are expected to follow suit shortly thereafter.
But this does not mean the market will return to good health in 2003. Sustained employment growth is required to absorb more than 10 years of office space supply. Look for higher vacancies and lower rents to hit building owners’ bottom line even harder this year, potentially resulting in a few distressed investment sales.
Heavy investment sales volume isn’t expected to regain momentum until 2003 or later, when buyer and seller pricing expectations come closer together along with in-place and market rents.
Albuquerque: The vacancy rate increased only 0.7% compared to 2% in the previous quarter. No major chunks of space were lost to downsizing, bankruptcies or large companies exiting … Bakersfield: Vacancy in the central business district is much lower than in the suburban area … Dallas-Fort Worth: The market had one of its weakest quarters in more than 10 years as tenants released 1.4 million square feet of office space. The silver lining: the office market clearly favors tenants seeking renewal (or early renewal) options Denver: The office market might have finally bottomed out. The vacancy rate only increased 0.3%, down from the 2%-plus average of the past four quarters. Several big deals were announced during the first half of April and the vacancy rate should begin to feel some relief over the next few quarters as these tenants begin to move into their space Eugene: Concessions are abundant in the form of free rent, tenant improvements and other valuable incentives. With sublease alternatives, tenants can save up to 50% off direct lease rates Fresno: The office market continues to grow with positive net absorption and a decrease in vacancy. Tenant expansion or relocation have spurred the growth Honolulu: The office market is showing signs of weakening. Vacancies are moving upward slightly and asking rental rates are holding steady. Vacancies will continue moving upward and effective rental rates will move downward modestly Houston: The financial collapse of Enron has caused major repercussions in the nation’s energy capital. Combined with the recession that begin last spring and other corporate layoffs, Houston rents have fallen at the fastest rate since the early 1990s Las Vegas: Tenants are still in the driver’s seat. Vacancies climbed for the third straight quarter and rose in all classes of space, resulting in an increase in the overall vacancy rate to 15.1%. For the first time in at least five years, downward pressure was exerted on the face rates in numerous buildings across the valley Oakland-East Bay: Office space continues to flood back as businesses downsize and rid themselves of excess space. The East Bay has had five consecutive quarters of negative net absorption. The vacancy rate is up to 11%, a five-year high Phoenix: The office market was flat in the first quarter. Construction came to a halt, as only 523,700 square feet of speculative office space was under construction at the end of March. This major slowdown in construction can largely be attributed to the rising vacancy rate, coupled with the all-too-present sublease space … Portland: The office market registered its highest single quarter increase in vacancy since the middle of 1999 as vacancy jumped almost two full points to 13.4%. There is little good news for landlords; sublease space has increased to over 1.3 million square feet and net effective rental rates have declined as a result of increased concession packages and the pressure of competing with sublease space Salt Lake City: Dotcom closures and corporate downsizing have doubled sublease space available. Landlords are offering better concessions, especially to tenants willing to sign long-term leases San Jose: The office market is showing signs of stability, as the pace of negative net absorption is finally beginning to taper off. There’s still absence of demand for users more than 50,000 square feet Seattle: The national recession and Washington’s current economic picture continue to have a negative impact on the Puget Sound office market with overall vacancies rising for the ninth consecutive quarter. The number of deals is increasing and some large tenants are in the market, but leasing activity has been unable to keep up with corporate give-backs.
