Office Space
by Greg Fogg
While office-market professionals may debate the finer points of San Francisco's changing market environment, all agree that the trend of diminishing vacancy and increasing rental rates is well-established. It's noteworthy that today's most frequent debate centers not on whether rents are rising but rather if they'll spike.
To use the old analogy of the forest and the trees; in this case, the rent spike is the tree. The fact remains that market fundamentals are improving for landlords, creating incrementally better leverage, quarter to quarter, going back to the beginning of last year. The closing of the second quarter of 2005 only reaffirmed this trend. To be sure, quarter-to-quarter market-wide vacancy dropped by almost 7% from 14.6% to 13.7%. Net absorption for the year is at 1,517,149 square feet, approximately the same level as it was for all of 2004, and we've still got two full quarters to go. It is unlikely that the comparatively fast pace of leasing activity will remain for the balance of the year, yet even with lesser demand, it's a sure bet that net absorption will be the highest it's been in the new millennium.
But will this trend continue? No one can know for sure; however, it is clear that many investors have chosen to believe that, at least over the next three to five years, vacancies will decline and rents will rise. Since the investors are the ones putting all that capital at risk, one could surmise that they really know what's going on out there. Yet there remains a significant disconnect between acquisition pricing and leasing values. The valuations of today's investors alone will create upward pressure on rents, notwithstanding demand. When a buyer overpays for an asset, its first reaction is typically not to make quick adjustments to market. Instead, the new owner often struggles to come to terms with a market that isn't meeting its yield expectations. So even if demand slows, we don't expect to see any near-term (12-24 months) change in owner expectations (other than the potential for increased rents and diminished concessions).
So what caused the strong second-quarter results? A handful of large and many average-size leases. The largest lease deal of the quarter was The Gap's relocation of Old Navy to the Mission Bay building it had been marketing for sublease (approximately 283,000 square feet). In addition, there were numerous other large lease deals, including UCSF's lease of about 55,000 square feet at 50 Beale Street and Interpublic Group of Companies' lease of about 53,000 square feet at 1160 Battery Street. The torrid pace of investment sales activity continued, with 17 buildings selling in the second quarter, totaling over 3.3 million square feet of office space. TMG Partners' sale of The Landmark to American Assets was of particular interest, at a purchase price of $475 per square foot.
Taken all together, the first half of 2005 has certainly been eventful. Our expectation is that while leasing fundamentals will continue to shift in favor of landlords, the oversupply of capital flooding the San Francisco market will perpetuate the high price of investment, maintaining the gap between market reality and buyer projections.
The opinions expressed in this article are those of the author and do not necessarily reflect the viewpoint of SFAA or the San Francisco Apartment Magazine. Greg Fogg is a managing partner at BT Commercial, specializing in real-estate representation of both landlords and tenants in negotiating office-lease transactions. He can be reached at 415-781-8100 or gfogg@btcommercial.com. Copyright © 2005 by the San Francisco Apartment Magazine. All rights reserved.