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October 18, 2019
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San Francisco Office Market Continues Strong in 2019

4/16/19

This report was provided to us by real estate services firm Kidder Mathews; prepared Jerry Holdner, Director of Research

San Francisco Office 1st Quarter 2019

The office market in San Francisco kicked off 2019 with over 770k sf of construction deliveries. Even with the large scale of deliveries, the construction pipeline remains robust with over 4.1 msf yet to be delivered, 72.9% of which is already pre-leased. Sales volume hit its highest quarterly total in two years, while average sales price per square foot jumped over $100 quarter-over-quarter, and skyrocketed more than $400 year-over-year. 2018 was a historic year in terms of occupancy, net absorption, rent, and development. The first quarter of 2019 has mostly maintained much of those gains, despite the quarter being less active than previous years.

New Construction

In 2018, the South Financial District submarket led all others in office property deliveries, with 1.83 msf. This trend continued into 2019 with the only delivery being Park Tower at Transbay on 250 Howard St that added 773k sf to the South Financial Districtís office inventory. The South Financial District also has the largest property in the development pipeline with the 1.25 msf First Street Tower expected to deliver in 2023. Mission Bay/China Basin is expected to be a major destination for construction deliveries in the near future with over 1.7 msf expected to be delivered either this or next year. With 100% of that space already pre-leased, the Mission Bay/China Basin submarket is quickly establishing itself as a premium destination for office tenants.

Asking Rental Rates

Direct asking lease rates ended the first quarter of 2019 higher quarter-over-quarter for the sixth straight time at $64.71 FS. This represented a 6.26% increase quarter-over-quarter, and a 9.59% increase year-over-year. Class A direct asking rents increased 9.78% on a year-over-year basis, while Class B buildings experienced a year-over-year rise of 5.72% in direct asking rents. Waterfront/North Beach had the steepest rise quarter-over-quarter with a 20.3% increase in direct asking lease rates. Year-over-year, Mission Bay/China Basin saw the most dramatic rise, as direct asking rent grew 72.7% to $70.87 FS. After many years as an afterthought, Mission Bay/China Basin is commanding the second highest asking lease rates in the city. The roaring growth of direct rental rates has continued, adding to an already stellar increase during this cycle.

Absorption & Vacancy

After one of the most active years in two decades, net absorption finished the quarter in positive territory for the sixth straight quarter. While this quarterís net absorption is in strongly positive territory, an increase in move-ins in Q2 is expected to significantly boost net absorption further positive for the year. The Financial and South Financial Districts led all other submarkets in leasing activity once again, as the two submarkets still dominate the downtown core. Large tech firms that normally dominate the market signed on to a significant amount of space in the first quarter. Pinterest had the largest lease of the quarter, as they committed to lease over 500k sf of a 1 msf proposed mixed-use building that will replace the former San Francisco Tennis Club at 88 Bluxome. Asana Inc made the second largest commitment with their lease of the entire 268k sf building at 633 Folsom St. Slack took on the third largest lease of the quarter when they decided to sign on to occupy 11 floors at 45 Fremont St, just minutes away from their HQ at 500 Howard St.

Overall net absorption ended the quarter positive, with both total and direct vacancy rates for San Francisco up slightly quarter-over-quarter. The total vacancy rate increased by 30 basis points quarter-over-quarter, while direct vacancy increased by 27 basis points in the same time frame. However, year-over-year, both direct and total vacancy rates remain lower by 123 and 90 basis points, respectively. With direct rates at 4.57% and total rates at 5.6%, the market is still very tight.

Investment

San Francisco office property sales jumped significantly from last quarter, with total dollar volume reaching over $1.3 bil by the close of the first quarter. Average per square foot price also rose 12.32% quarter-over-quarter to $943.43. Year-over-year, the increases are even more staggering as dollar volume increased by over $1 bil and average per square foot sales price jumped 74.42%. The most significant sale of the quarter was Gap Inc.ís February purchase of the Mission Bay/China Basin building they were previously leasing from Hines Global REIT Inc for $342.5 mil ($1.2k/sf). Clarion Partners purchase of the Charles Schwab Building at 215 Fremont from Jack Resnick & Sons Inc for $335.5 mil ($899/sf) was a close second. Rounding out the top three largest sales of the first quarter was JLL Income Property Trustís sale of 111 Sutter to Harbor Group International LLC for $227 mil ($775k sf). The crackdown on cross-border investments by the Chinese government has not had the lasting effect many thought it might, as REITs and other domestic investors have become very aggressive in obtaining assets in San Franciscoís robust office market. As predicted in the Q4 2018 market report, domestic investors were happy to fill the void left by Chinese buyers after the imposition of stricter capital controls from the ruling Chinese Communist Party. Furthermore, many Chinese investors remain unfazed by the capital controls, and continue to maintain a large presence in the U.S. market. Looking ahead, it is likely that this market will continue to be very popular among investors, as rental rates maintain all-time highs and recent sales have yielded remarkable returns on investment.

Spotlight

While traditional lenders for office investors have announced that they are taking a step back in commercial real estate lending due to risks associated with increased construction costs, REITs have rapidly increased their lending for commercial real estate purchases. Credit quality of the loans from these non-traditional sources remains strong, but observers have noted that these nonbank loans do have a higher default rate than loans from traditional banks. However, due to new accounting regulations that have gone into effect this year, these nonbank lenders will be required to set aside more capital to cover potential defaults. Due to the strong returns from the sales of office property in San Francisco, REITs and other nonbank lenders are expected to play a significant role in lending this year, as traditional bank lenders pull back.

Source: RCA, CoStar, San Francisco Business Times, The Registry
*Figures and information for this report look only at industrial buildings larger than 15k sf.







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