Rental rates in the San Francisco office market remain half of what they were in the boisterous dot-com days. But a surge in leasing activity has propelled investors to pay record prices for trophy buildings in recent months. Skeptics wonder whether buyers are wise to bet on a recovery that may still be a ways off.

Last year, a whopping $2.7 billion of office buildings were sold, eclipsing the record of $2.4 billion set in 2000, according to Grubb & Ellis. The first quarter of 2005 already has recorded $850 million in sales, which could set the city on pace for total volume to exceed $3 billion this year.

Like elsewhere in the country, the increase in deal flow in the city can be attributed to low interest rates and a flood of capital from new investors and long-time players. Practically all of the sales are occurring in San Francisco's financial district, where high-rise towers with attractive views are in great demand. Cap rates on recent office sales in the city have ranged between 7% and 8%, down from 9% to 10% in late 2002 and early 2003, when deal velocity began to accelerate.

But some investors are questioning whether recent record sale prices mean the market is overvalued. Among those waiting for the market to cool down is Doug Poutasse, chief investment strategist with Boston-based AEW Capital Management, a major institutional investor that manages $19.4 billion in capital for clients.

“We've been standing on the sidelines as people have come back into the market in the past year because we think that people are betting on a correction that is just beginning. They've priced in a good part of the recovery that is still to come,” Poutasse says.

The main question is how fast the city's rents will rise over the next five years. San Francisco's office market peaked in 2000, with vacancy of about 2% and average full-service rents of $80 per sq. ft. Now, the city's central business district is seeing vacancy of just under 15% and rents averaging $30 per sq. ft., according to BT Commercial Real Estate. Vacancies have been steadily declining since peaking above 20% in 2002 and are expected to continue that trend this year. But over the past few years, rents have been flat.

Trophy sales

Investors are buying buildings that previously hadn't been on the market in years. One of the largest deals under contract is the Landmark building at One Market Street for $190 million, or $496 per sq. ft. It's the city's second largest sale price per square foot in history, second only to the Bank of America Center at 555 California St., which traded hands last year.

TMG Partners is selling the historic 400,000 sq. ft., 11-story brick Landmark building to American Assets, a private San Diego firm that owns no other office properties in San Francisco. The deal is expected to close in a few months. The cap rate on the sale is 8%, according to a market source.

The Landmark building is nearly 100% leased and hosts the regional headquarters of Microsoft Corp. and Del Monte, along with an Autodesk regional office. Tenant Salesforce.com recently expanded into an additional 56,200 sq. ft. of space and now occupies about 170,000 sq. ft. of space in the building.

The average rent in the building is $50 per sq. ft., with most leases expiring by 2010. The property is right along the Embarcadero waterfront and commands impressive views of the Bay Bridge. The building will provide steady cash flow for the next several years.

However, there is a risk for the new owner: “When leases expire, are you able to get the same rent or better?” asks Colin Yasukochi, regional research manager with Grubb & Ellis in San Francisco. John Chamberlain, CEO of American Assets, declined to discuss his firm's motivation for buying the building, other than to say that it is a “long-term investment.”

Plenty of other investors have been willing to roll the dice by paying top dollar for trophy properties, banking on the prospects of significant rent growth in coming years. “We're seeing red-hot, if not laser, investment sales activity,” says Sven Pole, managing director of the Northern California region for Trammell Crow.

The most recent sales for trophy properties average $350 per sq. ft., Pole says. Data from Real Capital Analytics shows San Francisco office sales generally averaged $248 per sq. ft. in the first quarter, compared with the national average of $170 per sq. ft. Only New York, Washington D.C., and San Diego were more expensive markets.

Sumitomo Corp. of America recently purchased the 330,000 sq. ft. office tower known as 123 Mission in San Francisco from Shorenstein Co. for $130 million, or $406 per sq. ft. The building is 87% leased with tenants paying above-market rents. SEB Immobilien-Investment GmbH, the German real estate investment arm of Swedish Banking Group, recently purchased 225 Bush, an historic office building for $178.5 million, or $320 per sq. ft. The property is 94% leased and hosts the Internet division of the National Broadcasting Co. (NBC).

“Price has risen substantially because of the imbalance between supply and demand on the purchase side,” says Yasukochi of Grubb & Ellis. San Francisco, which has over 80 million sq. ft. of office space, has no new office buildings under construction. The conversion of several office buildings into residential condos has helped to keep office supply in check.

“The reason (investors) are willing to be aggressive is that it is a very land-constrained market, and the potential for rents to go high is very high,” says Poutasse of AEW.

“We know that rents in San Francisco can go above $60 (per sq. ft.). San Francisco, Boston and New York have proven they are great long-term markets.”

A return to $60 rents?

One firm that is bullish on San Francisco's prospects for significant rental growth is Jones Lang LaSalle, which markets some of the area's largest office towers for sale.

Wes Powell, a regional leasing director with the firm, predicts that office rates will grow 55% between now and 2009. That means rates could reach $58 to $60 per sq. ft. by that time.

Bolstering Powell's confidence has been the city's strong level of leasing activity in recent months. San Francisco's office market recorded nearly 1 million sq. ft. of net absorption in the first quarter of this year, with more than 400 lease transactions totaling 3 million sq. ft. of new leases, reports BT Commercial Real Estate. The total absorption for all of 2004 was 1.4 million sq. ft.

“It looks like 1999 all over again,” wrote BT Commercial in its first-quarter research report. San Francisco's real estate boom in the late 1990s was propelled by the irrational exuberance of ever-expanding dot-com companies, the bulk of which since folded.

Now, the city's economic base is firmly represented by a handful of sectors: business services, financial services, media, information technology, tourism, and government.

More than 95% of all city businesses employ 50 or fewer employers, according to the San Francisco Chamber of Commerce. Small firms continue to propel the city's office market. In the first quarter, San Francisco added 4,900 jobs. Leisure and hospitality added 2,200 workers, while financial services firms increased payrolls by 2,000 jobs, according to CB Richard Ellis.

Powell of Jones Lang LaSalle says today's market is much different from the dot-com days. Direct vacancy today in the financial district ranges between 10% and 11%, similar to 1998, he says. However, there is more sublease and shadow space on the market today, according to Powell. “The pendulum has swung,” he says, but “the market still carries a fair amount of vacancy Much of the financial district's office leasing growth of late is coming from the expansion of smaller companies leasing less than 10,000 sq. ft. Powell, of Jones Lang LaSalle, recently signed a 5,000 sq. ft. deal on behalf of an international real estate investment company. The firm's growth plans now exceed its original expectations, and the company is now taking 10,000 sq. ft. of space.

In the heady dot-com days, smaller companies expanded rapidly, and much of that was “artificial expansion,” Powell explains. Companies back then leased more space as “defensive plays.” Even if they didn't immediately need the space, they didn't want to be shut out of finding new space, as vacancies inched near zero, he says. Some of that space ended up back on the sublease market in the end. “People are expanding carefully now,” Powell says.

A view to a deal

Although it represents a somewhat small piece of the overall office market, trophy properties offering premier views of the San Francisco Bay and other city landmarks are commanding top dollar. Part of the reason is that firms switched to premier office space with attractive views several years ago when the city's overall office market experienced an overall increase in vacancy, leading to depressed rents for view space. Now, vacancy for office space with premier views is under 10%, compared to the 15% overall city average.

“San Francisco is not any longer a major headquarters city, but it has got tremendous wealth,” says Poutasse of AEW. Major financial services firms have been gobbling up premier space of late.

At the end of 2004, one of the country's largest hedge funds, Caxton Associates LLC, signed a deal for 6,600 sq. ft. of space on the 33rd floor of the Transamerica Building, San Francisco's highest office tower. Redwood Growth Capital leased 3,200 sq. ft. on the 44th floor of the building.

Both deals sold for approximately $60 per sq. ft. Several other deals are in the works for view space, with prices in the mid $50s, brokers say. That compares to average asking rents of $30 per sq. ft. for the rest of the city's central business district.

Those rents are comforting to investors currently making long-time bets on San Francisco. But questions still abound about the city's capacity for job growth. The Bay Area lost a tremendous amount of jobs after the dot-com bust, and the region's high housing costs (some of the highest in the nation) make it extremely difficult for firms to relocate there.

Yet for some firms, San Francisco is a necessary destination. The city is America's biggest gateway to Asia. “Those tenants are relatively price inelastic,” Poutasse emphasizes. “They're going to be there at whatever price they have to be there. You're not going to run your gateway to China out of Dallas.”

Nicholas Yulico is an Oakland, Calif.-based writer.

SAN FRANCISCO OFFICE MARKET

TOP FIVE INVESTMENT SALES THROUGH APRIL
Sale Date Address Sale Price Sq. ft. Price per Sq. ft. Buyer
1 April 2005 1 Sansome St. $214.5 million 550,000 $390 Beacon Capital Partners
2 April 2005 225 Bush St. $178.5 million 575,600 $310 SEB Immobilien
3 February 2005 50 Beale St. $168 million 641,328 $262 Beaon Capital Partners
4 February 2005 333 Market St. $155 million 699,334 $222 Wells Fargo
5 January 2005 123 Mission St. $130 million 320,000 $406 Sumitomo Corporation
Source: Grubb & Ellis

San Francisco - BY THE NUMBERS

POPULATION OF METRO AREA:

6.7 million

UNEMPLOYMENT RATE:

5.2%
Source: U.S. Census Bureau

LARGEST EMPLOYERS:

  1. City and County of San Francisco
    27,000 employees

  2. University of California
    18,000 employees

  3. Wells Fargo
    7,581 employees

Source: San Francisco Chamber of Commerce

METRO AREA STATS:

Office:

19.1% vacancy, 1Q 2004

14.6% vacancy, 1Q 2005

Rent per sq. ft.: $27.08 1Q 2005

Source: BT Commercial Real Estate

Multifamily:

7.5% occupancy, 1Q 2004

4.2% occupancy, 1Q 2005

Rent per sq. ft.: $1,773 2004 avg.

Source: Real Facts

Retail:

9.0% vacancy, 1Q 2004

8.0% vacancy, 1Q 2005

Rent per sq. ft.: $33 1Q 2005

Source: Marcus & Millichap

Flex-Industrial:

5.3% vacancy, 1Q 2004

4.8% vacancy, 1Q 2005

Rent per sq. ft. monthly: $0.74

Source: BT Commercial Real Estate

Hotel:

59.3% occupancy, 1Q 2004

62.4% occupancy, 1Q 2005

Average daily rate: $118.83 1Q 2005

Source: Smith Travel Research

MAJOR PROJECTS AND SALES:

Westfield San Francisco Centre

Type: Mixed-Use Development

Cost: $340 million

Sq. ft.: 1.5 million

Completion: Fall 2006

Developers: Westfield and Forest City Enterprises

Federal Express Building

Type: Industrial Sale

Cost: $35 million

Sq. ft.: 112,000

New Owner: San Francisco Distribution Center LLC

Federal Reserve Building

Type: Property Sale and Development

Cost: $46.8 million

New Owner: Bently Holdings Corp.

Buzz: The historic building is proposed to be converted into a 140-room luxury hotel.

Park Lane Apartments

Type: Multifamily Sale

Cost: $438 million

New Owner: Citi Apartments

Units: 33

Cost Per Unit: $1.2 million