Is it the advent of calamity or the return of sanity? That's the question San Francisco Bay Area observers are asking as the colossal real estate boom of the past two years continues its equally colossal reversal. Rents that skyrocketed in 1999 have plummeted in 2001, and the 1% and 2% vacancies of early 2000 have climbed to more than 10% today.

Initially, it appeared San Francisco would be the only market to suffer a tailspin. But when Hewlett-Packard, Cisco Systems, Intel Corp. and other hardware companies began large-scale layoffs, the Silicon Valley market also showed signs of strain as the dot-com damage seeped into nearly every economic sector.

“San Francisco saw the most significant softening in the first and second quarters, but other markets were right behind,” observed Jim Koch, managing partner in the Palo Alto office of Boston-based CSFB Realty Inc. “It's gone from incredibly strong in 2000 to incredibly soft right now.”

According to Mary C. Daly, senior economist with the Federal Reserve Bank of San Francisco, weakness in the technology sector, combined with the dot-com crash and a drop in demand for information technology contract workers, curbed other growth. Daly said business services employment fell at an adjusted average annual pace of 2% in the first quarter of 2001, following an expansion of more than 17% a year earlier. The fallout forced San Francisco investment brokerage firm Charles Schwab Inc. to announce plans to lay off 2,600 workers. Law firm Cooley & Godward also laid off 85 attorneys and 50 other employees.

The California energy crisis is another strike against the San Francisco market. The Bay Area Council, a regional nonprofit research organization based in San Francisco, predicts a $500 million decrease in the region's economic output due to rate increases alone. As increases in monthly electricity and gas rates drive up utility bills, businesses reduce output or lay off employees to cover the higher payments.

However, B.F. Roberts, president of Berkeley-based Economic Sciences Corp., an energy industry consulting firm, said this figure does not account for a potential $5 billion of production losses due to blackouts. According to Roberts, the impact should lessen over time as businesses and property owners invest in energy-conservation measures that will help balance increased energy costs.

Investors aren't panicking — yet

Despite memories of the real estate depression of the early 1990s, San Francisco investors aren't panicking. As Tim Mason, managing director of San Francisco-based real estate brokerage firm Whitney Cressman Ltd. noted, comparatively few buildings have changed hands. However, those that did sold at prices based on current, not projected, rents.

According to Mason, only three Class-A office buildings in San Francisco traded above $400 per sq. ft. last year: 150 Spear for $402 per sq. ft.; 343 Sansome for $411 per sq. ft.; and 200 California for $557 per sq. ft. Two Class-B properties also broke the $400 ceiling, with 233 Fremont selling at $425 per sq. ft. and 290 Sutter at $429 per sq. ft. The few sales in San Francisco this year have been considerably off last year's mark. The 80,000 sq. ft. One Montgomery sold for $312 per sq. ft., while the 340,000 sq. ft. 550 California fetched $324 per sq. ft.

Of course, some investors have lost money, most notably those that bought older warehouses, auto shops and other light-industrial buildings in San Francisco's South of Market (SOMA) district for conversion to the needs of multimedia tenants. Now that the dot-com industry has imploded and SOMA vacancies have climbed above 20%, investors are stuck with expensive loans but no tenants.

Only two SOMA buildings sold at all last year: 631 Howard for an undisclosed price and 639 Howard for $133 per sq. ft. The lack of sales reflects investors' caution toward the dot-com industry — a caution that proved justified.

The relative absence of overbuilding, as compared to the early 1990s, also reassures investors. A comparatively low number of new buildings became available during the 1990s, although there is a significant amount in the pipeline. According to statistics released by Whitney Cressman, San Francisco will add about 3.4 million sq. ft. of office space this year, while CB Richard Ellis reports the Peninsula will add 4.8 million sq. ft. and Silicon Valley 1.8 million sq. ft. The fact that almost all the new space is preleased offers little comfort, for both brokerages point out that nearly 50% of the total is destined for sublease.

Despite the generally gloomy outlook, the current situation does have its upside. Expanding companies that could not afford the rents of 2000 suddenly have several options. “A lot of manufacturing companies were pretty much priced out in 2000. These guys are now able to expand,” Koch said.

Many small industrial and office users are choosing to buy rather than rent to ensure themselves of affordable space. For example, Tracy, Calif.-based Advantage Metal Products purchased a 59,000 sq. ft. building in Livermore for relocation, and Harrell Remodeling acquired a $4.25 million, 16,200 sq. ft. industrial building in Mountain View. Large companies also are making corporate purchases. Houston-based Compaq Computer Corp. paid $28 million for a 41,000 sq. ft. building it was leasing in downtown Palo Alto, while San Jose-based BEA Systems Inc. paid $270 million for a 40-acre parcel in North San Jose to develop as a corporate campus.

However, more large companies are disposing of property than buying it. BEA, in fact, bought its site from Agilent Technologies, a Hewlett-Packard spinoff experiencing serious financial problems. Palo Alto-based Sun Microsystems Inc. has put a 260,000 sq. ft. building in Palo Alto on the market, while Dade Behring Ltd. is seeking a buyer for a 368,000 sq. ft. property in San Jose.

Koch considers corporate dispositions good news for investors. “A number of tech companies purchased properties when their stocks were high,” he said. “Now that's not the case and they're facing a capital crisis. They need to liquidate these properties. There are opportunities at good prices in sale-leasebacks or just dispositions.”

The Carlisle Group, Scranton-Pa., took advantage of one such opportunity to buy a new 126,000 sq. ft. building in Mountain View for $225 per sq. ft., based on figures by BT Commercial Real Estate in San Jose. The cost to purchase the building is half of what it would have been a year ago.

Though struggling corporations may be willing to sell property at moderate rates, investors are not, Koch observed. “Some investors are putting properties on the market at prices they can't possibly get. Others are saying they'll ride out the downturn rather than sell at current rates,” he said. The second-quarter San Francisco office report by Whitney Cressman supports Koch's view. In October 2000, $2.7 billion worth of property was on the San Francisco market, compared with less than $500 million of property in June 2001.

In Daly's view, the prominence of the technology sector in the Bay Area economy makes additional slowing likely. Although a few analysts say a turnaround may occur next year, most predict that it will be 2003 before the market rebounds. Daly added that long-term market fundamentals remain solid. “Given the phenomenal economic growth of the past few years, the area is in a good position to weather the downturn,” she concluded.

Office market hits a snag

Class-A office rents in the San Francisco Financial District have dropped nearly 50% from the peak of 2000. Nonetheless, they still are at least double the rates of the early to mid- 1990s. According to Los Angeles-based CB Richard Ellis, the average annual rent in both San Francisco and San Jose was $58 per sq. ft. in June. The average in Oakland was $40 per sq. ft., according to Boston-based Colliers International.

However, not everyone accepts these figures. Margaret Duskin, senior director in the San Francisco office of New York-based Cushman & Wakefield, contends rental rates are overstated because so few deals have been completed. According to Duskin, $40 per sq. ft. to $50 per sq. ft. is an accurate range for San Francisco rental rates.

But the market is a study in contradictions. On one side, New York law firm Covington & Burling in August signed a lease for nearly $60 per sq. ft. for 46,686 sq. ft. at One Front St. in San Francisco. Then, broker Jim Sobel of Colliers International offered two floors in a Class-A building at 150 California St., a couple of blocks away, for a mere $26 per sq. ft. Of course, the latter price is for space offered on sublease for a maximum of 12 months, a less marketable stipulation.

Huge inventories of sublease space also are available. Whitney Cressman calculates that more than 4 million sq. ft. of sublease space was available in San Francisco in June, and San Rafael-based Orion Partners Ltd. estimates 67%, or 531,000 sq. ft., of available office space in Marin County represents sublease situations.

Most space is offered at below-market rents by companies looking to stem hemorrhaging funds. Since some are desperate, sublease asking rents may bear minimal relation to asking rents for landlord-controlled space.

Industrial market suffers blow

The Silicon Valley industrial and Research & Development (R&D) market suffered a blow this year due to severe declines in the high-tech sector, but other markets have fared somewhat better. For example, the East Bay appears to have remained strong, with vacancies under 5% in most submarkets, according to Greig Lagomarsino, senior vice president in the Oakland office of Colliers International.

“If you compare what impact this downturn has had on Bay Area vacancy rates and average rental rates, the East Bay has held up better than other markets,” he said.

As evidence of this strength, Lagomarsino and Bob Ferraro, vice president at the Colliers International Pleasanton office, completed the sale of a 7,100 sq. ft. warehouse in Hayward for $129 per sq. ft, a record rate for the immediate market. The property sold to a distribution company for its own use.

Similar to the plight of the office sector, the R&D market is affected by a sizable amount of sublease space. According to the second-quarter Silicon Valley R&D report by BT Commercial, there was 5.1 million sq. ft. of available R&D sublease space in Silicon Valley for the second quarter.

Scheduled vacancies also loom over the market. According to BT Commercial, about 15 million sq. ft. of R&D space is immediately available, and another 17.5 million sq. ft. will become vacant in the future. The total is more than triple the 10.4 million sq. ft. absorbed in the first two quarters.

One bright spot in the industrial landscape is the biotech industry. While not entirely immune to the downturn, many biotech firms are expanding. Genentech Inc. followed completion of a 112,000 sq. ft. facility at its South San Francisco headquarters with a 280,000 sq. ft. research center expansion.

In the same city, San Francisco-based Tularik Inc. is in the market for 250,000 sq. ft. of R&D space. In Berkeley, Bayer Corp. bought a site for a 180,000 sq. ft. research building.

On the down side, the high cost of biotech facilities — two to 10 times what office buildings cost — combined with the five to 10 years it takes to bring a product to market presents a major obstacle to biotech growth.

Retail sticks it out

Through thick and thin, the Bay Area retail market remains healthy, largely because a shortage of sites constrains development. The strongest market, as usual, is San Francisco's Union Square area, which continues to attract high-end retailers. Yves Saint-Laurent, Boucheron, Prada and Helmut Lang are among those that have signed on during the last year. In particular, Grant Avenue has benefited from the influx as retailers find it nearly impossible to locate space on and immediately off the square.

The trend has even spread to Market Street, where New York-based Millennium Partners landed St. John's Knits for the retail podium of its new high-end residential and hotel tower. The recently approved Cleveland-based Forest City Enterprises 1.5 million sq. ft. vertical mall, anchored by Bloomingdale's, will further enhance the formerly downtrodden side of Market Street.

Union Square rents have remained strong, according to Vicki Johnson, a partner in locally based Johnson Hoke Retail Leasing & Development. She said annual rents on the square cost as much as $400 per sq. ft. But rents off the square drop off, according to Marti Christoffer, a retail specialist with San Francisco-based Starboard Commercial Real Estate, who said rents sink to $24 per sq. ft. at the district's far edge.

As in other locations, mixed-use projects are gaining popularity. Santana Row in San Jose, developed by Rockville, Md.-based Federal Investment Realty Trust, will include 680,000 sq. ft. of retail space, a 200-room Hotel Valencia and 1,200 residential units. Bay Street in Emeryville, developed by Cincinnati-based Madison-Marquette, will combine 380,000 sq. ft. of retail with 270,000 sq. ft. of residential and a 200,000 sq. ft. hotel.

According to Encino-based Marcus & Millichap Real Estate Investment Brokerage Co., Bay Area retail rents increased about 7% last year, averaging $2.50 per sq. ft. per month, but hitting $4 per sq. ft. in more popular destinations. The Palo Alto brokerage firm expects rates to rise 3% this year.

Hospitality down, despite luxury appearance

Luxury hotels grabbed headlines this year when Atlanta-based Ritz-Carlton Co. opened a 261-room resort in Half Moon Bay, the Clift in San Francisco unveiled a multi-million dollar makeover and a new Four Seasons hotel was completed on Market Street. However, these glamorous establishments disguise the condition of the overall industry.

In San Francisco, hotel occupancy as of late September had dropped to the 30% range as the effects of the Sept. 11 terrorist attacks impacted the hospitality market. Prior to Sept. 11, occupancy at the airport was down 17% from a year ago, 15% at Fisherman's Wharf and 13% in the Financial District, according to a report by San Francisco-based PKF Consulting. Silicon Valley and the Peninsula fared even worse, declining 22% to a 65% occupancy level. Although PKF reports the average San Francisco room rate fell only 3.2% to an average of $186.20, additional reductions are likely as the summer tourist season ends.

However, hotel developers are creating new projects. San Francisco-based Stanford Hotels has proposed a 12-story, 600-room hotel with 30,000 sq. ft. of meeting space in Burlingame near San Francisco International Airport. The company is developing a 430-room hotel along the Embarcadero in San Francisco, while San Francisco's Kimpton Hotel Group plans a 224-room boutique hotel in Cupertino.

Apartments: Tenants needed

A year ago, prospective tenants lined up at every apartment showing, often bidding up the asking rent. Now apartments sit vacant for weeks and even months as landlords hold to last year's inflated rates in the hopes the real estate industry boom will return.

The second-quarter report from Boston-based Prudential Real Estate Investors reveals San Francisco apartment vacancies have climbed to 10%, up from less than 2% in 2000. According to RealFacts, Novato, Calif., the average city rent dropped to $2,157 per month in June from January's $2,359 per month.

Silicon Valley and the Peninsula saw similar declines, but East Bay and Marin County endured smaller decreases, according to New York-based Merrill Lynch & Co. Inc., which nonetheless projects a worsening situation. The consulting firm ranked San Francisco, Oakland and San Jose among the five weakest markets in the U.S.

New York-based Lend Lease Real Estate Investments, on the other hand, ranks Oakland among the top six markets for investment because of the region's strong investment potential. “The current correction will allow a number of markets to eliminate some of the distortions that had been created,” said Richard Gold, principal and head of equity research for Lend Lease. “While this may adversely affect some private investors, most long-term institutional investors view the market run-ups as unsustainable and therefore not significantly affecting their pro forma returns.”

According to a report by Marcus & Millichap, the Bay Area median sales price surpassed $100,000 per unit last year, with the median for San Francisco at $150,000. The highest price paid was $402,500 per unit for an eight-unit building on Russian Hill. The report cites a sales volume decline in 2000, because landlords held on to property to take advantage of a 35% rent surge. The brokerage firm anticipates a greater volume of sales this year due to decelerating rents.

Development activity has waned, with only 4,750 units slated for construction compared to about 7,000 units in 2000, according to Marcus & Millichap. Gregg Nelson, a principal with Danville, Calif.-based Trumark Cos., estimates residential land prices are down more than 20% from a year ago. For example, he said, Tri-Valley residential sites that sold for $40 per sq. ft. in 2000 go for $30 per sq. ft. today.

John McCloud is a San Francisco-based writer.