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San Francisco: while the problems of the '80s still torment downtown,the suburbs are seeing growth.

Without question, the San Francisco Bay Area commercial real estate market performed better in the past year than in the several years preceding.

"If you're going to weed out the portfolio, now is as good a time as anadvises Robert Upton, partner with the San Francisco office of London-based Knight Frank Baillieu.

If the advice sounds less than upbeat, it is mostly a reflection of the hit most owners took from the plunge in values from the highs of the 1980s. Unless they have owned a building for a long time, sellers still must expect to take a loss.

Buyers, on the other hand, are in a good position, if they use caution. As Upton puts it, "There are a lot of deals out there that make sense. There are even more that don't make any sense at all."

According to most observers, San Francisco remains comparatively strong in office, hospitality and retail, though significant problems linger in the first two due to overbuilding and overpaying in the80s. A fixed amount of space and long-term limits on new construction are the city's saving graces. The suburbs, on the other hand, are beginning to experience significant growth, with several office and industrial submarkets poised for expansion.

A good indicator of the changing market, says Bert Sandell, managing director for Trammell Crow Co.'s Northern California office, is the relative ease with which his company sold the CalFront portfolio this spring. The portfolio included four buildings and two sites in downtown San Francisco plus buildings in Oakland, Pleasanton and San Ramon. The buyer, Highbridge Partners of Los Angeles, paid $140 million for 14 buildings and 295 acres of land.

"We contacted over 140 national and international candidates as buyers," says Sandell. "We ended up with eight letters of intent and selected three finalists. It was a signal that commercial real estate in California, Northern California in particular, was making a comeback."

Of course, the comeback has a down-side for some investors. Great buys have become relatively rare compared to the past few years.

"The opportunities to purchase something at a deep discount are few and far between. Most of that stuff is gone," asserts Ray Melani, vice president and Western regional manager for San Francisco-based USL Capital Corp.

Office

Even with the recession, San Francisco's office vacancy rate remained one of the lowest in the nation, hovering between 10% and 12%. Upton and other commentators believe the vacancy rate will remain at this level for some time to come.

Class-A rents appear to have stabilized at about $21 per sq. ft. annually, according to both Julien J. Studley, Inc. and TRI Commercial Real Estate Services, although some better deals are available. Tenant improvement dollars are on the decline.

"Citywide net absorption was negative for the second consecutive quarter and the highest in more than four years," says Steven F. Lachman, regional president of The Galbreath Co. of California Inc. "This is attributable to a significant increase in the amount of sublease space on the market, particularly in the Financial District South. However, leasing activity was by no means sluggish."

Upton believes now is a good time to buy, though he cautions, "The buyer is going to be somebody who is prepared to work on the buildings and take the leaseup risk. When you figure out the rents and cost of operating and the difficulty and cost of putting in code upgrades, particularly ADA compliance, it's difficult to make [some buildings] pencil out, even at $90 or $100 a foot."

"An interesting development in the San Francisco office market is the surprising increase of office buildings for sale," Lachman says. "As suburban office parks in other parts of the Bay Area were the investments of choice throughout the late-1980s and early-1990s, San Francisco could be the last opportunity to purchase large-scale investment properties below replacement cost."

The San Francisco Peninsula enjoys a lower vacancy rate than San Francisco, according to CB Commercial Real Estate Group, with vacancies for San Mateo County close to 5% (below 2% in certain submarkets) on a base of 21 million sq. ft. Vacancies are so low that WSJ Properties of Palo Alto, Calif., broke ground on a 65,000 sq. ft. office building in San Mateo, the first speculative office project on the Peninsula since 1987.

According to James W. Lees, a CB Commercial first vice president, the developer would build even larger if zoning permitted. "There's no space on the market for tenant's needing more than 5,000 sq ft."

Lees says average monthly rental rates of $1.50 to $1.70 - with a few very select deals as high as $2.25 - bodes well for investors. "This is the third consecutive year of a rental spike," he says. "It's getting ever so tight."

Richard Larsen, senior vice president and district manager for Grubb & Ellis in Oakland, says Class-a activity in downtown Oakland and Berkeley increased in the second quarter. He anticipates positive absorption through the second half of the year.

The North Bay is a micro-market by regional standards, but investors in Marin, Napa, Solano and Sonoma counties benefit from tight growth controls that prevent overbuilding. The generally tranquil and scenic environment attracts many high-tech entrepreneurs who want their business near their homes. David Rabb, of David Rabb REIT, reports his $3.5 million trust, which consists of 10 properties within an hour's drive of his San Rafael office, consistently returns in the 7% to 8% range.

Industrial

According to the San Francisco office of The Yarmouth Group, the Bay Area contains approximately 470 million sq. ft. of warehouse, distribution and R&D facilities, the majority of it on the Peninsula and in the East Bay. Alameda and San Mateo counties also have some hightech manufacturing facilities, and biotech and high-tech manufacturers are beginning to expand to Solano and Napa counties, where appropriately zoned land is available to develop.

Yarmouth reports record levels of net absorption, declining vacancies and stabilizing rents in 1994, continuing into 1995. The overall vacancy level is just over 10%, down from nearly 20% in 1992. Yarmouth notes that the last year and a half brought a significant increase in investment activity, especially user purchase of warehouse and R&D properties.

Sandell agrees there is strong investor appetite for industrial product, but he adds, "We can't find it, and when we can find, there's intense competition. There's not a lot of new product coming on line. People who wanted to sell pretty much have done it."

"As the economy in general comes back, a lot of companies are realizing there's no space available to accommodate expansion," Sandell says. " I think you'll see a lot of build-to-suits."

Retail

There are several major retail properties which changed hands in the past year. The biggest was Equitable Real Estate Investment Management, Inc.'s $70.5 million purchase of the 425,000 sq. ft. Corte Madera Town Center. The seller, Los Angeles-based Solus Property Co. (now Helios), took the property back from its developer in 1992, investing $7 million in improvements and marketing to bring leasing from under 50% to over 90%. Another struggling project by the same developer, the 111,000 sq. ft. Napa Town Center, sold this year for a paltry $5 million to two San Francisco investors, who hope to accomplish a Corte Madera-type turnaround.

Rents are high throughout the Bay Area, ranging from about $12 a sq. ft. annually in ordinary neighborhood centers and districts to $200 and up in San Francisco's Union Square area, where a host of national and international retailers have been opening 20,000 sq. ft. to 50,000 sq. ft. stores. With Federated's purchase and planned closure of the Emporium, rumors have been flying that Bloomingdale's will be brought in to take over the department store's historic Market Street building.

Appropriate sites for today's big-box retailers are hard to come by, but several power centers are in development in the Livermore-Pleasanton area, and Marin City, Pleasant Hill and Concord will get new downtown shopping centers.

Muiltifamily

Prospective buyers are abundant, but viable properties rare, according to most Bay Area residential specialists. \Wile a combination of static rents and rising expenses means properties bought in the 1980s holds down profits, most properties are at least close to paying for themselves and owners are reluctant to let them go at a loss.

"There are a lot more buyers than sellers," says Gary Lucas, manager of the San Francisco office of Marcus & Millichap, a Palo Alto-based brokerage house. "The properties that are for sale tend to be in riskier areas, so anything worthwhile generates interest. If you've been sitting on the sidelines, this is a good time to move."

Opinions are divided on prospects for the next year. Keith Guericke, CEO of Essex Property Trust in Palo Atto, says the Bay Area market is strong enough that Essex will be raising rents 3% to 4% this year. Others say rent increases are risky.

"In California, when the market gets good and construction has been down, building starts up immediately," points out Marc Levinson, an associate with Skyline Realty in San Francisco. "That puts a lot of pressure on owners of older properties because they have to compete with the newest that's out there."

Also, unfortunately for owners who bought at the top of the market, prices do not measure up except in a few choice markets. Guericke reports Essex bought a portfolio of 92 REO or delinquent properties last year at an average price of about $20,000 a unit. The previous owner had paid more than $50,000 a unit. Essex was able to turn the properties around quickly and sell them at $30,000 to $35,000 a unit, he adds.

For other owners, however, the situation appears to be very good, according to Michael Anthony, a broker with Century 21 Vision Realty in Daly City. "For owners who've had their buildings for longer than seven years, there's a window of opportunity that never existed before that allows owners to trade up and do a tax-deferred exchange for more property of comparable quality that's getting better returns."

Hospitality

Bay Area occupancy levels and room rates both increased by 2% in 1994, according to the Yarmouth Group, with the former averaging 74% and the latter $93 a night. Yarmouth predicts performance will improve over the next several years due to anticipated increases in business and pleasure travel.

Several new projects have been announced or begun in San Francisco, including Forte Hotels' winning bid to build a 22-story hotel in the Yerba Buena Gardens redevelopment area. Many significant expansions and renovations are newly completed or under way, including the Westin St. Francis, Hyatt Embarcadero and Hotel ANA in San Francisco and Claremont Resort Hotel in Oakland.

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