Article by Jim Emerson The office market malaise is expected to worsen this year in most of the San Francisco Bay Area. San Francisco and major Silicon Valley submarkets to its south will suffer the most acute economic pain from foreclosures, while the impact of the recession may seem milder in some market niches. "We haven't hit the bottom," said Jeffrey S. Weil, senior vice president at Walnut Creek-based Colliers International. "There's 84 million square feet of vacant office space in the greater Bay Area, including 15 million feet vacant in San Francisco and 40 million feet vacant in Santa Clara, plus 30 percent to 40 percent sublease space in some submarkets." Weil and other analysts have pushed back their forecast for recovery in the Bay Area to 2004 and beyond, assuming interest rates stay low. Office markets are expected to stay sluggish until investment capital returns to high-tech, communication and biotech industries, which drive the economy in this region. Although the downward office sector spiral appears to be slowing, when economic recovery occurs will depend on what happens to the pace of job layoffs and how quickly vacant space fills up, particularly the subleased space, according to analysts. Another concern this year will be what happens to financially strapped United Airlines, which has a hub at San Francisco International Airport. "The recovery in the Bay Area will happen when the dominant high-tech sector rebounds or the region's economy is repositioned to become more diverse," said Raphael Bostic, director of the Casden Real Estate Economics Forecast at the Lusk Center for Real Estate at USC. "But, I don't think that's going to happen in the next 12 months." Regionally, the whole economy is weak despite otherwise strong economic fundamentals because little venture capital is being invested to spur recovery in the high-tech industries, which strongly influence all the real estate sectors in the region, Bostic said. Bad Fundamentals Nationally, the economic downturn seems mild compared to the troubled Bay Area. To Bostic, who analyzes national and statewide trends, the Bay Area this year likely will remain the hardest-hit region in the nation. Bostic said the Bay Area's office sector is ailing the most for two reasons: The regional economy makes office building owners over dependent on high-tech tenants, and astronomical housing prices make the Bay Area less competitive for companies that might otherwise consider locating facilities there. Demand for office space may remain depressed for another five years, except in areas relatively untouched by the dot-com boom and bust. Small Saviors The properties expected to have most immunity to the economic malaise are trophy buildings in prestigious locations favored by tenants trading up and by institutional investors. Also favored are small offices almost anywhere and suburban offices in eastern Contra Costa County, which was bypassed by dot-com-driven speculation. The best-performing segment of the office market during the downturn and early recovery likely will be small office buildings, which typically are leased by startups and small expanding firms needing more space. "The most dynamic part of the office market are buildings with 1,000 to 5,000 square feet, followed by buildings with 5,000 to 15,000 feet," Weil said. Owners of small buildings in many instances have been able to increase rents because the demand for small footprints remains healthy among tenants and investors seeking to purchase small office properties. This likely will lead more owners of larger offices to divide spaces to attract more active smaller tenants, he said. Bostic doubts that office rents in larger properties pumped up by speculative investments in high-tech industries will recover for many years. "I don't think we'll see rents at the level we saw three years ago for a very long time," he said. By the end of 2002, rents in the financial district of San Francisco had fallen from $90 per square foot at peak to closer to $32, according to Weil. The suburban office market in Walnut Creek was healthier, with rents in the $36 to $38 per-square-foot range because supply has been tighter with 10 percent to 12 percent vacancy due to little major new development and no dot-com boom, Weil said. Sluggish economy or not and despite the overall 20 percent office vacancy, public sector office development will continue in San Francisco. The state Department of Compensation Insurance plans to break ground in the fall on an $82-million, 11-story, 267,000-square-foot office building at 55 Ninth St. Meanwhile, the city is seeking development proposals for a 400,000-square-foot office building near the Civic Center. Going Low Tech The most troubled parts of the Bay Area, not surprisingly, will continue to be closer to San Jose in the Silicon Valley where submarkets like Santa Clara will see increasing foreclosures this year, especially on properties suffering 30 percent and higher vacancy, Weil said. Unfortunately, the foreclosures may represent just the tip of the iceberg, unless corporate profits are sustained, leading to more leasing to achieve positive absorption of office space, he added. Another market outside San Francisco being challenged to fill vacancy is the East Bay city of Emeryville, which during the boom transformed itself from a dying industrial center to an office haven for high-tech companies seeking cheaper rents. Since the bust, occupancy and rents have declined as much as 40 percent from the peak in Emeryville. "Now, its nickname is Emptyville," Weil said. North of San Francisco in office-rich Novato in Marin County and elsewhere in the Bay Area tenants are negotiating with landlords to get out of leasing commitments. Weil anticipates landlords will become less willing to break leases this year than earlier in the recession because vacancy increases probably haven't peaked yet. "They're going to want to keep tenants on the hook," Weil said. It's a Tenants' Market Office tenants can expect the present renters' market to last a few years in most parts of the Bay Area. In downtown Oakland, Shorenstein Co. reportedly is offering generous tenant improvement concessions and leasing space for substantially below-market rents to attract tenants to its new high-rise at 555 City Center. "More concessions will be available almost across the board in the Bay Area for office space," Weil said, "but whether tenants can get them depends on factors, such as rent escalations in leases and the creditworthiness of tenants." Investor demand will outpace supply this year, which is surprising with rents falling, vacancies increasing and subleasing activity growing. The reason for this is low interest rates and the fact that many owners are reluctant to sell because other types of investments seem less attractive than real estate, he said. "With low interest rates low, even buildings with 30 percent to 40 percent vacancy can still generate cash flow for some owners," he said. "If they sell, what else can they do with the money?"
January 6, 2003