The San Francisco office real estate market continued to steamroll forward this quarter, with the second quarter seeing high absorption, a further decrease in vacancy, and steady rent growth. Vacancy has shrunk to 5.7% citywide, and competition for choice product is heating up so much that nearby markets are tightening as a result. Another byproduct of this is a lack of space options for tenants in the market, which allowed only 1.5M square feet of leasing activity this quarter. This is the lowest amount of leasing activity in San Francisco in the past six years. While this may not be a sign the market is slowing down, it is an indicator that net absorption may be lower, or even negative, in the next few quarters. Demand should cause rates, which are increasing at an average of 10% annually, to continue to climb. This should continue throughout the year, especially with fewer space options after 372,665 square feet of net absorption this quarter further lowering the supply of available office space.
Sublease space is typically a leading indicator of slowing real estate market growth. Historically, an increase in sublease space usually precedes slowing market growth by three to five quarters. As bubbles in the market start to burst, tenants tend to put excess space on the market to improve their bottom line, giving a precursory look into how the companies within a local economy will affect real estate trends quarters into the future. Sublease space availability in the San Francisco office market is at historic highs, and continuing to grow.
It has been almost a year since we first addressed this concern in the current market cycle, when we concluded that the increase in sublease space was no major cause for concern. Our sentiments remain unchanged, even as the proportion of space available for sublease has continued to increase to new heights. As the supply of direct space shrinks, the proportional amount of sublease space increases. The other key factor to consider is why space is being marketed for sublease. Companies closing their doors or consolidating and subleasing space is cause for concern, however, this is only a small amount of space in the current San Francisco market. Most of the subleases are indicative of a strong market; for example, tenants outgrowing their space before their lease expires, or large tenants taking large blocks of space for future needs and subleasing unneeded floors now.
San Francisco's unemployment rate fell in the second quarter of 2015, down an additional 0.5% to 3.4%, the lowest it has been since December 2000. If unemployment keeps falling at this rate, it should surpass the previous record-low from December 1999 of 2.4% sometime in the fourth quarter of this year. The San Francisco area has experienced job growth of 3.2% over the past year, or 30,600 new jobs. Both San Francisco's labor force and employment numbers are at record high levels and continue to climb. The spillover from this employment growth to the office real estate market is noticeable. Companies need space for their employees, so as job growth continues, the San Francisco office market will grow to meet this need.
Direct asking rental rates for Class A, B and C buildings currently average $59.03 per square foot, $49.24 per square foot and $48.28 per square foot, respectively. Year-on-year rental rates for Class A buildings are up 6%, year-on-year rental rates for Class B are up 15%, and Class C buildings are up 26%. There are no obvious signs that this rapid rental growth, which started in 2011, will stall anytime soon.
Net absorption (the change in occupied space) for San Francisco overall was a positive 372,665 square feet in the second quarter, as many tenants moved into space leased in previous quarters. All of this positive net absorption was in the Class B market, as Class A and C space both saw slight occupancy losses this quarter. The largest transaction was 510 Townsend Street by Stripe, which signed a lease for the entire SOMA building slated for delivery in 2017. The largest lease for existing space this quarter belongs to LendingClub, which took eight floors totaling 112,000 square feet in 595 Market. In addition, Sheppard Mullin (4 Embarcadero) renewed 65,234 square feet and Instacart (50 Beale) took 56,228 square feet this quarter. The San Francisco office market is seeing strong activity across all product types throughout many submarkets.
The vacancy rate in the second quarter fell another 53 basis points, to 6.1%, making it even more of landlord's market. With much of the office space being developed already pre-leased, and robust leasing activity, this number will continue to drop.
The investment sector activity dropped dramatically in the second quarter of 2015, with approximately $279M in San Francisco office real estate changing hands. While deal volume was down, prices increased slightly, to an average of $685 per square foot across all building classes. The most notable transaction, Tishman Speyer's purchase of 160 Spear, was the only large office transaction this quarter, and accounted for 71% of this quarter's sale dollar volume. Aside from this large transaction, some of the other buildings sold in the second quarter include: 555 Howard for $27M ($1,000/SF), 547 Howard for $6M ($988/SF), and 580 Market for $24M ($721/SF).
The $279M in deal volume is comprised of ten San Francisco market office properties. A total of 407,619 square feet transacted with an average price of $685 per square foot, which is a 13% increase in average dollars per square foot over the first quarter of 2015. Cap rates dipped this quarter to an average of 4.00%, albeit from a very small sample size.
SPOTLIGHT: HOUSING SHORTAGE
It is widely known that San Francisco is one of the most expensive U.S. markets in many aspects, including cost of living. At the heart of this issue is the cost of housing, which has been skyrocketing since emerging from the recession. This is a result of record-setting job growth and a housing supply that cannot keep up with demand. While this report focuses on the office real estate market, housing costs have a huge impact on the city. If the workers are unable to live in or near San Francisco, the workforce, and subsequent office market, cannot grow.
The Bay Area currently has over 57,000 apartment units planned or under construction. In San Francisco alone, there are 6,550 units under construction, second only to Silicon Valley. As new construction is being delivered, the total number of multi-family units is growing at slightly over 2% annually, which is easily outpaced by 3.2% job growth. Therefore, the small supply of housing is shrinking relative to demand of people hoping to move to the city, which should cause the 4.4% vacancy to shrink even further.
Quoting the basic law of supply and demand is one thing, seeing the potential impact in real figures is a whole different story. Rental rates have risen 15% over the past year, to a median of $3,198 per month, according to Zillow, which is more than double the national median. Assuming a 30% rent-to-income ratio, a household would need to make $128,000 yearly (without debt) to afford an average apartment, over $50,000/year more than the median household income. If that seems dismal, purchasing a home is even less promising, with median house prices six times as high as the national median, at $1,250,000 for houses and $1,100,000 for condos. With a quarter million dollar salary being a minimum requirement to purchase any reasonable real estate in San Francisco, it becomes worrisome that housing affordability may stifle huge amounts of growth in all aspects of the real estate market.
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