Leasing by San Francisco-area technology firms is slowing just as developers are poised to add 6.5 million square feet of office space to the city and Silicon Valley, the most construction in a dozen years.
Twenty-six projects are under way, from glass towers in downtown San Francisco (ROFFSFRV) to suburban office parks in Sunnyvale and Santa Clara, California, according to brokerage CBRE Group Inc. About 3.4 million square feet (316,000 square meters) of the new development, or more than half, is speculative, meaning landlords broke ground without signing tenants, CBRE data show.
The building boom comes after three years of expansion by companies including Google Inc., Apple Inc. and Salesforce.com Inc. (CRM:US) spurred a surge in rents, making San Francisco the top U.S. office market in 2012 based on forecasts for future increases, according to Green Street Advisors Inc. Growth has cooled, with leasing down 43 percent in the city and two quarters of occupancy losses in Silicon Valley in the past year, raising the prospect that tenants won’t be easy to find at higher rates.
“Companies decided to lock up space before rents climbed further, so they accelerated their normal leasing,” said Donald Wise, chief executive officer of Metzler Realty Advisors Inc., a Seattle-based investor whose $445 million purchase of an office tower in San Francisco’s South of Market district was the city’s priciest deal per square foot in 2012. “Demand is now muted.”
Newly occupied space in San Francisco totaled 80,850 square feet in the first quarter, down from a quarterly average of 118,000 square feet in the trailing 12 months and 526,000 square feet in 2011, according to data from Los Angeles-based CBRE. In Silicon Valley, roughly the area between San Francisco and San Jose about 45 miles south in Santa Clara County, occupancy tumbled by a net 94,000 square feet from the fourth quarter, with the vacancy rate rising to 11.4 percent from 11.2 percent.
Some software, social-media and mobile-application firms have rented too much space for their current needs, said Steve Barker, San Francisco branch manager for Studley Inc., a tenant brokerage. Large firms are assessing global markets for mobile devices, online services and cloud storage on the Internet before signing more leases, while smaller companies take longer to consider deals as landlords raise rates to see what tenants will bear, said Todd Shaffer, managing director in Santa Clara for broker Cornish & Carey Commercial Newmark Knight Frank.
“People are getting all worried, but it’s a good sign that they’re thinking things through,” said Shaffer, referring to office renters. “I’ll be concerned if we’re having this conversation at the end of the third quarter.”
San Francisco’s leasing boom drove up costs for the most desirable office space -- including rent, local taxes and service charges -- by 36 percent in the year through September, the biggest jump among 133 global markets, CBRE said. Technology firms accounted for more than half of all deals, with San Francisco-based Salesforce.com (CRM), the biggest provider of online customer-management software, leasing 1.3 million square feet, the most by one company in a year since at least 2000, the brokerage said.
Asking rents in San Francisco rose 18 percent in the first quarter from a year earlier to $50.79 a square foot, the 12th straight gain, and in Silicon Valley they climbed 7.9 percent to $37.68, the highest since 2001’s third quarter, CBRE said.
During the recession, rents bottomed in San Francisco at $30.50 a square foot, and vacancy peaked at 16.2 percent, in the first quarter of 2010, according to CBRE. Silicon Valley rates hit a low of $27.71 a square foot in the third quarter of 2010, with vacancy peaking at 21 percent a year earlier.
Across the country, office leasing in central business districts fell 5.3 percent in the first quarter from a year earlier, and vacancies were little changed at 13 percent, according to brokerage Cushman & Wakefield.
San Francisco’s office market is now in the “fifth inning” of a nine-inning recovery, with “decelerating” growth that’s dropped its five-year outlook for rent increases to second in the U.S. based on revenue per square foot, Michael Knott, managing director of Newport Beach, California-based research firm Green Street, wrote in an e-mail. West Los Angeles (MODCMMAP) is the top office market based on forecasted rent growth through 2017, he said.
The current development wave, the most since 9.1 million square feet were added in 2001, include speculative projects in San Francisco such as Tishman Speyer Properties LP’s Foundry Square III, with large floors that “create a sense of voluminous space illuminated by floor-to-ceiling glass,” and a tower by Boston Properties Inc., at 535 Mission St., with “excellent natural light” and a “dramatic two-story lobby,” according to the developers.
In Silicon Valley, Menlo Equities LLC and Beacon Capital Partners LLC are constructing three buildings at 3333 Scott Boulevard in Santa Clara, which the firms describe as “a traditional Silicon Valley mid-rise corporate campus with ample parking and stand-alone identity.” Jay Paul Co. is developing the second property of a planned six-building campus in Sunnyvale, dubbed Technology Corners, with “landscaped plazas, fountains and walkways,” the company said.
San Francisco’s office market has a “genuine groundswell of demand” that justifies site development and building that’s “a little bit more aggressive,” Boston Properties Chairman Mort Zuckerman said on the firm’s May 1 earnings call. Google, Microsoft Corp., Yahoo! Inc. and San Francisco-based startups Square Inc. and AppDynamics are all looking for large blocks of space, said Doug Linde, president of the Boston-based landlord.
Job growth is still robust, with employment rising for the 33rd straight month in both San Francisco and Silicon Valley. This year through March, 33,000 new jobs were added in the city and 28,900 in the valley, according to California’s Employment Development Department. Two-thirds of professional and business-services positions came from the technology industry, the agency said on April 19.
Companies are willing to pay triple the cost of suburban space to locate in the city because workers prefer an urban environment, said Carl Bass, CEO of Autodesk Inc. The San Rafael, California-based maker of computer-aided design software signed three leases last year at San Francisco’s One Market and Pier 9 that will almost double its occupancy to 287,000 square feet by mid-2014.
“If you get better people, it’s worth it,” Bass said in an interview.
Landlords are contending with smaller space needs from tenants across industries, down by almost a third to 170 square feet per employee, on average, said Studley’s Barker. Technology firms in San Francisco need 30,000 more hires to fill space that’s already been leased, he said.
“This tech market has been driven by a race to control contiguous space and pre-empt rising rates,” Barker said in an interview. “They’ve massively over-leased. It remains to be seen whether they can fill it.”
The rise in San Francisco rents means that offices comparable to those leased at $30 a square foot in early 2012 are now asking $50 a square foot, according to Barker. Spec buildings under construction will require rents of $60 to $70 a square foot at minimum to cover development costs, he said.
Each project has its own financing structure, starting with the price of land, that can dictate success in a fast-moving market, said Henry Bullock, chairman of Palo Alto, California-based Menlo Equities. Low-rise construction in Silicon Valley, at $375 to $425 a square foot, is cheaper than urban towers in San Francisco, Bullock said. Menlo and Boston-based Beacon Capital will seek rents of $35 a square foot at the Scott Boulevard project in Santa Clara.
“There’s not a lot of development as a percentage of the existing inventory, so we’re not worried,” Bullock said in a telephone interview. The three buildings will be “shell-ready” by mid-August, with “name-brand companies” in discussions to lease one or all of them, he said.
Among San Francisco spec projects, the 535 Mission St. tower by Boston Properties, the biggest U.S. office real estate investment trust, will cost $700 a square foot, Green Street said in a Feb. 6 note. That’s 15 percent more than Kilroy Realty Corp. is spending to develop nearby 350 Mission St., a high-rise that’s no longer spec after being fully preleased to Salesforce.com.
The Boston Properties investment, with an expected 6 percent yield, “seems just OK” compared with Los Angeles-based Kilroy’s 6.5 percent or more and a guaranteed tenant, Green Street said in its note. “Without any known preleasing, these economics seem so-so on a risk-adjusted basis,” the firm said.
Spec builders probably believe the potential for profit is greater by “developing to core, rather than buying to core,” said Wise of Metzler Realty, whose acquisition last year on behalf of a German pension worked out to $802 a square foot.
“There’s strong reason to be optimistic,” Wise said. “I don’t think the market has gotten so overheated that new supply will outstrip reasonable expectations of demand.”
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