Bay Area Market Feels Pinch of ‘Dot-Com’ Fall
For the first time since “new-economy” firms sent Bay Area commercial rents soaring four years ago, sputtering “dot-coms” are taking some lift out of the supercharged market.
Vacancy rates are rising. Rents are flattening or, in some areas, falling. Huge chunks of sublease space have come back onto the market. Even the seductive practice of trading rent for stock has faded. And credit, once again, is king.
“Old,” as in “old economy,” “is starting to look pretty good again,” said Tom Poggi, a broker with San Francisco’s CAC Group, a leading downtown brokerage.
Certainly, no one is pushing the panic button in what remains one of the country’s strongest office markets. Even if rental rates--which are among the nation’s highest at about $75 per square foot per year--were to fall 10% to 20%, most landlords would still be generating decent cash flow. And though the vacancy rate has doubled in the last three months, local brokers estimate it is still hovering at a miniscule 3% to 4% including sublet space--a figure most cities would drool over. Class A rents in downtown Los Angeles average less than $20 per square foot annually, according to CoStar Group Inc., and vacancy is close to 20% including sublet space.
Still, the dot is off the com, so to speak, and the real estate market is feeling the pinch.
“I don’t think we’ve heard all the bad news yet,” said Douglas Rosenberg, one of the city’s larger developers in the tech-heavy South of Market District, known locally as SoMa. “The question is, how bad is bad, and how much will the market soften.”
The list of Internet-related companies returning space to landlords or putting it up for sublease is long--and growing. Some of the biggest include Web-hosting company EGroups Inc., which never moved into the 125,000 square feet of prime downtown space it rented at 555 Market St.; Internet consultant Organic Online Inc., which has given 77,000 square feet back to its SoMa landlord; and online drugstore More.com, which is subleasing 66,000 square feet.
Several real estate firms tracking sublease space in San Francisco estimate there is close to 1 million square feet available. That represents a small, but not insignificant, portion of the nearly 65-million-square-foot overall market.
Brokers insist that although conditions are dampening, they aren’t in a free fall.
“If there’s a bottom to this market, it’s not going to be very deep,” said Meade Boutwell of Cushman & Wakefield, citing the critical mass of programmers, Web-enablers and financial institutions that remain in the city.
Reasons for the sudden flood of sublease space vary. Consolidation has played a role, as in the case of EGroups, which was acquired by Santa Clara-based Yahoo Inc. Other firms, in a rush to secure space in an air-tight market, simply grabbed more than they needed, or overestimated their growth projections. Still others, such as Pets.com--which has become the Internet poster child for failure--simply ran out of funding and went belly up. Its 40,000-square-foot SoMa headquarters space is up for grabs.
Such volatility has created a mood of uncertainty, particularly among landlords.
“There’s a different attitude,” said Marty Dalton, a principal with developer Union Property Capital Inc., which saw its 77,000-square-foot deal with Sectorbase.com come apart as the company’s funding dried up. “Landlords will have to quit saying, ‘Here’s the space. Take it or leave it.’ ”
Dalton and other property owners said they now scrutinize potential tenants more closely and demand larger financial guarantees, such as multimillion-dollar letters of credit. At the same time, tenants are now able to force greater concessions such as money for space improvements and smaller down payments. And traditional firms with good credit are garnering the attention they lost when the dot-com frenzy was in full force.
That may be one reason why earlier this month San Francisco-based Catellus Development Corp., owner of the massive Mission Bay mixed-use project near Pacific Bell Park, inked a 283,000-square-foot deal with clothing retailer Gap Inc. Its first was with struggling Internet consultant MarchFirst.com.
For companies with solid track records that were tossed around or outbid by upstart tech firms, the recent reversal of fortune also has spurred a bit of gloating.
“Everybody was having to pay higher prices because of dot-coms,” said Michael Pitre, managing director for tenant-rep broker Julien J. Studley Inc. in San Francisco. “It was a negotiating strategy for landlords.”
Schadenfreude among old economy tenants aside, the city is still a landlords’ market. Premium properties, mostly in the traditional downtown area north of Market Street, command rents in the $80- to $100-per-square-foot range. This month Dresdner RCM Global Investors shelled out $90 a square foot to renew 100,000 square feet at Embarcadero Center.
But less desirable buildings with fewer amenities--mainly in SoMa, Potrero Hill and other outlying areas of Multimedia Gulch south of the city center, are starting to lose their clout and their position could get worse if the economy continues to slide.
A two-tier market is beginning to emerge, said Ezra Mersey, Bay Area regional director for Tishman Speyer Properties. He predicts the downtown core will remain strong, but marginal submarkets that blossomed because of the dot-com boom will suffer from softer rents and property values.
Despite the dot-com fall-off, San Francisco has a number of built-in constraints that should keep values and rents steady, brokers said. Some are natural, such as the limited supply of land in a city bounded by water on three sides. Then there is the controversial Proposition M, a 14-year-old, voter-approved initiative that limits new office construction to just under 1 million square feet annually.
And unlike the 1980s, when a number of major corporations such as Chevron Corp., Pacific Bell and Pacific Gas & Electric fled to the Peninsula and East Bay because of escalating rents, today rates in the suburbs are often just as high, if not higher, than in the city.
Indeed, a number of Peninsula and Silicon Valley firms such as DHL Airways Inc., Visa USA and, most recently, Sun Microsystems Inc., have relocated or moved into the city with large lease deals.
“The market is more diversified than it’s ever been,” said CAC’s Poggi.
Some market observers are less sanguine. Bill Benton, one of the more active dot-com brokers in San Francisco, recently conducted his own unscientific analysis of the market. According to the CB Richard Ellis Inc. broker’s figures, 8 million square feet of new space was added to the market in the last two years, of which 5.9 million square feet, or nearly 75%, was leased by young start-ups. And of that, a whopping 3.8 million square feet is what he would deem “weak credit.”
“The dot-coms are going away just as fast as they appeared, so who’s to say that rates won’t come back down quicker and lower?” said Benton, adding that he wouldn’t be surprised if rates fell 15% to 25%.
To many minds, the leveling off is a healthy development after several years of spiking rents and little vacancy--a business climate that has forced many companies to reconsider settling or staying in the Bay Area. One beneficiary has been the cross-bay city of Oakland, where rents have hit $50 per square foot in the best buildings and leasing activity is robust. Although still significantly below San Francisco’s figures, the surge has been enough to entice developers such as The Shorenstein Co. to kick off new office buildings for the first time in over a decade.
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Market Loosens Up
Sputtering “dot-com” businesses are cooling the Bay Area office market. San Francisco vacancy rates have ticked upward and rents are flattening out.
Vacancy rates are climbing ...
3rd quarter 2000: 1.9%
... and rental rates are leveling off.
Price per square foot of office space per year in downtown San Francisco
3rd quarter 2000: $65.88
Source: Cushman & Wakefield
