Bay Area’s Real Estate Market Bust Turns Up the Heat on Wall Street

The San Francisco Bay Area’s commercial real estate market is going through a meltdown, and the heat is being felt all the way to Wall Street.

The region’s collapsing rents and soaring vacancies for apartment, industrial and office properties have undermined the performance and raised concerns about a wide variety of large, publicly traded real estate companies with large stakes in Bay Area real estate.

Wall Street analysts have lowered their company ratings, and some firms have cut their earnings and revenue projections in part to reflect the woes of the Bay Area’s once-roaring property markets. Executives who once crowed about their new San Francisco office building or Silicon Valley apartment complex are more apt to talk about other, better-performing markets.

“Anyone that has a concentration in that market has a tough story to tell,” said Jim Sullivan, an office and industrial real estate analyst with Green Street Advisors in Newport Beach. “Clearly that market is one that is recognized by most as having dropped the furthest, the fastest.”

In defense of the region, many real estate executives say that concerns about San Francisco and Silicon Valley properties have been overblown and that, in the long term, the real estate market remains one of the most attractive in the nation. Even with the steep declines in rents and property values, many firms said their Bay Area properties churn out profits.

“San Francisco exceeded our projections,” said Nelson Rising, chairman and chief executive of Catellus Development Corp., speaking of his company’s prominent properties and developments. “It belies the image that things are under siege.”

But there is no question that the Bay Area’s real estate market, undermined by the failure and cutbacks at once-booming high-technology and dot-com firms, is one of the nation’s most troubled. San Francisco is “clearly the weakest region in which we are currently operating,” said Edward H. Linde, president and chief executive of Boston Properties Inc., in a conference call with Wall Street analysts last month.

Asking rents for San Francisco office space dropped by about 50% last year while the nearly nonexistent vacancy rate for Silicon Valley research and industrial space shot up past 12%, according to Grubb & Ellis. The apartment industry also is suffering, with rents falling 10% to 20% during the last year and landlords offering move-in concessions.

These conditions have created bargains for tenants but problems for public and privately owned real estate companies loaded with San Francisco-area real estate. The public companies, however, have the burden of revealing their results and facing the criticism of Wall Street.

Some public companies that have been stung by their exposure to San Francisco real estate include:

* Avalon Bay Communities Inc. The nationwide apartment company, which owns 9,000 apartments in the Bay Area, has postponed two projects in the area as demand weakened beyond company and Wall Street expectations. The company’s fourth-quarter net operating income dropped largely as a result of the region’s weakness.

“It was the drag from Northern California that really caused that,” said Timothy J. Naughton, chief operating officer for Avalon Bay.

* Catellus Development Corp. Although the firm said its Bay Area operations had exceeded expectations during the first three quarters of 2001, the steep drop in demand probably would delay future leasing and development activity at its huge Mission Bay project in San Francisco and Pacific Commons office and industrial park in Fremont, say analysts. As a result, the value of its land holdings may have dropped by as much as two-thirds from the peak of the market, said Sullivan at Green Street.

* Equity Office Properties Trust. Merrill Lynch in January downgraded the rating on Equity Office Properties, the largest publicly owned real estate investment trust, from “buy” to “neutral” and cut its operating income forecasts for 2002 in part because of the weakness in San Francisco and Boston, which also is suffering from troubles in the high-tech business.

The Chicago-based company dramatically expanded its presence in the Bay Area last year after acquiring Spieker Properties Inc. for more than $5 billion. As a result, Equity Office depends on San Francisco and Silicon Valley for more than 20% of its net operating income.

“In hindsight, it looks like they paid too much” for Spieker, said David Shulman, a real estate industry analyst at Lehman Bros.

* Mission West Properties Inc. The owner of nearly 7 million square feet of Silicon Valley industrial and research space has cut its 2002 earnings estimate twice. In the fourth quarter, the firm also took a one-time charge of $1.7 million to cover the costs of tenants that are expected to break leases.

Few expect the region’s problems to overwhelm many of the large public real estate companies, which have deep financial pockets and diversified holdings spread around the country. “The balance sheets of most of these major companies will allow them to weather the problems,” Shulman said.

But those firms will continue to face increased Wall Street scrutiny because the San Francisco real estate markets are expected to remain on the decline for much of 2002 despite signs of an economic turnaround.

Some quarterly reports this year are expected to be particularly bleak as the full effect of the real estate bust takes hold.

“There are still some earnings risks in some of these companies,” said Steve Sakwa, a real estate industry analyst with Merrill Lynch. “We will be in for some tough sledding.”