Real Estate Close-Up: San Francisco

Battered by the dot-com bust earlier this decade, the San Francisco commercial real estate market has staged an impressive rebound and is arguably one of the strongest markets in the country. The growth has fueled a resurgence in the city's downtown, but the slowing economy could kill the party.

Buoyed by the explosion in the biotechnology and "green" tech sectors as well as old standbys, vacancy in the city's central business district has fallen dramatically to about 9 percent at the end of last year from about 20 percent only three years earlier, according to Marcus & Millichap Real Estate Investment Services. That compares to a national office vacancy rate of almost 13 percent.

Office rent growth also has outpaced the national average the past two years, skyrocketing 19 percent last year and almost 15 percent in 2006, compared with national growth of 9 percent and 11 percent.

"The market has held up well in an environment where many businesses are watching and waiting to see what finally comes of the financial disturbances," said Tom Hart, executive vice president of office owner Shorenstein Properties LLC.

But as the U.S. economy teeters on the brink of recession, some cracks are starting to emerge in the San Francisco market.

About 850,000 square feet of so-called shadow space, or sublease space, has appeared on the market in the last two quarters, said Margaret Duskin, a senior director at real estate services firm Cushman & Wakefield Inc. Another 50 percent more is expected this quarter, a harbinger of a sluggish economy which could undermine rental growth this year.

"Professional firms are shedding excess space. Tech tenants have overcommitted and are either consolidating or releasing excess space," she said, also noting the bankrupt retailer Sharper Image and biometrics startup Pay By Touch together dumped 200,000 square feet on the market.

However, interest in downtown from the large Silicon Valley companies is helping to shore up vacancies too. Big tech players like Google Inc., Microsoft Inc., Facebook, and eBay Inc. have or looking to have satellite offices there to draw young people who want the urban lifestyle.

"The problem for these companies is human capital. It's very expensive to have offices in downtown, but they're finding it's a gigantic recruiting tool (to have offices there)," said Robert Gilley, a senior vice president at CB Richard Ellis Inc.

He called Google the "poster child" of the trend; the tech giant took 200,000 square feet in downtown, complete with food kiosks and ping pong tables.

This migration is helping to revive the downtown, especially the Mission Bay section of town, which has boosted the city's apartment fundamentals. Rents there grew 11 percent over the past year, topping Marcus & Millichap's apartment market list. Vacancies came in just under 4 percent at the end of last year.

But the delivery of 4,100 condos in the next two years could compete with the apartment market, luring some tenants to buy. Like much of the country, San Francisco hasn't been immune to the housing downturn.

The median price for a single-family home in San Francisco fell to $779,000 in the first quarter from $818,000 in the year-ago period. However, the median price for an existing condo edged up to $620,441 from $616,091.

Or, condo developers frustrated by the sales market, might turn their units into rentals for better returns, again taking on apartment owners in the market.

On the retail front, San Francisco has been one of the top markets in the past several years, due in large part to its high household income and strength in capturing tourism dollars, said Marcus & Millichap Managing Director Hessam Nadji. The vacancy rate clocked in at 4 percent at end of last year, down from 6 percent in 2004.

Nearly 16 million visitors and convention participants come to the city each year, spending $7.37 billion. That's an average of $137 per day. So far, the sluggish economy has yet to affect the city's huge convention business, mostly because those events are booked years ahead of time.

And the soft dollar is boosting retail sales in the city as well as filling hotel rooms. April hotel occupancy rose to 74 percent from 73 percent over the same month last year, Marcus & Millichap said, while revenue per available room increased 9 percent to $112.42.

"The number of international tourists here is phenomenal," Cushman & Wakefield's Duskin said. "We're seeing many European and Japanese tourists offsetting people here cutting back on spending."

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