San Francisco's Comeback
Leon, Hortense, Mortgage Banking
Not that long ago the commercial real estate market in San Francisco was lost in a bank of fog, with few prospects for immediate clearing. Today the outlook is completely different.
After a bruising few years following the double-whammy of the dot-com bust and the post-9/11 fallout, the San Francisco economy is recovering, although some segments more than others. * Among the various sectors in the economy, the hospitality industry is the biggest winner today. Tourism is San Francisco's No. 1 revenue-generating industry, and the city attracted 15.74 million visitors in 2005. That is a 4.1 percent increase over 2004, according to the San Francisco Convention & Visitors Bureau. A According to Condé Nast Traveler magazine's annual poll, San Francisco has been voted the No. 1 travel destination in the United States for 13 consecutive years, and for 17 of the past 18 years. * The tourism industry in San Francisco generated $418 million in taxes in 2005, a year when it employed 66,315 people and had an annual payroll of $1.80 billion, according to the Convention & Visitors Bureau. * The rest of the economy is less buoyant. In the period from 2000 to 2004 there was a "big wipe-out" in the Bay Area economy, says Stephen Levy, director of the Center for the Continuing Study of the California Economy, Palo Alto, California. Even though tourism is doing well today, it is not back at the level it was five or six years ago, he says.
Between 2000 and 2004, the San Francisco area (San Francisco, San Mateo and Marin counties) lost 145,500 jobs, according to the California Employment Development Department, Sacramento, California. From April 2005 to April 2006, the area expanded by 11,900 jobs, an approximately 1.3 percent increase, according to the California Employment Development Department.
While these numbers do not suggest a spectacular recovery, the Bay Area Council, San Francisco, a business-sponsored public policy group, reported in its quarterly confidence survey released in May that 43 percent of 512 chief executive officers and executives polled plan to hire more local workers in the next few months.
Hospitality industry takes center stage
Whatever the pace of job creation in San Francisco, the commercial real estate market shows definite signs of strength-especially the hospitality sector. According to Smith Travel Research, Hendersonville, Tennessee, the upper upscale hotel category in the San Francisco-San Mateo metropolitan statistical area (MSA) averaged an occupancy rate of 77.5 percent.
One sign of the times is that 30 percent to 40 percent of the premium hotel inventory in San Francisco has sold within about the last six months, says Rick Swig, a San Francisco-based hotel consultant.
"This is an extraordinary and probably unprecedented event," says Swig, referring to the unusual number of recent hotel sales. Plus, the prices paid for these properties were probably the highest per-room prices ever paid in San Francisco, he says.
"What this means is that there is phenomenal investor belief that San Francisco is on a significant rebound, with probably more growth potential than in other major cities in the country," says Swig.
Included among premium hotels snapped up during the latest buying binge is the 277-room Four Seasons Hotel, San Francisco, which was sold to New York-based Millennium Partners in the first week of February for $130 million, or $470,000 per room, according to Swig. "Millennium Partners, which developed the Four Seasons with Goldman Sachs' money, bought out their partner in this deal," he says.
In June, the Westin St. Francis Hotel at Union Square in San Francisco was sold for $440 million to Strategic Hotels and Resorts Inc., Chicago, for about $440,000 per room by New York-based Blackstone Real Estate Partners.
"The St. Francis sits on Union Square, the epicenter of downtown's shopping area," says Swig. The frontage of the hotel has 39,000 square feet of prime retail space, so the rent the hotel owners get from those stores inflates the value of the hotel, he says. "But if you take out the retail space, you are still at over $400,000 per guest room," says Swig.
Another high-flying sale took place last fall. Campton Place hotel, with no rooms, was sold to the Kor Hotel Group, Los Angeles, in November 2005 for $44 million, or $400,000 per room, says Swig.
For all the sales activity of existing hotels, there is little new hotel development, says Swig. "There are limited hotel sites, and the cost of construction is ridiculously expensive," he says.
Only a couple of new hotels have opened recently-the 199-room Hotel Vitale, which was built on city land on the Embarcadero and opened in March 2005; and the St. Regis Hotel, with 260 rooms, which opened in November 2005 near the Moscone Center.
Only one hotel is under construction-the approximately $200 million, 550-room Intercontinental hotel, also near the Moscone Center, says Swig. It is scheduled to open in 2008, he says. The cost per room is about $380,000.
Office market making a comeback
Although the office market has suffered during the downturn, it is starting to recover, even in the absence of a surge in new office jobs. In 2002, San Francisco's office market had a vacancy rate of 20.2 percent, says David Klein, senior vice president at NAI BT Commercial Real Estate, San Francisco. In 2005, the city had an office vacancy rate of 12.6 percent, and in the first quarter of 2006 the vacancy rate was 12 percent, he says.
The overall trend has been a continued reduction in supply and appreciation in average rents, according to a first-quarter 2006 report put out by NAI BT Commercial. Citywide net absorption in the first quarter of 2006 was just less than 375,000 square feet. If that pace continues for the whole year, there will be 1.5 million square feet of positive absorption, which is average for San Francisco, according to the report. "To have this much positive absorption is very good, in light of the serious recession experienced in the first half of the decade," says Klein.
The increase in office space absorption, coupled with a slowdown in the condominium market, has inspired some developers that had concentrated on residential condominiums to turn their sights back to office development, says Jeff Mishkin, regional manager for Encino, California-based Marcus & Millichap Real Estate Investment Brokerage Co.'s San Francisco office.
Among these trendsetters are Beacon Capital Partners Inc., a Boston-based firm which, in April, purchased a $30 million parcel in San Francisco's desirable South Financial District at 535 Mission Street, where seller Monahan Pacific Corporation, San Rafael, California, had planned to build a condominium tower.
In an April article in the San Francsisco Business Times, Jeff Hutchinson, Monahan Pacific's director of acquisitions and finance, said that the tremendous increase in construction and labor costs, as well as a shortage of both, were reasons that the company decided to pull the project. Office buildings are less complicated to build than condominiums.
The scenario at 535 Mission Street epitomizes the interplay between the office and condominium markets that has occurred in the last five years in San Francisco. When there was a sharp downturn in the office market, Houston-based Hines, a real estate development company, scrapped plans to build an office tower at this site. Today, it is the plan for a residential condominium that is being discarded.
San Francisco-based Shorenstein Properties Inc. is planning to build several office towers in the city. The site at 350 Bush Street, where the company plans to build a 350,000-square-foot office tower, is the last large, undeveloped site north of Market Street in the Financial District, says Tom Hart, executive vice president at Shorenstein. But he doesn't give a date when the project will start. "If we can locate an anchor tenant, we will break ground by end of the year," he says. The 350 Bush Street project was approved by the city in 2001, says Hart, but because of the downturn in the office market, the plan was put on hold.
In Mission Bay, a 303-acre redevelopment area just south of downtown-the former site of railroad yards-will be home to a new University of California at San Francisco (UCSF) life sciences campus for teaching and research. Shorenstein has received approvals to build a 450,000-square-foot life sciences building and is in discussions with a couple of prospective tenants. The building will be within a block of the 43-acre UCSF campus at Mission Bay.
As plans for new office buildings have taken shape recently, existing buildings have been the subject of investor attention as well. "Investors have favored the office as an asset class, but those sales have slowed down recently because so much has sold," says Michel A. Seifer, managing director, capital markets in the San Francisco office of Chicago-based Jones Lang LaSalle Inc.
"Almost 50 percent of the institutional class-A office product has sold in the last 24 months," he says. "In the most recent cycle, I've seen office buildings trade for over $500 per square foot, including 555 California Street, which sold in the spring of 2006 and which set a high-water mark," he says.
"There remains a lot of liquidity both in equity and debt," says Seifer. "Lenders are aggressive in terms of pricing and innovative in product," he says. "Spreads have been tightened-not just in San Francisco-even though interest rates are going up." Conduit lenders are offering the most aggressive financing terms, although life companies and banks have offered greater flexibility over last several years, he says.
Residential development takes many forms
Not all office buildings are selling for high prices as office product. A number of class-B properties, some of which have outlived their useful life as office buildings, are being retrofitted into residential condominium units.
"The demand for residential has been far greater than the demand for office [in recent years], hence the profitability," says Jeff Heller, president of Heller-Manus Architects, San Francisco, who has done a number of these retrofits. "But that is starting to change again as the cost of residential development has suppressed demand," he says-a situation partially the result of slowly rising interest rates and higher construction costs.
These factors affect office projects to a lesser extent, because in this case the buildings are already office thus requiring no major retrofitting, says Heller. Plus, office buildings are less complicated than residential construction, he says.
The 100,000-square-foot building at 733 Front Street is one of the buildings Heller is retrofitting into residential. It was built in about 1930 as a warehouse/office structure, but about 25 years ago Heller's firm updated it, adding three new floors and turning it into all office space with an atrium. "Now there is a new owner, who wants to make the building residential, so I am working on it again at a cost of $189 per square foot," he says. "Rehab is more expensive than new construction if you are changing use," says Heller.
At 201 Sansome Street, Heller is renovating an office building into 46 units, at a cost of $306 a square foot. "The cost is higher than for other, similar projects, because it is a fussy historic building in the North Financial District," says Heller. "Retrofitting of older office buildings in this area has taken off in the last couple of years, but because the office market is heating up and the condominium market is cooling a bit, the conversion trend may slow down," he says.
In another part of town-the Mission Bay redevelopment area-there are 6,000 new residential units planned, of which about 1,700, or 28 percent, will be affordable to moderate-, low- and very-low-income households, according to the development plan for the project. The units will be built over a 15-10 25-year period, which began in 2000. The Mission Bay redevelopment plans were approved by the San Francisco Board of Supervisors and other local regulatory bodies in 1998.
Substantial residential development is under way in Mission Bay North with a mix of rental, for-sale and affordable projects completed and under way. Active developers in Mission Bay North include Signature Properties, Pleasanton, California; AvalonBay Communities Inc., Alexandria, Virginia; The Opus Group, Minneapolis; the Urban Housing Group, San Mateo, California (a subsidiary of Marcus & Millichap); and The Related Companies, New York. To date, five projects totaling 1,079 units, including 148 that are categorized as affordable, have been completed. An additional seven projects with a total of 1,179 units, including 395 that are affordable, are under construction.
Looking at the residential market, San Francisco-based Ted Levenson, director of loans for Irvine, California-based Commercial Capital Bank, says that fewer people are buying residential units today because prices and interest rates have risen-which is why many people are renting when they would like to buy. But the landlord is not necessarily in a good position, either, he says.
"With rent control, landlords can't raise rents to market levels until a tenant leaves, and there is a 50 percent spread between current and market rents," says Levenson, who adds that he does not speak for the bank, but is giving his opinions based on 25 years of experience in commercial real estate.
Few new apartment buildings are being built today in San Francisco "because the cost of building is so high; it is more economical to build a for-sale building than a rental," says Levenson. But as the condominium market softens, those units will turn into apartments, he says.
In spite of conditions in the rental market-including higher interest rates and, in many cases, stagnant rents-apartment cap rates have been compressing and in some cases have been as low as 2 percent, says Marcus & Millichap's Mishkin. "The apartment market has defied gravity since 2000; values have increased every year, while neither the rents nor the occupancies were going up," he says.
"In the last six or seven months, the frenzy, the overbuying has probably decreased, but last year we sold a 33-unit apartment building for $38 million across the street from the Fairmont Hotel with a cap rate as low as in the 2 percents," says Mishkin.
Mishkin says he has a couple of buildings in escrow in A locations today, which are being sold for well above the listed price and with multiple offers. But the prices are not as far above listed prices as last year, he says.
Another difference between this year and last, says Mishkin, is that about 80 B and C properties are not moving and the cap rates for those B and C properties that do sell are higher than last year. Cap-rate compression only applies to A properties today, he says. But cap rates won't rise very much, predicts Mishkin, because demand is still outstripping supply. Cap rates that were 4.5 percent are now 5.5 percent to 6.5 percent, he says.
Housing prices are very high in San Francisco, and there is a need to build more housing in a reasonable price range, says Paul Maltzer, environmental review officer at the San Francisco Planning Department. In the southeastern portion of the city, there has been a battle going on for the past four or five years among industrial, housing and commercial interests, he says. "The city has been trying to figure out whether and how to rezone land in the area" in a way to satisfy these competing interests, says Maltzer.
The controversy is centered around one development-a condominium project in the Mission District at 2660 Harrison Street-which is being held up pending the completion of an environmental impact study. A decision in March by the planning department that the developers of the project-who had been previously exempted from having to perform such a study-must now do one, will also affect similar projects. The study must take into account not just the environment, but how the project will affect blue-collar jobs and affordable housing in the area.
"Because the larger environmental review will take a year, developers call [the ruling] a de facto moratorium," he says.
The area in question is currently zoned for production, distribution and repair uses, including everything from food distribution to auto repair, says Maltzer. These light industrial uses are part of the city's overall economy, he says.
The reason the city has required more expansive environmental analysis for the 2660 Harrison development than usual is it is looking at ways to rezone the land in a way to include housing, says Maltzer. This can be a tricky process, because some of the land has industrial pollution and may not have adequate public transportation as befits a residential area.
Retail development favored
"There is a strong desire [by investors] for retail in San Francisco, but there is not much activity because there are not a lot of sellers," says Seifer. "San Francisco is a great retail market with great demographics," he says-which is why owners want to hold on to their properties, according to Seifer.
The most significant new retail project in San Francisco today is the Forest City-Westfield project in Union Square, says Seifer.
Australian shopping mall developer The Westfield Group and Cleveland-based real estate company Forest City Enterprises are expanding the Westfield San Francisco Centre with a new Bloomingdale's, additional retailers and a nine-screen movie theater. In all, the two developers are adding 1 million square feet, including the movie theaters, to the existing 500,000 square feet of retail space. The project is expected to open in late September.
In April, Westfield and Forest City bought the 300,000-square-foot Sony Metreon retail complex in the South of Market (SOMA) district, but the price was not disclosed by the buyers. The sellers are the Yerba Buena Entertainment Center, a joint venture between Millennium Partners and the Sony Corporation of America, New York.
The retail sector in San Francisco suffered during the downturn in the city's economy in the recent past. During this period, landlords gave away free rent and other concessions, says Rhonda Diaz, vice president of Terranomics Retail Services, San Francisco. But those concessions are no longer necessary for retailers to attract tenants, she says.
"Today, rents have tightened" as vacancies have dropped significantly, says Diaz. In this case, "tightening" means that asking rents are much closer to negotiated or actual rents today, she says. Actual neighborhood retail rents run from about $48 to s6o per square foot, while high-rent districts such as Union Square boast rents of anywhere from $100 to $550 per square foot.
These rates may seem a bit steep. But one need only take into account the demographics of the local population with its significant disposable income, not to mention well-heeled tourists, to put the rates in perspective.
"Between 1990 and 2000, in every income category under $75,000, we lost households-while the number of households earning $100,000 or more went up," says Ted Egan, an economist in the San Francisco office of Fairfax, Virginia-based ICF International, an international consulting firm. Anecdotal evidence gleaned from migration patterns, school enrollment data and the continued escalation of housing prices suggests that these trends have continued, according to Egan. This may be bad news for the middle class, but good news for retailers and other businesses that depend on a critical mass of people with means.
All of these trends will continue to shape the future of the commercial and multifamily real estate markets in this highly desirable destination city.
Whatever the pace of job creation in San Francisco, the commercial real estate market shows definite signs of strength.
Substantial residential development is under way in Mission Bay North.
The retail sector in San Francisco suffered during the downturn in the city's economy in the recent past.
Hortense Leon is a freelance writer based in Miami, Florida. She is a regular correspondent for the Florida Real Estate Journal. She can be reached at email@example.com.…
Questia, a part of Gale, Cengage Learning. www.questia.com
Publication information: Article title: San Francisco's Comeback. Contributors: Leon, Hortense - Author. Magazine title: Mortgage Banking. Volume: 66. Issue: 10 Publication date: July 2006. Page number: 34+. © 2009 Mortgage Bankers Association of America. Provided by ProQuest LLC. All Rights Reserved.