MARKET DRIVERS
San Francisco continues a streak of ten consecutive quarters of negative net absorption in quarter one, posting negative 211,904 SF. Total office vacancy has decreased to 30.6% in Q1 2024, a drop of 20 basis points from the previous quarter. The continued popularity of subleases for companies wary of long-term commitments outpaced supply this quarter with the sublease vacancy rate decreasing 20 bps to 5.7%. This continued sublease popularity coupled with a historically low number of deliveries helped to lessen the impact of a decline in leasing activity to see the third smallest negative net absorption figure in the post pandemic era.
Leasing activity throughout the quarter shrunk year-over-year by 25.7% to 1,078,373 SF. Class A and B office buildings led leasing activity, accounting for approximately 62.6% (675,049 SF) and 31.7% (342,303 SF) of total leasing activity, respectively. Throughout the market, rental rates continue to decline as average direct rental asking rates fell to $50.50/ sf. Within the Financial District, direct rental rates for Class A and Class B spaces have fallen to $55.90 /sf and $49.00 /sf respectively. Despite the dip in rental rates, there is a large discrepancy in pricing with very limited compression. Overall, the office market still exhibits the bifurcation characteristic of the post-pandemic era as premier Class A offices with desirable amenities regularly rent for above $75 /sf full service and average direct rental asking rates for Class B and C offices have fallen to $42.50/ sf and $34.50 /sf full service respectively. Meanwhile, turnkey and sub 10,000 SF spaces have continued to drive activity with larger and non-plug-and-play product remaining a difficult sell.
32,394 SF of office properties traded hands for $12,170,000 throughout the quarter. This represents a historic low point in investment activity, even within the post pandemic era. The investment sales market remains depressed with this quarter underperforming all but four quarters in the post pandemic era. High interest rates continue to exert downward pressure on the market.
ECONOMIC REVIEW
The unemployment rate throughout San Francisco continued to tick up slightly through January reaching 4.0%, the highest figure since October of 2021. Since then this growth has reversed course with February posting a figure of 3.8%. That said, this marginal recovery is fully attributable to a decrease in the labor force, not a growth in employment, thereby it should not be taken as an indicator of the strengthening of the labor market. Tech / Information industry and professional / business services sector layoffs have driven the majority of job loss from mid-2023 through Q1 2024 according to data from California Employment Development Department.
Inflation has exhibited declines in recent months, though it still remains above the Federal Reserve’s long-term target. This said, the continued overall improvement has largely eliminated the chance of any further rate hikes in 2024, with cuts and their potential timing very much TBD. Despite this decline, inflation remains high, and the effects of two years of robust price increases continue to contribute to layoffs, supply chain strain, and high raw material costs used in construction, the latter of which is delaying delivery times and tenant improvement projects.
NEAR-TERM OUTLOOK
Despite a historically slow quarter in terms of leasing and investment activity, there are a number of positive trends that may signal a long-awaited recovery for the office market in 2024. Firstly, many landlords are faced with critical near-term decisions: years of large vacancies coupled with a bottoming out of both the office and retail markets will drive many properties back into the hands of lenders, force debt restructuring, and/or drive many into discounted sales of their underperforming assets. This reset should not just drive up sales activity but will increase landlord willingness to lease their product at current market rates, thus driving up leasing activity and bringing tenants back into the market. Secondly, looking forward there are limited deliveries scheduled for San Francisco in the near-term. This consistency in supply will help to bring about a return to positive net absorption and will help to stem the decline in rental rates.
Office occupancy in San Francisco for the week of March 13th was measured at 45.7% according to data from Kastle Systems, a company that tracks building occupancy through its access card systems. While occupancy has varied throughout 2024, it has exhibited a general affinity for the mid-upper 40th percentile range, with Q1 occupancy figures the best in four years, marginally outperforming 2023. Federal Reserve narrative concerning cutting rates in 2024 has fluctuated in recent months. If rate cuts were to occur, real estate transaction activity of all kinds would in all likelihood surge upwards. This said, with rates still well in line with historical averages and with other positive trends likely to affect the market this year, we may see a persistent recovery begin in 2024 with or without this stimulus.
Click here to subscribe to Kidder Mathews market research.