MARKET DRIVERS
San Francisco posted its nineteenth consecutive quarter of negative net absorption, posting negative 155,400 SF in 3Q 2024, bringing the year-to-date total to negative 841,039 SF. As a result, the market wide vacancy rate hit an all-time high of 31.8%. However, the rate of negative activity has notably slowed compared to 2023, when the quarterly average was negative 1.8 MSF. This deceleration is cause for optimism, possibly signaling a future rebound in both market energy and leasing activity. Total leasing activity has been on the rise over the past four quarters (Q4 2023 through Q3 2024), totaling more than 6.7M SF over that span, largely driven by AI firms, startups and small to mid-sized tenants.
On a year-to-date basis, Class A and B office buildings accounted for nearly 95% (4,441,969 SF) of the of total leasing activity since January (4,681,677 SF). The flight to quality is still evident as trophy Class A properties are continuing to attract tenants at discounted rates compared to pre-covid levels. Throughout the market, rental rates continue to decline as average direct rental asking rates fell to $47.61 PSF across all markets and building classes. Within the Financial District, direct rental rates for Class A and Class B spaces have fallen to $54.00 PSF and $47.00 PSF, 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 of the post-pandemic era as trophy Class A offices with desirable amenities regularly rent for above $65 PSF full service and average direct rental asking rates for Class B and C offices have fallen to $42.50 PSF and $34.50 PSF 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.
ECONOMIC REVIEW
The unemployment rate in San Francisco rose in August, reaching 4.1%, the highest figure in nearly three years. In addition, labor force participation has declined versus the previous year, meaning total employment has fallen to a larger degree than unemployment figures suggest. Tech / Information industry and professional / business services sector layoffs have driven the majority of job loss from May 2023 through May 2024 according to data from California Employment Development Department. VC funding, underpinned by the rapidly growing AI startup space have seen notable gains in 2024.
Inflation continued to exhibit decline in recent months, though it still remains above the Federal Reserve’s long-term target. A softening labor market coupled with inflation has led the Federal Reserve down a path of rate cuts. This said, Federal Reserve Chair Jerome Powell has pushed for a more pragmatic approach to future rate cuts, stating that in the moderate term reaching an equilibrium would be preferable. In this way it seems the Federal Reserve will look to stimulate the economy and rein in unemployment while also avoiding another inflationary spiral. The cumulative effects of 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
Many owners are currently struggling with non-performing assets. As landlords are unable to service their debt one of three things has regularly begun to occur – office product returns to lenders, financing is restructured, or assets are forced into distressed sales. Of these options, refinancing and returning to the lender have been the most popular paths, with lenders and borrowers alike unwilling to stomach large losses (as of yet) with the modus operandi of short-term leases and patience persisting. The effect of current and future rate cuts will likely increase the viability and popularity of refinancing, an option often preferable to banks reticent to become directly involved in direct management when avoidable.
The future growth of the San Francisco office leasing market will largely be determined by the acceleration of return to office (RTO) along with future job growth trends. While some firms have already started to push RTO mandates, many others are continuing to embrace the hybrid work model. Office attendance rates are estimated to be hovering just above 45% according to recent keycard usage data from Kastle Systems. Market indicators to keep an eye on moving forward include a sustained rate of return to office, a continued increase in leasing activity, persistent shedding of sublease availabilities (currently at a 2-year low), and positive economic and employment growth.
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