CRE Demand in Tech Markets Starts to Cool as Market Returns to 'Normal' Pace

Posted by Brent Hart on Apr 4, 2016 in News

CRE Demand in Tech Markets Starts to Cool as Market Returns to 'Normal' Pace

Office Demand By Tech Companies Slows in Top Markets
March 31, 2016
There are increasing signs thatcommercial real estate fundamentals are returning to more moderate levels after an extended period of blistering growth in such tech-focused office and apartment markets as San Francisco, Silicon Valley, Seattle, New York and Los Angeles. 

According to an analysis by Fitch Ratings Senior Director Stephen Boyd, the office and multifamily sectors are expected to see lower demand from tech tenants from what the markets experienced over the past three to four years. 

The San Francisco office market, where Google, Apple, and numerous other tech firms have increased their presence in recent quarters, is the epicenter for any potential real estate exposure to a decline in space demand by tech companies which, along with energy companies, jump-started and drove the recovery of the U.S. office market into expansion mode. The amount of space put back on the market by occupiers as sublease space "has become a big topic of conversation" of late among brokers and landlords, according to Robert Sammons, research director for Cushman & Wakefield. 

The amount of sublease space jumped from 1.3 million square feet in the third quarter of 2015 to nearly 1.7 million square feet in the fourth quarter. The figure climbed to 1.9 million square feet in the first two months of 2016, according to a recent analysis of San Francisco's office sublet market by Cushman & Wakefield. 

Historically, the level of sublease space in San Francisco is 1.6 million square feet. Recently however, cloud storage firm Dropbox put 213,000 square feet back on the market at 185 Berry St. while financial services giant Charles Schwab began marketing 305,000 square feet at 215 Fremont St. 

Plenty of Takers for Vacant Tech Space

Views within the San Francisco brokerage community differ as to the significance of the bump in sublet space, including the amount of space made available by tenants. Another analysis by JLL pegged the amount of sublease space in San Francisco at 2.27 million square feet in the last week of March, up from an average of 1.5 million square feet throughout 2015 and a 49.4% increase since third-quarter 2015. 

While any rise in sublease space is concerning as the current amount is approaching 2009 levels, "We still have a long way to go to reach the astronomical level of sublease space, 9 million square feet, that was dumped on the market in 2001" in the wake of the dot-com bubble, according to JLL Vice President Amber Schiada. 

San Francisco brokers report that most large sublease spaces are seeing plenty of touring activity, with five of the top eight sublease spaces having pending lease deals in place. 

"We still have robust tenant demand, especially among large space users. JLL is tracking about 9 million square feet of current demand and there are around 20 tenants in the market for spaces over 100,000 square feet," Schiada added. 

Office leasing momentum in the Bay Area seems to be slowly returning to historical levels from the elevated pace it's maintained, although it is still expected to continue to outperform over at least the next 12 months as office and apartment vacancies remain at lows not seen in almost 15 years, according to Adrian Ponsen, senior economist for CoStar Portfolio Strategy. 

New supply deliveries will intensify across property types next year, Ponsen said. A long list of companies, including Uber, IBM, Apple,, Prosper and EMC, have a commitment to expand their office footprints and head counts, helping keep the local economy in expansion. 

The Silicon Valley Venture Capital Confidence Index, based on a survey gauging venture capitalists’ optimism over the next six to 18 months, and a leading indicator of VC funding levels, has been in general decline since early 2014. 

Respondents are concerned about aggressive valuations of tech firms, leaving tech firms more vulnerable to changes in global investors’ appetite for risk, Ponsen noted. 

Other recent warning signs include Twitter's layoff of 8% of its workforce, about 336 employees, during the second half of 2015. Dropbox delayed its IPO indefinitely, a sign of a potential gap between its private valuation and what public market investors are willing to pay. 

SF Better Positioned to Endure Tech Downturns

“Although there is caution in the air about frothy tech valuations and the continued availability of venture-capital funding, office real estate in the Bay Area remains a strong asset,” said Colin Yasukochi, CBRE’s director of research and analysis in the San Francisco Bay Area. This time around, however, the Bay Area CRE market has greater support and lasting power, and "the conditions that led to an extreme spike in 2000 are not expected to surface" in spite of the large stable of unicorn firms and other young companies in the market, Yasukochi said. 

Boston Properties, Inc., one of the San Francisco's largest office landlords, acknowledged that leasing declined toward the end of last year compared with its high levels of 2014, when Salesforce and Twitter and Dropbox alone took a combined 1.4 million square feet. That said, leasing finished last year at exactly the same level as 2013, BXP President Doug Linde noted during a call with analysts last month. 

"Tech demand continues to average around 50% of the volume in the city," Linde said. "There is no question that there are going to be failures in certain tech industries. All of the mobile payment companies are not going to survive. There are, in all likelihood, a couple of unicorns that are not going to make it." 

In general, however, large tech companies have strong balance sheets and long-term strategies with global reach that will allow them to weather the storm, Linde said. 
Between demand from startups and more established and fundamentally sound tech firms, "on a relative basis, the city of San Francisco is in a really good place," Linde said. 

In its report, Fitch Ratings noted that many of today's fast-growing social media and sharing economy companies are using technology to disrupt a wide array of established industries, arguably making them less sensitive to cyclical changes than the computer and networking manufacturers that dominated Silicon Valley in the second half of the 20th century. 

By contrast, many of the companies that failed during the dot-com bust "proved to be little more than a marketable idea in a white-hot capital markets environment," Boyd said. 

Today, sharing economy companies such as Airbnb, Inc., Uber and arguably office sharing provider WeWork may actually have counter-cyclical elements in their business models that could help shield them during a downturn, the Fitch Ratings analyst added. 

However, the sour outlook for venture capital availability and generally weak tech IPO performance and later-round private equity financings may be signs of more difficult times for the tech industry. 

"Most tech employment resides at larger, established tech companies, but smaller startups play a key role in marginal office demand and pricing," Boyd said. "The enviable stories of wealth creation surrounding their success can set the market tone." 

Is Apartment Leasing Softening More Than Seasonal?

Large multifamily landlords have acknowledged they're keeping a close eye on job growth, absorption levels and rising deliveries of new supply in the Bay Area and other West Coast markets. 

UDR, Inc. said in financial documents last month that fourth-quarter weakening of occupancy and rental rates in the firm's San Francisco and San Jose markets "is possibly more than just seasonal" and "[we] do not expect this market to post the double-digit revenue growth it has in recent years." 

That said, Jerry Davis, chief operating officer for UDR, noted that Bay Area apartment metrics showed signs of improvement at the outset of 2016. 

"We’re going to know in the next 60 days if it is [seasonal]," Davis said. "Over the last three to five years, there’s probably been two or three times in the first quarter when I grew concerned about the strength of San Francisco, only to see things turn around as we got into the month of March and April." 

Job growth at companies like Amazon, which is delivering 4 million square feet of office space in downtown Seattle, continues to drive high apartment demand in Seattle and suburbs like Bellevue, said David Santee, executive vice president and COO of Equity Residential. Seattle has absorbed 3,100 units over the past two quarters and should absorption inventory with minimal disruption. 

In San Francisco, EQR's largest market, near-term pricing pressure will follow the concentration of new supply entering the market, with urban core properties feeling the most impact, Santee said. 

"While headlines are quick to recognize the slowdown of VC tech spending, the large-cap giants continue to buy, lease or build new office space in anticipation of future growth and elevated hiring," Santee said. "As we all know, trees don't grow to the sky, but our dashboard tells us that fundamentals remain strong." 

Santee said apartment renewals were strong through March and if history plays out, new lease rents will seasonally adjust upward to higher levels during the upcoming peak leasing season.