Recovery in San Francisco has been slower than most other major markets, which improved rapidly in 2021. The trailing 12-month absorption for market-rate apartments sits at 1,900 units, compared to the 10-year average of 2,100 units. Looking ahead, positive absorption is projected for the metro market, but the rate of improvement in areas close to Downtown San Francisco will depend upon both a return to in-office work and improvements to safety and security.
The vacancy rate currently stands at 7.1%. Moreover, in alignment with national trends, demand, and absorption have slowed in recent quarters in response to high inflation and rising interest rates, which have dampened renter activity and new household formation. Annual net absorption is at about 1,900 units. Among the submarkets with the highest vacancy rates are those that saw the greatest exodus of tech workers during the pandemic and those with the worst street-level social problems. These neighborhoods include parts of Downtown San Francisco, Haight-Ashbury/Castro/Noe Valley, and Civic Center/Tenderloin.
The pace of new construction has picked up recently. Almost all of the stock of market-rate units under construction is in 4 & 5 Star buildings. In total, there are 3,700 units underway; however, that total includes 3,500 units in the massive Treasure Island redevelopment project, which will create a new neighborhood of around 8,000 homes. Although recent development has been robust in comparison to historical standards, San Francisco is generally more insulated from supply risk than most markets in the country. Stringent zoning, costly affordable housing requirements, NIMBY objection, and a lack of available land make the development process in San Francisco more arduous than in the vast majority of U.S. cities.
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Approaching the end of the third quarter of 2023, there is a growing acceptance among participants in the San Francisco office market that weak leasing conditions are not going away in the immediate future and that office values have fallen substantially below their pre-pandemic levels. The persistence of high-interest rates and weak operating performance is also making it hard for some building owners to meet their mortgage financing obligations. Up until recently, downtown San Francisco has borne the brunt of the collapse in office demand. However, areas outside of downtown, including the northern part of the San Francisco peninsula, are now seeing rising vacancy levels.
While most tenants have now settled on their space strategy, the process of delivering that strategy continues to play out as leases reach their expiration dates. Office utilization in downtown San Francisco, as measured by Kastle Data Systems keycard activity, has increased slightly since last year, but has been generally flat in the current quarter, at around 45% of pre-pandemic levels. In common with other US cities, office usage peaks in the midweek and falls on Mondays and Fridays, suggesting wide acceptance of hybrid working patterns. The midweek peak is around 55%. The overall vacancy rate for the San Francisco Market increased to 18.9% in the third quarter and is forecast to rise further.
Office construction activity in San Francisco remains subdued, with developers reluctant to commence projects while demand for existing spaces remains weak. Most development projects that are currently underway target the life science subsector, focused mainly in South San Francisco, Millbrae, and Redwood City. There is currently about 3 million SF under construction. About 1.7 million SF of net new office space completed during the past 12 months.
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In the third quarter of 2023, the San Francisco industrial Market is characterized by rising vacancy and moderating rent growth, as an influx of new flex space encounters slowing demand. The inventory of logistics and distribution space in San Francisco has been on a steady downward trend for many years, as old industrial sites were demolished or repositioned for other uses. The San Francisco Peninsula is mostly built out and land is expensive. With continued new development, flex properties now account for around 30% of the San Francisco industrial market, a much higher share than in most other markets.
The leasing slowdown has come about as higher interest rates and economic uncertainty reduced demand for industrial space. Moreover, the demand from biotech companies for R&D space has diminished as venture capital funding has dried up. Coming at a time that coincides with a spike in the delivery of newly constructed flex R&D space, the result has been an increase in vacancy. Overall market vacancy ticked up to its current rate of 7.7%. Continued economic uncertainty and deliveries of speculative flex space in the months ahead may cause vacancy to rise further in the coming quarters. Of the 4.4 million SF currently under construction, 3.5 million SF is available.
San Francisco’s industrial market is seeing a historically high level of development, with over 4 million SF of space currently under construction. These projects are all R&D flex space aimed at the life science/biotech industry. This sector has seen high levels of growth and occupier demand in recent years, but as of the third quarter of 2023, expansion activity has slowed sharply on the back of high-interest rates and recessionary challenges. In addition to current new construction projects, there are a handful of conversion projects, typically involving older office, retail, or industrial buildings being redeveloped as flex space.
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Central to the retail market’s weak performance is the notable decline in San Francisco’s population, which began several years ago as a reaction to the city’s high cost of living and was then exacerbated by the pandemic. Coupled with the continuing gains in market share by non-store retailers, the retail spending market is not growing enough to support rent growth. On the supply side, the market has a low amount of new construction, partly because of limited availability and restrictive planning policies, but also because of weak demand.
As of the third quarter of 2023, San Francisco’s retail market is lagging the performance of most other metros across the nation. The retail vacancy rate is now one of the nation’s highest, at 5.5%. This performance is due to economic uncertainty and social problems in the downtown area as well as rising crime. Over the longer term, the stock of shopping center space is falling as other uses become relatively more valuable. Some buildings have proposals for redevelopment plans for mixed-use and residential use.
Currently, there is about 92,000 SF under construction in the market. Renovation of existing properties is the most common source of new-to-market retail space. Redevelopment of brownfield sites is an additional source of new retail space; however, these projects tend to focus on other uses, such as apartments and offices, with a smaller component of ancillary retail. There is a greater trend towards this repurposing of retail spaces for other uses, including shopping center redevelopment for biotech facilities and the conversion of upper-level retail spaces into residential or office uses.
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