Positive future absorption is projected for the metro market as demand exceeds the pace of new deliveries, 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. Social problems associated with homelessness, drug activity, and crime are a significant disincentive to residents. In the investment market, sales activity has slowed substantially over the past year. Local private investors remain active buyers of smaller deals, whereas most institutional investors are staying on the sidelines until market conditions improve.
As of the fourth quarter of 2023, the apartment vacancy rate in San Francisco stands at 6.8%, a slight increase from the previous quarter. This is the first time the vacancy rate has moved upward since the height of the pandemic in Q4 of 2020, at which point it reached 10.9%. For the moment, at least, the downward momentum in the market’s vacancy rate has stalled at a level that is well above the pre-pandemic average of around 5%.
Weak demand has impacted the rate and location of construction activity, with the focus shifting from San Francisco to the Peninsula. Much of the current construction pipeline is located to the south of San Francisco. Spurred by growth in life sciences and biotechnology, new projects are clustered in Peninsula employment markets such as South San Francisco, San Mateo, and Redwood City, which have emerged as popular locations for transit-oriented development around Caltrain stations.
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In the leasing market, brokers report an increase in the amount of space sought by tenants in the market. Moreover, leasing activity by AI companies has been a bright spot, and this includes two examples where expanding AI companies are set to take over 200,000 SF of sublet space, according to reports. Activity indicators for San Francisco’s central business district, such as Kastle Data Systems’ Back To Work Barometer, and transit ridership data from BART, show that the return to office, which had been steadily increasing in previous years, has plateaued in 2023. While some large Bay Area employers are urging more staff to return to the office, the general trend is one of switching from fully remote to a hybrid pattern of two to three days in the office per week, rather than a return to working in the office full time.
Leasing conditions in the fourth quarter remain subdued, with many tenants continuing the process of reducing their leased space in response to the changed nature and location of office work. While most occupiers have now settled on their space strategy, the process of delivering that strategy continues to play out as leases reach their expiration dates. The overall vacancy rate for the San Francisco Market increased to 21.4% in the fourth quarter and is forecast to rise further, having now passed the previous high point of 16% that occurred during the dotcom bust in 2002. Annual net absorption was negative by -9.3 million and, with 12.4 million SF of sublease space available, the availability rate has increased to 26.1%. Two-thirds of available sublet space is vacant, indicating that many tenants have already vacated spaces that will not be renewed. By comparison, the national availability rate currently stands at 16.6%.
Most development projects that are currently underway target the life science subsector, focused mainly in San Mateo County. For example, the Elco Yards project in Redwood City is a mixed-use development that includes approximately 500,000 SF of life sciences office space in four individual buildings. Other life science projects include the Alexandria Center for Life Sciences in Millbrae and Lane Partners’ Southline project in South San Francisco. About 1.0 million SF of net new office space completed during the past 12 months and there is currently about 2.2M SF under construction.
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In 2023, economic headwinds have slowed demand for industrial space. Higher interest rates and banking turmoil have slashed venture capital funding in the biotech sector, while the slowing economy has also caused many logistics property users to decrease leasing activity. Total industrial leasing in the first nine months of 2023 was the second-lowest volume since the Great Recession, and activity remains weak in the fourth quarter. Several life sciences tenants have made blocks of space available for sublease, contributing to annual net negative absorption of -1.7 million SF.
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 a sharp increase in vacancy. A small number of larger leases have been signed this year in the logistics segment. In 23Q1, battery supplier Ample signed for 90,000 SF at 245 S Spruce Ave. in South San Francisco. In June, TriMark renewed its lease for a 120,000-SF distribution warehouse in Brisbane. The seven-year renewal has a starting monthly rent of $1.80/SF.
In South San Francisco, new buildings have been completed in 2023 for Graphite Bio and Genentech. Speculative deliveries in 2023 include 310,000 SF of flex/R&D space at Tishman Speyer’s Mission Rock development in San Francisco. In South San Francisco, Kilroy Realty’s Oyster Point development has delivered the first of three Phase 2 life science and R&D buildings. In total, Oyster Point has 860,000 SF set to deliver in 2023. Phases III and IV have not yet broken ground but are planned to deliver another 1 million SF over the next five years. In addition to these 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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Heading towards the end of 2023, the San Francisco retail sector is looking back at a difficult year, during which its overall operating performance has been held back by the deterioration of Union Square and the neighboring areas in downtown San Francisco. In the outer parts of San Francisco and in San Mateo County, the retail structure has a greater representation of malls and shopping centers. The main regional malls include Stonestown Galleria in San Francisco, the Serramonte Center in Daly City, and Hillsdale Mall in San Mateo. Retail performance in San Mateo has been stable, with both vacancy and rent growth generally flat over the past year.
As of the fourth quarter, San Francisco continues to see growing vacancy, with local centers and suburban locations faring better than downtown. San Francisco’s performance lags behind most other metros across the nation. Retail vacancy in San Francisco was one of the lowest in the nation in 2019, but it is now one of the nation’s highest, at 5.9%. Similarly, average market rent, which increased at an annual rate of 3.3% nationally over the past 12 months, increased by just -0.5% in San Francisco.
Several unfavorable supply and demand trends have quashed retail construction activity in San Francisco. For many years, a lack of developable sites and restrictive planning policies have limited the volume of new retail development. More recently, population decline has reduced demand and diminished the viability of new retail projects. Moreover, in the past year, the persistence of high interest rates has raised the cost of construction financing, thereby presenting an additional challenge to the feasibility of retail developments. Currently, there are about 218,000 SF under construction in the market.
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