Moving into the second half of 2023, the loss of workforce and population from the pandemic has only partially recovered. Unlike most other markets in the Bay area, apartment demand in San Francisco is still below pre-pandemic levels. Vacancy in the second quarter is 6.5%, and rents are lower than they were in 2019. Within the market, San Mateo County has enjoyed stronger demand than San Francisco County. Vacancy for 4 & 5 Star buildings is above 9% in San Francisco and below 6% in San Mateo. Moreover, the average rent for this subtype in San Mateo County has recently moved above the San Francisco County average. The trends in demand have also impacted new construction, with the focus shifting from San Francisco to the peninsula.
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. Nevertheless, annual net absorption, at 2,200 units, is only slightly below the metro area’s 10-year annual average of 2,200 units. The apartment vacancy rate in San Francisco stands at 6.5%. 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.
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. As a result, supply growth over the past 40 years falls below most major U.S. markets on a percentage basis, despite strong demand for more housing.
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At the midpoint of 2023, there are signs of 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 presents challenges for some building owners to meet their mortgage financing obligations. Owners of buildings with some combination of declining net operating income, variable interest rate loans, or upcoming loan maturities are in negotiation with lenders to adjust or extend terms.
Leasing conditions in the third quarter remain muted, with tenants reducing their leased space in response to the changed nature and location of office work. 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 recent months, 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%.
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 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. In San Francisco, construction started in 2022 on Lendlease’s 30 Van Ness mixed-use tower, which will be the tallest tower to have broken ground in San Francisco since the pandemic. The project will comprise 235,000 SF of office space and 333 condominiums.
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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. Meanwhile, economic headwinds have slowed demand for industrial space.
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. Overall market vacancy ticked up to its current rate of 9.2%.
San Francisco’s industrial market is seeing a historically high level of development, with more than 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, tenant expansion activity has slowed sharply on the back of high interest rates and recessionary challenges.
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Across the nation, retail leasing has slowed in recent months, due in part to low levels of space availability and to slowing consumer demand. Availabilities are particularly tight in small centers and single tenant net lease spaces but are trending higher in malls and lifestyle centers, as consumer shopping patterns shift away from these property types. Absorption, however, is positive, led by general retail and neighborhood centers. Quick service restaurant (QSR) tenants are the main takers of smaller spaces, while dollar stores, fitness, and experiential retailers are showing the greatest interest in medium and large spaces.
As of the third quarter of 2023, the San Francisco retail market continues to see growing vacancy and flat rents, with local centers and suburban locations faring better than downtown. One positive note for downtown San Francisco is the opening of a small format Ikea store at 945 Market St. Another positive point for downtown is the continued presence of a critical mass of high-end fashion retailers, centered on Grant St. and Post St. These designer boutiques have maintained, and in some cases expanded, their presence in recent years, despite the drop in foreign tourism, which provides a large share of their income. San Francisco’s smaller retail centers and urban main street shopping districts have generally performed well in recent years, benefitting from the shift in working patterns that has led to people spending more time shopping closer to home in their local neighborhoods.
The stock of shopping center space is falling as other uses become relatively more valuable. In Union Square, the renovation of the old Macy’s Men’s Store at 100 Stockton St. involves most of the 243,000SF project being repositioned as office space, as evidenced by the 22Q4 commitment by co-working space provider Convene to take 65,000 SF. Another building that was previously part of Macy’s Union Square complex, at 233 Geary St., was sold for redevelopment in 2020. Plans for the site call for street-level retail, several floors of office space, and residential condominiums on the upper levels.
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