It’s Different This Time: San Francisco’s Commercial Real Estate Bubble

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By: Hudson Smythe, Vice President


By every measure, San Francisco’s commercial real estate market is on fire, and the tech industry continues to fuel it.  Tech companies occupy 25% of San Francisco’s office inventory and yet are accountable for 70% of the city’s net occupancy growth.  The health of the tech economy and that of San Francisco’s commercial real estate market are therefore tied at the hip.

Bubble conversations are everywhere, and mixed in are assertions that, “It’s different this time.” Although “different” can mean “better,” it doesn’t always.

So, what about this real estate cycle?  It’s different this time, and that’s both a good thing and a scary thing.

Different is good

San Francisco’s role in the tech community has changed.   With more VC money now flowing into San Francisco than any other part of the Bay Area (or world), it could now be considered the capital of Silicon Valley.  The war for talent is central to this transformation.

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Access to top talent is the leading reason San Francisco is being chosen over Silicon Valley.  Today’s hot startups are software/internet based companies, not the hardware companies that gave Silicon Valley its name.  Without reliance on space-intensive R&D facilities, these companies can base location decisions purely on people.

San Francisco’s millennial talent pool, vibrant urban work environment, and transportation fundamentals are the key people-related reasons that tech companies are choosing to scale here.  This includes many of Silicon Valley’s major players such as Google, LinkedIn, and Intuit, which have taken huge positions in San Francisco in acknowledgement of the city’s new significance.

Different is good because San Francisco has established itself as a hub of innovation, with a talent pool and roster of mature tech companies that will increase its resilience to broader economic challenges.

Different is scary

During the dot-com boom, 19 office leases over 100,000 square feet were signed in San Francisco.  In the last five years, the total was 58.  These are enormous office spaces, each accounting for hundreds and sometimes thousands of people.

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Some of this growth is due to what’s been described above, Silicon Valley tech giants taking strategic positions in San Francisco.  Further growth has come from public tech companies like Salesforce, Twitter, and Yelp who have cobbled together massive urban campuses.  The remainder can be attributed to so-called unicorns, who are leasing huge amounts of space in order to accommodate future hiring projections.  What Tomasz Tunguz of Redpoint Ventures has called, “the runaway train of late stage fundraising” has translated into a runaway train of large scale office leasing.

The scariest element of this leasing trend is its highly speculative nature.  Of the 3.1 million square feet of office space currently under construction in San Francisco, 53% has been pre-leased, some of which won’t deliver until 2018.  Since leasing office space requires significant lead time and years of commitment, the decision of how many employees to account for into the future can require quite a bit of guesswork.  Establishing a clear pathway of physical growth is seen as critical in maintaining a pathway of growth for a company’s overall business.

Different is scary because the cumulative speculation amongst San Francisco’s hottest tech companies accounts for millions of square feet of office space.  Individual failures, or a broader industry hiccup, could cause a more severe market shockwave this time around because of the sheer scale of the real estate bets being made.

The moment of truth

San Francisco’s commercial real estate market will correct, it’s only a matter of when, and how severely.  It’s too soon to tell to what extent the good differences of this cycle will counterbalance what may prove to be the bad.

Over the next few years, there will be a steady series of “moments of truth,” when large pre-committed office spaces deliver for occupancy and companies are left to fill them.  Will certain companies fall short of the growth projections on which they based their leasing?  Is San Francisco’s talent pool deep enough, and is the region’s housing/transportation infrastructure strong enough, to support the total number of jobs that this speculative leasing implies?

Yes, over half of San Francisco’s new office construction is pre-leased, but what about the rest?  Unless pre-leasing continues at its torrid pace, office developers will face similar moments of truth as their buildings near completion with vacancy left to lease.  Will San Francisco stay hot enough long enough for developers to achieve the high rents they’ve underwritten?  And again, where will the people come from to fill all of this new space?

One thing is clear, it’s different this time.  What that ultimately means for the San Francisco commercial real estate market remains to entirely be seen.

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