“Flight to quality” in San Francisco office market

Class A office space gets top marks for lease ups in still-recovering San Francisco, with many companies taking advantage of subleasing opportunities from downsizing or relocating businesses, according to several Q1 office reports.

Premium office space accounted for nearly 80% of all leasing activity in the first quarter, according to data from Avison Young. That pushed direct asking rents for class A properties above $82 per square foot citywide, $1.67 more than the last quarter of 2021. Class B office space has remained flat, at just under $70 per square foot, for the past year, at around $75 a square foot in the downtown core.

Class A and trophy office space has “dominated office demand” for the last three quarters, according to the report, which called the “flight to quality” a clear trend driven by employers looking to lure employees back to offices with high-end amenities. Among other listings, Avison Young has a listing for 130,000 contiguous square feet of Class A space across five floors at 199 Fremont, a 25-story tower that will see another four floors become available in January 2023. The listing advertises amenities such as on-site daycare, a fitness center, car and bike parking, and a location two blocks from the Embarcadero BART/Muni station.

The report points out that overall BART ridership was up twofold between March 2021 and March 2022, with over 10,000 people getting out at the Montgomery station daily, and over 11,000 using the Embarcadero station. Each station had less than 4,000 commuters in March 2021.

“The sharp increase in BART commuters is likely attributed to a combination of rising gas prices and larger companies returning to the office,” according to the report.

Nearly 40 percent of leasing deals in the first quarter were subleases, led by Sephora’s nearly 290,000-square-foot sublease in the 30-story Salesforce East—by far the biggest lease up of the first quarter, according to the report.

Companies are still sorting out what a return to offices looks like, which is one reason subleases and leases under 10,000 square feet have been so popular, according to analysis in a Kidder-Mathews a first-quarter report on the office market. While the overall vacancy rate was 20% at the end of the first quarter, a one-fifth increase over 2021, the sublease vacancy rate was down 17% to less than 5% vacancy during the same period, the commercial real estate firm found.

“The sublease market is approaching pre-pandemic levels, which indicates some level of demand,” the Kidder report states. “Our read is that prospective tenants may still be wary of long-term leases due to the latest Omicron surge but would still like to have office space in the city.”
Kidder Mathews also reported seeing more tenants actively searching for space under 10,000 square feet, with a nearly one-quarter increase in tenants in the market for that smaller footprint since the last quarter of 2021. The pattern could be indicative of new startups coming online as VC interest “soared” in the Bay Area last year, according to the report.

In the year ahead, inflation may play a bigger role in both rents and the delivery time for new office spaces, the report predicted. Some landlords are now asking for rents over 3 percent higher than a year ago, in an effort to keep up with rising costs, while continuing supply chain issues push up costs on construction and push out delivery timelines.

In a press release touting its upcoming second quarter report, Kidder said availability of premier Class A offices with water views remains tight, and asking rates above $100 per square foot “for some of the best suites in the city” are now typical. Touring activity has also picked up as prospective tenants scout out “open-office creative spaces” instead of more traditional floor plans.

With big commercial trades still few and far between, it remains to be seen how much these trends will impact the value of commercial buildings downtown. The biggest deal of the first quarter was well outside the downtown core in Potrero Hill, where the San Francisco District Attorney’s Office sold in January for $183 million.

Last month, UBS listed its downtown office tower for $280 million and Wells Fargo listed one of its towers for $160 million. Those sales should give a good indication of where office values are more than two years after the pandemic upended the market.