Derek Daniels has tracked the ups and downs of San Francisco’s office market for about 20 years, most recently as the Bay Area regional research director for Colliers. Lately, his work has involved a lot more downs in the market: the city has the highest vacancy rate out of any major U.S. market, with about one in three offices sitting empty, and effective rents are more than 40 percent reduced from their peak in 2019.
While Daniels expects vacancy rates to keep going up and rents to keep heading down, he said he’s “cautiously optimistic” that the city has at least passed the bottom in terms of leasing activity, with AI companies leading the way for big leases, along with traditional FIRE companies on smaller leases.
Most of big tech is still “pencils down,” he said, but AI is “growing and growing fast.”
“We’re starting to see requirements of 100,000 square feet or more,” he said. “There’s market chatter that there are pending large-block leases in San Francisco.”
Daniels spoke to TRD about how the recent announcement of Elon Musk’s X move to Texas could impact the market, why some buildings are still getting record rents, and how the “blend and extend” trend may transform into “end and extend” as owners try to get ahead of upcoming lease negotiations.
Google has announced it will have a much smaller office footprint and X is leaving San Francisco entirely. How do moves from big names in tech impact the market?
There have been a few waves of big tech decisions to market space for sublease. The X availability is certainly going to affect Mid-Market. There is an opportunity there, though. If a tenant commits, that should provide a much-needed influx of workers to that part of the city on a daily basis.
Before that was announced, sublease availability had been ticking down a bit for a few quarters. But obviously with that new space hitting the market, it’s going to push the number back up closer to the record of around 9.8 million square feet.
I think, right now, tenants are putting a priority on finding a “plug and play” space, as well as flexibility.
If a tenant can get into a sublease space that’s already built out, and already furnished, that’s desirable. If you look at the deals that AI companies have signed, quite a few of them have been subleases.
To compete with subleases, we’re seeing landlords spec out suites to try to deliver that as well. There’s always going to be an appetite for certain tenants that want to sign a long-term lease
on a direct basis, especially for Class A view space.
How has the vacancy rate and high sublease rate impacted the value of San Francisco offices?
There have been a few trades at a very low price per square foot, and those groups are able to compete heavily in the marketplace right now. Some people are calling this “the Great Reset,” not just in San Francisco, but in many markets. There’s a reset on rents that’s going to cause a reset on property values as well.
But if that leads to more sales activity, it’s just part of the process of going through the market cycle. There’s probably over a dozen office buildings that are on the market right now, so we’ll see.
How does vacancy impact value?
Here’s one thing to consider when you read these headlines that say a building has sold for a 90 percent discount compared to what it sold for a few years ago: if that building is empty today, and it was full before, that’s going to cause a huge difference in price.
There has probably never been more opportunity in the market than there is today for groups that are able to go in and buy and take that risk right now.
What data do you track to see where we’re headed in 2025 and beyond?
We look at net absorption. We’re on a 17-quarter run of negative absorption. We’re finally starting to see that change course a bit. It’s still negative, but it’s a bit flat.
We’re looking at leasing activity. Renewals are still a big part of it. As tenants or as leases transact on a relocation, many tenants are taking a bit less space than they had previously.
I think the composition of tenant industries that are signing leases right now has shifted a bit. Tech is still there, it’s still a big factor, but it’s less of the pie than it used to be. There’s actually quite a bit of leasing happening right now with professional services and legal — what you might call traditional office users.
One trend that is emerging is “end and extend.” So a landlord might want to just renegotiate the terms for the tenant right away rather than wait for the lease to expire to get more term on the back end. Coming out of the global financial crisis, you saw a lot of “blend and extends,” and that was sort of a similar strategy, but this is a renegotiation of the current lease, with a bit of a reset on the rent to match today’s conditions, and then adding lease term for a tenant that maybe has just a couple of years remaining.
Market participants understand that there’s a bit of a reset. It took a while to get here, but it’s happening.
How are remote work policies impacting the market?
It seems hybrid work is here to stay. Many companies are publicly announcing the three-day in-office work week. Some groups are in four days a week. It’s very rare to see anyone in five.
But also, it’s probably pretty rare these days to see anyone fully remote.
How does San Francisco’s office market compare to the wider Bay Area, particularly Silicon Valley?
Silicon Valley is faring a bit better than San Francisco. It wasn’t as impacted by remote work. Subleases are still fairly high, but not at the levels that you’d see in San Francisco. Downtown Oakland has its challenges as well.
Silicon Valley also gets the benefit from a very strong R&D market and that market has fared better than traditional office.
Workers want amenities, companies want amenities. Anything that causes friction around getting to the office in any way is a factor right now. I think there’s an argument to be made that Silicon Valley as a more suburban market, where people don’t need to take mass transit, is benefiting from that.
What about the amenities?
If you look at buildings that are highly amenitized, where the buildings themselves are providing the amenities, there’s absolutely a premium on rent that’s achieved in those buildings, and they have a lower average vacancy rate.
The highest quality view space in San Francisco has probably never been priced as high. Those averages are probably getting pushed up a bit by certain projects that are achieving pretty high rents right now.
How can trophy buildings maintain these high rents even as the lease rates drop in the rest of the city?
The spread between commodity, Class B space and that trophy view Class A space has never been higher.
There’s a strong historic correlation in trophy rents and the Nasdaq, and the stock market is doing well. Plus that segment has always had limited inventory. On the other side, you have so much competition in the commodity A and B markets right now that it’s kind of a race to the bottom.
Concessions are still high, including months of free rent. The average lease term is shrinking. TI dollars are significantly higher than they were a few years ago.
What encourages me is just seeing more leases transact. In the second quarter, the total volume was around 2 million square feet. That’s not bad for a quarter, especially considering so many of the deals are for partial floor transactions. There certainly is more activity now, but obviously San Francisco has a long way to go to get back to a stabilized vacancy of 10 percent.
It would be a different picture without AI but we need to see much, much more than just AI to see a recovery. It’s going to take every industry. It’s going to take workers coming back downtown.
If we’re settled into a hybrid work week, where are these workers going to come from?
Luckily, we are still a major tech hub. The Bay Area still has so much to offer. People want to live here. We have close proximity to Stanford and Cal. If you look at VC funding numbers, this is ground zero for AI funding. It’s really San Francisco, not so much the whole Bay Area. Those are strong indicators that there are a lot of things to look at for the future of San Francisco that could be positive.
But office markets are challenged right now, and it’s going to take time. As more buildings change hands, that will allow those new owners who bought in at a low basis to become even more competitive.
As more buildings change hands, that will allow those new owners who bought in at a low basis to become even more competitive.
As more leasing occurs in those buildings, you may start to see a more material drop in average transaction rents.
I’m consciously optimistic. With the conversations that I’m having, it does feel like things are moving in a better direction now and I think my peers at other firms would say the same.
Are we past the bottom?
From an activity standpoint, the bottom was hit in the second half of 2023. After the sale of 550 Cal [550 California Street], and after some of the big AI leasing that we saw coming out of late summer and early fall of last year, that’s when things started to really pick up.
That doesn’t mean that we’ve hit a bottom on rents or we’ve hit a peak on vacancy. But that’s when things started to change.
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