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Rents in S.F. Falling After Dot-Com Shakeout


Rising vacancies and falling rents continue to pull San Francisco's dot-com driven real estate market down to earth.

The return to normalcy in one of the country's most constrained office markets has contributed to another trend: a growing spread in rents between top-quality buildings and lower-tier properties that garnered artificially high rates during the Internet leasing frenzy.

"Six months ago, a shed in South of Market could command the same rent as the Bank of America building," said Paul Stein, a principle with San Francisco-based developer SKS Investments, one of the more prolific builders in the old industrial area known as South of Market, or SoMa. "That's like paying the same for a used Volkswagen as for a new Ferrari."

Since the end of the third quarter, rents in Class A high-rises have only dropped slightly, and in some buildings they have even increased, local brokers said. But buildings on the fringe of the Financial District and in parts of the SoMa and Mission districts have dropped 20% to 40%.

"It's become a tale of two markets," said Mike McCarthy, a broker with Colliers International in San Francisco who has worked primarily with Internet firms the last few years.

Two to 3 million square feet of sublease space, primarily from technology companies, has flooded San Francisco in recent months, several real estate firms said. Many companies have gone belly up and others have pulled out of real estate deals.

Last month for example, MarchFirst, a once-highflying Internet consultant, pulled the plug on a 273,000-square-foot lease at the massive Mission Bay mixed-use development in SoMa--swallowing a $4.5-million deposit in the process. As a result, the overall office vacancy rate in the city's roughly 60-million-square-foot market has nearly doubled since the end of the year, jumping from 3.88% at the end of December to 6.27% at the end of January, Grubb & Ellis Inc. said.

Rental rates across the board also have continued to fall. In the same one-month period, asking rents for Class A space have dipped 7.2% to $71.91 per square foot and Class B space has dropped 11.1% to $58.86, according to a Grubb & Ellis report. The reversal of fortune is especially evident in the dot-com heavy SoMa/Multimedia Gulch area, where vacancy is 14.5%.

Still, San Francisco remains one of the most expensive and tight markets in the country. Asking rents in Los Angeles County, by comparison, averaged $29.72 for Class A space last quarter and overall vacancy was around 12.2%, Grubb & Ellis said.

The uptick in vacancies has reestablished a stratification in the market that became skewed by the scramble for space from the horde of start-up and venture capital-backed technology companies.

Prominent space in trophy properties continues to command eye-popping numbers. In January, investment banking firm Adam, Harkness & Hill of Boston inked a $110-per-square-foot lease for 33,000 square feet at Embarcadero Center, one of the city's top financial district properties. That is among the highest rates ever recorded in the city.

Meanwhile, asking rents for Class B space, which makes up 75% of the SoMa submarket, has plummeted more than 26% from the end of October to $55.64 per square foot, Grubb & Ellis said.

Peter Victor, who oversees leasing for the 4-million-square-foot Embarcadero Center complex, said he is negotiating another triple-digit rent. Overall, he added, rents have tailed off very little, if at all, at the 99%-leased property.

But the Boston Properties Inc. executive cautioned: "If we go through six months of weak demand, then all bets are off."

A precipitous drop in the market here is unlikely, observers said. The region has a limited supply of land, major barriers to entry and an artificial growth cap. Known as Proposition M, the controversial local ordinance limits new office construction to about 1 million square feet annually. Efforts to relax the cap in November's election failed.

For the first time since the measure was passed in the late 1980s, several developers are competing for building rights. City officials in March will review proposals by Tishman Speyer Properties, McCarthy Cook & Co., Pacific Resources and A.F. Evans Development Co. for about a million square feet of office space. However, only about a third of that, 336,000 square feet, will be allowed.

The upshot: Though the contest will leave some developers out in the cold, it should restrict the supply of new buildings and thus bolster rents in existing buildings.

But some landlords who circumvented the city's cap on new office development by gaining a so-called business-service designation for industrially zoned buildings could be particularly vulnerable to the dot-com downturn, observers said.

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