San Francisco's Demand Problem
The San Francisco office market consists of 86M sf. Currently, 18.7M sf is available, 13.7M direct from landlords and 5M for sublease. This means that 72.3M sf is leased and not being marketed for sublease. We can assume there will not be much (if any) new supply added to the market over the next several years. Demand will be the key factor in determining the market’s trajectory.
In any given year, only a small percentage of the total leased space expires. Of the expiring leases, a small percentage will be for space otherwise available for sublease and for which the master tenant has no interest in continuing to lease. This space will revert to direct vacancy. The big question is what happens with the balance of the leases, whether these tenants sign new leases that are smaller, equal to, or larger than the space leased at expiration.
Our view is market vacancy will continue to increase for at least another year as we see an aggregate reduction in demand for space. How might this play out? For example, let’s say 8% of the leased space (72.3M sf) expires next year. This represents 5,784,000 sf of leased space at the time of expiration. But let’s assume 5%, or 289,200 sf of this space was available for sublease and will not be extended. That leaves us with 5,494,800 sf of potential demand. This demand can grow, shrink or remain unchanged. At this time, we’re generally seeing a net downsize of ~25% to ~30%. At 25%, this would reduce leasing activity to 4,121,100. Of course, there will be some level of net new leasing from companies that had not previously existed and/or whom did not previously have an office in the San Francisco market. Let’s assume this new leasing totals 500,000 sf. These net new leases bring total demand up to 4,621,100. But the overall net effect of this hypothetical year would be to add 1.35% to total vacancy, bringing it from 21.7% to 23.05%.
To be sure, market performance will vary by asset and submarket. But prolonged periods of high vacancy and reduced demand will have a material impact on rental economics, driving down the average cost to lease. Tenants can expect significant leverage, with many options to choose from. For occupiers, this is the silver lining of San Francisco’s office demand problem.