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'Haves And The Have-Nots': Gap Widens Between Classes Of Office In S.F.

Lower-tier office buildings in San Francisco have struggled to find tenants.

As the flight to quality continues for tenants seeking space in San Francisco’s stumbling office market, the divide between Class-A buildings and the rest of the city’s office stock widens, emphasizing the importance of high-end space and the capacity to build and maintain it.

Two years after the pandemic brought office leasing in San Francisco to a standstill, large office leases remain rare, with those that do occur taking place in the city’s stock of Class-A buildings as employers seek to create ideal working conditions that will lure workers out of their remote work cocoons.

“It’s becoming a market of the ‘haves and have-nots,’” Woodstock Development partner William Syme said at a recent Bisnow event. “It’s getting harder to compete with capitalized owners spending money on their spaces, and with new construction.”

“You either have the amenities and are well-located, or you don’t,” he said.  

Tenants are betting that high-quality real estate with attractive amenities will ease the transition back to the office for their employees. The gamble has paid off in metros like Dallas-Fort Worth, which is near the top of the office-occupancy pack.

This trend contributed to rising prices for Class-A spaces in San Francisco and other markets, according to a recent CBRE report that covered 12 major U.S. metros. The report illustrated the difference in pricing between Class-A and lower-tier properties, with average rents for high-quality buildings increasing by 6.7% this year, compared to a 1.1% increase for older properties.

Generally, landlords with Class-B and C properties have used lower rents to entice tenants, but in the Bay Area, where the predominantly tech-focused tenant roll is flush with cash and particularly keen on remote work, cheaper rents are simply no longer enough.

“Ninety-nine percent of the time, when we are trying to recruit or retain people, it becomes a push for hybrid work,” Redwood City Community Development and Transportation Director Mark Muenster said at the same Bisnow event.

In submarkets like Union Square that aren’t known for their large inventory of office space, the flight to quality and the associated implications for lower-tier space aren’t as relevant.

But in the office-heavy Financial and SoMa districts, the flight to quality is in full effect, with Class-A vacancy in FiDi hitting 19.5%, compared to nonprime property types hitting anywhere between 20.8% and 35.6%.

Subsequently, owners of lower-tier office buildings find it tougher to keep up with the financial strain that renovating their buildings requires — particularly as it gets more difficult to bring tenants in the door and construction costs rise.

Rents are less of a factor than they used to be when attracting tenants, San Francisco-based CBRE Executive Vice President Bob Kraynak told Bisnow in an email. Tenants want quality, as well as flexibility in their lease terms, or even concessions like tenant improvement contributions to help them soup up their spaces.

“There are also a number of buildings advertising one-year terms to compete with subleases and co-working space,” he said.“Rents have dropped some but it’s often not the biggest factor in attracting tenants — flexible terms, path to growth, an engaged landlord, responsive property management and on-site amenities are just as important.”

Class-B and C spaces that remain vacant are likely in for a different future than what they've known, according to JLL CEO Christian Ulbrich.

“Those buildings will eventually be either repurposed or taken down and you will be seeing new developments maybe in completely different asset classes. And yes, we will believe that this is a key driver of future demand for other service lines [for] us,” Ulbrich said in the company’s Q2 2022 earnings call.

Investors are increasingly willing to explore adaptive reuse for office property, such as attempting life sciences conversions, and local economic development officials are interested in the idea as well.

The Greater Sacramento Economic Council, for example, has been investigating how much of the city’s existing office stock could be converted into industrial or life sciences uses in order to better align with current investor and tenant demand.

In the meantime, lower-tier office property continues to sit vacant. A Transwestern report on San Francisco’s second-quarter occupancy rates painted a particularly grim picture for the asset class, spurring Transwestern Senior Research Manager George Entis to remark that Class-C space is essentially becoming "useless."

Another recent analysis by CBRE, focused specifically on the Bay Area, noted huge gaps in the office vacancy rate between prime and nonprime office real estate, which suggests that the market’s overall office vacancy picture is not as clear as it looks at a glance. 

Direct effective rent for Class-A properties saw a 0.2% increase from 2019, hitting $99 per SF, while so-called nonprime, or Class-B and C properties, saw rental rates drop by 13.6% down to $79 per SF, according to CBRE.

Vacancy rates differed greatly. While total vacancy increased across the board, prime vacancy rates rose to 12.7% in Q2 2022, while nonprime space increased to 24.9%.