Companies interested in leasing, subleasing, purchasing or selling office space in the Bay Area

Commercial Real Estate is on Fire

What Will be Hot and Where for 2015

Presentation given at Scott’s restaurant by Jeffrey S. Weil, Colliers International on January 21, 2015.

Thank you so much for letting me share the first part of your morning. A few ground rules. First, feel free to interrupt me anytime. Second, we have handouts with links to all the material I will be talking about and all of you, please feel free to call or email me anytime if questions pop in your mind later. Third, I hope you like my humor, and if you know better jokes, just take me to lunch, so I can learn them. Finally, please use the RINA, CPA firm, for all your accounting and tax consulting needs, use Teresa Moss and Chicago Deferred for all your 1031 exchanges, and, of course, use me for all your commercial real estate requirements.

If you expect a smooth organized presentation this morning, forget it! On purpose, I will bounce around a bit because there is so much juicy exciting stuff to share with you.

When I began preparing for this event, I started from scratch, and spent the first two weeks interviewing top industry experts to see what they are experiencing and what they predict. Then, while I began organizing my notes, I thought of others to call, and other aspects of the market, so please bear with me as it all will come together.

Industrial, apartments, commercial, financing, hot retail trends, the office market, Santa Clara, San Francisco, the I-880, 680 and Tri-Valley – we will hit them all.

Rick Keely, an Industrial specialist out of our Colliers office, said the I-880 Industrial market is going strong. A lot of new construction has already been leased, like the 300,000 square foot Amazon deal in the Newark area. Livermore has a two million square foot industrial development, and out in Tracy, Prologis will be building a one million square foot distribution facility. The trend is, build then big and build then high. In the old days we had 12 foot clear height, then 18 foot, then 24 foot, now the new normal is 36 to 40 foot clear height. Southern Wine and Spirits just built a 60 foot clear height facility in Union City, and it is all automated. Just think how much less liquor disappears when you use robots to move the stuff around!

I asked if the obsolete 18-foot clear height warehouses will be knocked down and rebuilt, and the answer is, in general, not for warehouse because $25 a square foot for dirt is way too expensive. There are also companies that specialize in raising the roof, but this sounds better than it actually works, so no go for that. The I-880 vacancy rate in the 3 to 7% range, and will get ugly for tenants over the next 12-24 months as rents continue upwards.

According to Rich Martini, one of our East Bay apartment house specialists, the cap rates for multi-family dropped from 5.4% a year ago to 5.2% today, and the top three apartment rental growth markets in the United States are, #1 Oakland (11.5% annual rent growth); #2 San Jose (10.5%) and #3 San Francisco (9.8%). The East Bay apartment market is supposed to slow down a bit for 2015, and is expected to be 8.5%. There are a number of older, sometimes obsolete retail shopping centers and garden office buildings being purchased by multi-family developers as future tear-downs, with cities sometimes resisting zoning changes.

San Francisco has ‘micro-units’, which are 350-450 square foot apartments or condos, with a fold-down bed, built-in furniture and selling for $350,000-$500,000 or renting for $2,500 a month. A comparative bargain, compared to the $5-6,000 per month two-bedroom rental market, but in most other regions of California and the United States you can buy a nice house for these prices.

According to the San Francisco Planning Department’s latest Quarter 3 Pipeline Report, there are 50,000 housing units on the way. More than half of these are in three big projects, Hunters Point/Candlestick, Park Merced, and Treasure Island. These projects may not be completed for years, so there is no immediate fears of gridlock, but if one estimates three people per housing unit, this suggests an increase in San Francisco population of 150,000! No new freeways or public transit systems.

Last year California’s new Title 24 Standards went into effect. These new standards introduced requirements for photosensors, occupancy sensors and multi-level lighting controls, both indoors and out, making adaptive lighting the new standard in California. Why should we care? – I will explain in a minute, but this hugely expensive mandatory requirement is having an impact on the cost of tenant improvements.

What adaptive lighting is – lighting that automatically dims or shuts off when not needed, and it will be a huge near-term opportunity for energy savings.

The CPUC is calling for a 60% to 80% Statewide reduction in electrical consumption by 2020, with new residential construction to be net-zero by 2020 and commercial construction by 2030. Lighting accounts for 30% of California’s electricity use.

For the first time, occupancy sensors and controls will be required in aisles and open areas in warehouses. The same goes for book stacks in libraries and non-residential corridors and stairwells.

What does this mean to us? When you change out 10% or more of your lighting, you trigger this, and local commercial contractors estimate this can add $6 to $12 a square foot to your tenant improvement cost. Not too long ago a normal lease renewal TI job might cost $10 to 15/sf and a relocation $20-25 a square foot for second-generation space, meaning your ceilings are already in and you are just moving some walls and doing new paint and carpet. Today here in the East Bay renewals $15 to 25/square foot, and relocations $40 a square foot, and in San Francisco for new space it is not unusual for the Landlord to contribute $40-60 a square foot for tenant improvements with the tenant contributing an additional $40 or more a square foot.

With the cost of office tenant improvements so outrageously expensive, what if Landlords offered tenants a choice – $10 for paint and carpet, then if the walls and the rest of the space left as-is, $15 to $25 worth of free rent, so the tenant can save money by not re-doing the entire space. I know this does not take into account space, efficiencies by having it custom-designed, but just imagine if residential real estate was like office leasing – sure I’ll rent or buy your house, but, instead of four bedrooms, I want five, and I need a much larger kitchen.

What is happening in the commercial real estate financing world? Zillions of dollars at super-low interest rates looking for solid investments, not like back in 2006 and 2007 when they were making 90% loan to value mortgages on junk that triggered our Great Recession.

Mandy Pakes, with the Colliers mortgage division, says you can get Commercial Mortgage – Backed Securities, which are CMBS, 30 year amortization fixed rate at around 3.8 to 3.95%, non-recourse, for prime commercial properties. There are interest-only loans for less than 65% loan-to-value properties, and apartment house loans for 10 year fixed are in the 3.7% range. Over the next 36 months there is a huge bubble of CMBS loans coming due, somewhere around $300 billion dollars worth, but a low percentage that is still underwater and the rest will be refinanced or traded.

John Machado, one of our retail gurus from Silicon Valley, also commented on the downsizing of the large box retailers. He said that while Internet sales have increased dramatically, they still only represent less than 5% of overall sales across the U.S. Down in Santa Clara 100% of all new retail development is, for the most part, all leased up. No hard times for the regional malls, but the Class B shopping centers have had to learn to adapt. Non-retail users like Sylvan Learning Centers are turning out to be valuable synergistic uses for retail centers. Mostly affluent parents who can afford this private tutoring drop their kids off, then go shopping until it’s time to pick their kid up.

I interviewed several top retail commercial brokers, including Solomon Ets-Hokin out of our Colliers Oakland office. One question I asked, “What impact is the internet having on brick and motar stores?” The mid-boxes might be challenged, like Best Buy, Linens & Things, Barnes & Noble, of course, Toys R US – Many are in the process of downsizing, going from 25 to 30,000 square feet down to 10,000 square feet, and stocking just the hot sellers. Of course, you can order from a more extensive selection, but not necessarily touch and feel what you want to buy beforehand. Walmart and Target also stock the best sellers in so many more departments, so this may be a tough road for mid-size box stores.

Millennials Sensibility – this generation may be more frugal and not as willing to shell out $300 for Gucci sunglasses or $1,500 for a Louis Vuitton purse, and may not pay a premium for the logo or the brand. They will shell out 500 bucks for an iphone 6, or the smart watch that tracks their workouts.

Millennials are more into experiences than ‘stuff’, and may have no problem spending $14 on a decent glass of wine or flying to Colorado to go skiing with friends, but there are tens of thousands in San Francisco who choose not to own a car, but take a Bart, Muni or Uber to get around and rent a car when necessary, and there are millions of Millennials across the country who do not have owning a home on their wish list.

In a recent article in the National Real Estate Investor, “Sears is laying off at least 6,067 workers and closing over 110 Kmart, Sears and Sears Auto Center locations.” Sears’ revenue has declined for 30 straight quarters. It has posted losses of over $1.8 billion during the past four quarters. Some industry experts are linking this to the sinking of the Titanic… It may take a number of years, but eventually it will go down…

Top retail trends, according to Hubba research, Trend #1: Consumers are always connected and are constantly in a consideration phase. Trend #2: Consumers want personalization, they want retail advice based on who they are. #3 Trend, Brands need to transfer online searches into stores – consumers are looking offline but buying online. #4 Trend, The Internet of things, products and devices will become more connected to one another. You can heat your house before you get home, your refrigerator will notify you when the milk is low or you need more beer, and your workout smart watch that counts calories may not let you use your smart credit card to buy junk food.

#5 Trend, The Changing Storefront, where content has become sales, channel via mobile and second screen technology. Relevant product information will be delivered to shoppers at key points along the path to purchase.

My opinion, we will see less and less ‘static’ storefront displays, things will be alive with screens, motion, and enticing connectivity to your mobile device to get you involved.

More significant retail real estate industry trends to watch out for – redevelopment and phase two development can be a lot less costly and shave years off the delivery schedule versus fighting through Environmental Impact reports, neighborhood protests and ground-up development hassles. What do you mean they just found dinosaur bones in the construction site?

Sustainable will be an increasingly important initiative with commercial real estate concerns. More and more government-mandated energy audits, benchmarking and energy-efficiency disclosures.

Shopping centers may become 24-hour hubs, and don’t be surprised one day to see doctor offices and urgent care facilities in shopping centers.

Junior anchors like Ross Dress for Less, Bed Bath & Beyond will quickly fill big-box spaces vacated by struggling retailers.

Jim McMasters, one of the few brokers around who has my 39 years of experience beat, has focused on retail leasing and development since 1972. A few of Jim’s observations: Walmart and Target are starting to move into major retail malls, especially in areas where there isn’t reasonably-priced land to build new stores. Overall, retailers are incorporating Internet into their business process. He has heard reports that Internet now makes up 10% of all retail sales, and is heading towards 20%. I googled this and came up with exactly 6.45% as of last Friday.

Amazon is opening huge warehouses in every state of the country, with the goal by 2018-2019 of being able to provide same day delivery. Order in the morning and get on your doorstep that afternoon.

East Bay retail vacancy overall is around 5%. Closer to home, the new retail project in downtown Walnut Creek across from Tiffany – rumor has it the high-end clothing store Vineyard Vines will be taking the ground floor, and McCovey’s is closing its doors next month and opening near AT&T Park in San Francisco, to be replaced by Slater’s 50/50, a designer burger sports bar based in Southern California.

Downtown Oakland has seen a definite spike in San Francisco companies touring office space. Grant Jones of CBRE estimates 80% of all his Class A Downtown Oakland tours are from San Francisco, and the largest contiguous space available is 70,000 square feet.

East Bay corporate downsizing continues. We are still awaiting the fallout from Safeway Stores HQ downsizing in Pleasanton and Wells Fargo has been rumored to be shedding 250,000 square feet of Walnut Creek/Concord office space. On the good news side, General Electric has a software group in San Ramon that has grown from 100,000 sf to 400,000 sf, and Workday in Pleasanton has had its explosive growth.

To quote the Pleasanton Colliers 3rd Quarter 2014 Office Market Review,

“The summer evidenced a healthy economy with seemingly long vacations for executives and decision makers – they were not out touring office space in any event. Overall Tri-Valley office and office/flex market absorption numbers for the quarter look atrocious at negative 661,197 square feet.”

          This sets the tone for not just the Tri-Valley region, but the I-680 Corridor as well. The major factor impacting the negative absorption was Bishop Ranch officially, putting the 953,000 square foot AT&T space on the market. Up in Concord we have 400,000 square foot of B of A space; and overall both markets have about a 15% vacancy rate. Yet in spite of this, many of the submarkets saw Calss A landlords raise their rental rates over the past 12 months.

Mike Copeland of DTZ down in Pleasanton says,

“Two more years of market prosperity. Overall feeling is that things are pretty good. Past that, maybe the cycle changes again.”

We haven’t seen the migration to the East Bay that we expected last year, and we are still hopeful it comes this year.

No speculative office development is seen in the near or medium-range future, and with the Rosewood Commons in Pleasanton and the AT&T space in San Ramon we still have millions of square feet of Class A office space at very low rental rates.

John Dolby of DTZ, an Oakland office leasing expert, said Oakland doesn’t have product to attract big San Francisco tenants. Oakland needs to build major Class A new office buildings. $45/sf rents will make this pencil, and it will be a 50% or greater savings factor over San Francisco. Oakland has a number of 2-10,000 square foot relocations out of San Francisco.

Young millennials want Bart, centric, walkable and livable work places.

San Jose

Silicon Valley is in a groove. Nearly 3.9 million square feet of office space absorption will be recorded in 2015 from projects currently under construction. Total gross absorption for R & D, Industrial, warehouse and office for 2015 is predicted to hit 25 million square feet. Similar to San Francisco, more than 80% of all new office construction scheduled for completion this year, is already leased. As Jeff Fredericks, the Managing Director of the San Jose Colliers office stated, “Office is on fire in Silicon Valley.” At the end of 2010 the office vacancy rate was almost 25% – today it is 11%. Average full-service asking rental rates have increased during this time from $2.58 per square foot to $3.52 a square foot today.

The Santa Clara and San Francisco office markets are like a speeding Ferrari compared to the I-680 Corridor’s Prius with two flat tires…

Silicon Valley office rents are hitting heights not seen for many years, and this market is running out of inventory. Folks ask, is this a bubble and if so, when will it pop, and the experts respond, probably, but no one can predict when, and with companies like Apple, Facebook, Google, and LinkedIn helping fuel this huge need for office space, with their billions of cash and staying power, most don’t think the financial cliff is even on the horizon.

With the commuter traffic bumper to bumper heading out of East Bay bedroom communities like San Ramon, Walnut Creek and elsewhere heading daily on 3 to 4 hour round trip commute to Santa Clara, the Peninsula and San Francisco, the bigger question is, when will companies start migrating eastward to be closer to their employees?

Here is what Alan Collenette, Executive Managing Director of the San Francisco Colliers office, stated this month, “The City is now the undisputed urban epicenter of the world’s knowledge-based economy.”

Our San Francisco office brokers barely had time to chat, they are so busy closing office deals. It is felt that we will see some of the higher-image office projects like 101 California, the Bank of America building and the Ferry Building, for example, will hit the $90 to $100 annual per square foot range. They are seeing tenant improvements and furniture hitting $140 a square foot for new shell office space with Landlords contributing $50 to $65 a square foot and Tenants paying the rest.

According to the latest Colliers San Francisco market report, 2.8 million square feet of office space was absorbed, there were 8.1 million square feet of office transactions, and rents rose 16.2% over the same time last year. The vacancy rate is 7.5%, kept up due to millions of square feet of new office construction. There have been 18 straight quarters of positive absorption and declining vacancy.

Possible office trend designs of the future

Imagine the 1800’s when the wagon train was attacked by hostile Indians? They created a circle and fought from the inside. Now imagine workstations arranged like a wagon train circle, but with a few conference rooms and informal meeting areas in the middle. You get privacy for concentrated tasks, and easy access to brainstorming and synergy work.

You want space-efficient privacy, put together a small enclave with a door, a table, a chair, and phone and laptop with Internet connection.

Activity-based planning is key to space design. What do employees do when they get to work – they check voicemail and e-mail. You only need touchdown space for this. Then they might have a meeting either informal, formal, open conference room or private enclave. Hard files stored in central accessible file area, the rest stored on the cloud.

These thoughts and predictions are from the Certified Commercial Investment Institute through Steelcase surveys.

“In this country, 90% of real estate is allocated by title. A vice president gets X-amount, a salesperson gets Y-amount. In the future, this will be the other way – the percentage of real estate that workers occupy actually will be based on how much time they spend in the building. An engineer working on a project who is there more than 60% of the day will get a bigger space than the president or salespeople who are there less time.

Credit for the following information goes to Eric Von Berg of Newmark Realty Capital, Inc., “The 7.5 million people in the Greater Bay Area represent 19.6% of the State’s population and 2.4% of the Nation’s. The Bay Area’s GDP of 616 billion ranks 21st in the world if we were our own country. “The Bay Area per capita productivity is 2.5 times the U.S. average. The Bay Area has more Fortune 500 companies (30 with combined sales of $1.14 trillion) than any U.S. region except New York. Of the 134 high-tech start-ups worldwide that gained a $1 billion valuation in the last 10 years, 52 were from the Bay Area.“

 “The Bay Area has more graduate programs ranked in the top 10 nationwide than the consistently 2nd ranked metro area – Boston. There are 97 colleges, universities and academies in the Bay Area. The Bay Area has over 2,027 biotech companies and 22% of VC funding. The Bay Area dominates social networking with eight of the top eight sites by market share: Facebook, YouTube, Twitter, Google, Yahoo, Pinterest, Lincoln, and Instagram.”

Five reasons there is a feeding frenzy for decent commercial real estate properties of just about all types. Interest rates for new financing are still at historically low levels, and investors can get 5 or 10 year fixed-rate mortgages at sub-4% rates. The economy is on the upswing, so there is less risk of vacancy and tenant default. Alternative investments such as bonds or fixed-rate financial vehicles are at very low returns, making even the crazy commercial real estate cap rates look comparatively attractive. In many markets new construction is still too costly to be viable, pushing vacancy rates downward and rental rates upward. And the United States is a global safe haven for investments.

          I am going to spend a few minutes touching on major commercial real estate industry trends and issues that at least I find of interest.

For a number of years telecommuting has been an increasingly important part of the corporate work culture. Starting maybe 20 or 25 years ago every year the percentage of the workforce telecommuting, either par-time or full-time, seemed to go up. Being able to work from home for a number of industries and types of work, is here to stay, and there are millions of workers who might have a touch-down space in an office, but for the most part are mobile warriors, working from clients facilities, home, either branch offices or from Starbucks. I haven’t seen any formal data on this, but I believe this trend has peaked. Google, Facebook, Salesforce, LinkedIn, Apple and on and on and on are buying and/or building huge office campuses and Class A high-rises to take advantage of the creative and immensely powerful synergistic brainpower you get when you have employees collaborating, inspiring and brainstorming in-person, in small, medium and larger groups, but in person. Face time, Skype and video conferencing are all well and good, but your top corporations today leverage the power of their employees, and it is much harder to do this at home in your pajamas.

           Connectivity, mobile technology, wireless, Bluetooth, the Cloud- I was at a presentation a few months ago, by General Electric software, where they described the huge economic value in having sensors, monitors, computer chips and connectivity in turbines, motors, jet engines, in everything where you can know 20 flights or 10 million revolutions before a part wears out, so you can minimize downtime by proactive replacement or repair.

Office buildings in my lifetime will be net zero energy, as may be retail, industrial and residential buildings. Roofing systems will be integrated solar, exterior surfaces will be solar generators, they have exterior glass now that captures sunlight, there will be powerful tiny energy-collecting windmills on the top and sides at buildings, your office lighting will only be on when you are there to use it, LED’s will become increasingly more efficient, your office or workstation sensors will communicate with your building HVAC system, and there will be much more transparency. Buildings now have to register their energy usage and disclose to buyers, investors will give a premium to low-energy commercial real estate investments, the parking lots and garages, instead of just a few, will have rows of electric charging stations.

In conclusion, we discussed Industrial, how hot a market is and the new 40 foot clear height bigger is better. We touched on financing, unbelievable amounts of money at incredibly low interest rates. Apartments are sizzling and will stay that any until interest rates shoot up. Retail is changing in a huge way, and those who don’t transform themselves will join the dodo birds and brontosauruses. Office, what a difference a Bay makes. Class A in San Francisco at almost 70 bucks a foot, Class A in Concord with bells and whistles at 25 bucks a foot.

          If 40 terrorist cells hit 40 locations at the same time in the US, all bets are off, and if the drought keeps droughting off cell bets are off, but Downtown Walnut Creek Class A rents will keep rising regardless of the vacancy rate, at some point non-tech San Francisco companies will begin migrating to the East Bay, both for financial necessity and to be closer to their workforce, and when the multi-family construction boom slows down, and suburban office rents go up another buck or two a month, we may begin to see new office construction, but not in the near future.

          Call me anytime for anything, especially to ask me to sell your commercial property or represent your firm in a renewal or relocation.

Thank you, Pam Raumer at RINA accounting and Chicago Deferred, Theresa Moss, and let’s open this up to questions and answers.

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