Where in the Real Estate Cycle is the Bay Area? (Q3 2016)

Thursday, August 25, 2016

Real Estate Indicators from Thomas Foley, HFF San Francisco capital markets and investment sales team member.

VCs and PEs and M&A. Oh my!

Both the U.S. and San Francisco Bay Area commercial real estate markets have been growing strongly for quite some time, continuing to break through high price-per-pounds and low capitalization rates, largely driven by strong market rents and a historically-low interest-rate environment. A majority of this appreciation was felt strongest in major established and developing cities, where job growth fueled office expansion and the need for additional housing.

But where was the most explosive of the job growth? It was in the tech-dominated Bay Area – San Francisco, Silicon Valley and the East Bay. While the country was experiencing healthy, five-year annualized rent growth of 3.4 percent and 2.3 percent in apartment and office, respectively, the Bay Area markets experienced significant rent increases in both apartment and office of 6.1 percent and 4.3 percent-plus rent growth over the past five years! Out of 82 key metros, the Bay Area's three apartment markets' rent growth has ranked in the top four markets for the past five years, while the Bay Area’s office markets have been the first, second and 13th strongest with regards to five-year annualized rent growth.

To put this in some kind of Olympic-relevant comparison, over the past five years, the Bay Area’s performance compared to the other apartment and office markets in the U.S. is quite similar to how Katie Ledecky performed in the 2016 Rio Olympic 800-meter freestyle final, where she smashed the world record with no other fellow Olympic swimmer even close!  The future also looks bright for the Bay Area markets across both apartment and office forecasts. Over the next five years, REIS predicts the U.S. apartment and office markets to grow at 2.9 percent and 3.5 percent, respectively, while the Bay Area is still expected to outperform, with an average five-year forecasted growth of 3.1 percent in apartments and 4.2 percent in office.

At some point, this growth is naturally bound to moderate, and we are starting to observe commercial real estate investors gain greater security and try to anticipate where this market is going next. That being said, based on the data we can see, whether this cycle is in the middle or late innings, we are optimistic about the Bay Area’s commercial real estate scene. Here’s why:

How VC Funding is Changing Bay Area Commercial Real Estate

Source: Real Capital Analytics (RCA), PWC MoneyTree

Bay Area commercial real estate has been largely correlated to venture capital (VC) investment, but that correlation is more tied to the total number of deals done versus the volume of the real estate transacted. The 2005 to 2007 previous peak in real estate was driven by leverage and not venture capital, whereas this most recent real estate increase in value had a much larger connection to the VC funding environment.

Source: Real Capital Analytics (RCA), PWC MoneyTree

Despite the cost of starting a company at all-time lows due to major cost-saving innovations, including the ability to use the cloud, working from short-term co-working space and virtual office innovations, the average venture capital round has increased. This is likely due to the longer time and greater size expectation required to be able to consider going public. The average commercial real estate deal size across the San Francisco Bay Area remains relatively the same, likely for a couple key reasons:

  1. The increase in real estate deals because of new high-octane real estate investors in the market, in coordination with
  2. This cycle’s "Manhattanization" of San Francisco.

If this trend is to continue, we’ll start to see greater growth in values than growth in deal velocity, which will show an eventual increased average commercial real estate deal size trend.

A Tale of Three Cities

The Bay Area can be divided between San Francisco, Silicon Valley and the East/North Bay.

Source: Real Capital Analytics (RCA)

On average, each of these markets have about 70 to 80 trades per year, but the San Francisco market has dwarfed the East/North Bay and Silicon Valley markets in terms of total dollar value. 

Source: Real Capital Analytics (RCA)

For reference, the average deal in San Francisco is $54.7 million, Silicon Valley is $32 million and East/North Bay is $18.5 million. We’ve seen a cross trend in average deal size with Silicon Valley decreasing and San Francisco increasing because:

  1. San Francisco has become the new epicenter of technology companies, largely driven by employees preferences to live in a big city and have a short commute (relatively greater San Francisco demand growth to Silicon Valley) and
  2. Silicon Valley’s large supply of land to continually add new product to the pipeline versus San Francisco’s land and supply constrained marketplace (limited supply + high demand = higher relative rents).

During the this past cycle, San Francisco has experienced a "Manhattanization" effect with a plethora of beautiful, large construction projects delivered by investors, and, because of that, they are willing to break through historical price-per-square-foot ceilings and buy into product that may be considered a commodity in other markets. This occurs because of the strong belief in the staying power of San Francisco.

Revenge of the Nerds

Technology has permeated most every aspect of our lives and wallets. As venture capital markets cool and the window to viable public offering becomes ever more elusive, mergers and acquisitions become ever more attractive and likely. There has been a consolidation of cash in public companies, and much of it belongs to the tech giants.

Over the next two to three years, it would not be surprising to see these companies go on major acquisitions sprees, picking up many previously venture backed companies, some for outsourced R&D and some for talent aggregation.

From prominent angel investor, Jason Calcanis:

“Tech companies that are wildly deep-stacked right now:
1. Apple $200b+ in cash/equivalents, $593B valuation
2. Google $75b+ in cash/equivalents, $551B valuation
3. Amazon $16b+ in cash/equivalents, $366B valuation
4. Facebook $23b+ in cash/equivalents, $362B valuation
5. Microsoft $105b+ in cash/equivalents, $457B valuation
6. Cisco $60b+ in cash/equivalents, $157B valuation
Those six companies have $470b+ in cash/equivalents and $2.5t in market cap.”

This will have an interesting effect on the Bay Area commercial real estate markets. With acquisitions comes immediate credit enhancements (positive), but also the risk of job consolidation and relocation to headquarter locations (negative).

The major factor that will tip the scales (positively or negatively) for both the economy and the real estate markets is around ongoing and additional job displacement by by new technology and if these displaced employees will be able to retrain and reintegrate in this new technology fluent and driven economy. We believe they will!

Thomas Foley is a real estate analyst in the San Francisco office of HFF with more than 10 years of experience in finance, technology and venture capital. He is primarily responsible for performing financial and market analysis, preparing offering documents and coordinating the due diligence process for the investment sales and capital markets teams. Mr. Foley joined the firm in September 2015. Prior to joining HFF, he co-founded and led multiple venture-backed, financial technology companies, including Venovate, an alternative asset investment platform; CapRally, a CRM for company fundraising; and Xpert Financial, a private company fundraising and trading platform.

Mr. Foley was an All-American Water Polo player, and was part of UCLA’s 2004 National Championship award-winning team. He also went on to represent the United States on the Men's Junior National Team and won a Silver Medal at the U20 Pan American Games. Mr. Foley graduated from UCLA and has held leadership board positions at Menlo School, the Olympic Club and the BizWorld Foundation.

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