The VC Bubble Just Popped, So What's Next for Bay Area Commercial Real Estate?

Wednesday, June 1, 2016

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

The party is over in startup land. 

Over the past three years, we have seen one of the most robust venture capital (VC) investment booms in history. Starting a company has never been easier or less expensive. Incubator and co-working space has popped up in more and more places and investors who have never before participated in this market began investing large amounts of capital.



Since 1995, the Bay Area has benefited from being the largest recipient of venture capital investment. During that time, the concentration of venture capital investment has increased substantially from below 20 percent to above 40 percent.

The average venture capital investment in the Bay Area has been about $3 billion a quarter over the past 20 years, which is substantially less than the $5.5 billion a quarter over the past three years.

Finally, the PWC MoneyTree Venture Capital investment data does not reflect the additional $15-20 billion of capital invested into VC-backed private companies by non-traditional investors, including hedge funds, sovereign wealth funds and mutual funds (Fidelity, T. Rowe and MFS).

Historically, the main focus of most startups seemed to be achieving “unicorn” status, a term coined to describe these superstar companies that attained a valuation of more than $1 billion (sort of like private market cap, but different). There wasn’t much of a plan after that for liquidity or actually turning a profit.

The demand economy creates a new class of on-demand worker. If every upcoming actor in Hollywood moonlights as a waiter, then every next entrepreneur moonlights as an Uber or Lyft driver.

If this VC boom had a hashtag, it would be #GrowthAtAllCosts; acquire the most customers, land and expand, hire more people and get enough space for at least the next three years into which to grow.



This VC boom has driven low unemployment, high salaries and large amounts of employee migration into the Bay Area. Since 2006, the amount of IT professionals in the Bay Area has grown by more than 55,000 employees, or 52 percent.



Unsurprisingly, there is a large correlation between the large amount of venture capital flows and increasing rent growth.

‘“Zumper has found that for every $1 billion in venture capital injected into a local economy, one-bedroom rents will increase $69 per month, and two-bedroom rents will increase $99 per month. Although this may not seem significant, we must account for the massive scale of venture capital investment in major technology hubs of San Francisco, San Jose, Boston, and New York. In these metropolitan areas, the influx of capital has raised one-bedroom rents significantly.
At the highest level, $1,069 or 33 percent of a one-bedroom in San Francisco can be attributed to economic stimulation from venture capital investment. 
San Jose takes second place, where 25 percent of rents can be attributed to investment ($476 monthly), followed by Boston, 13 percent ($307 monthly),
and New York, 10 percent ($292 monthly)

– Zumper “Are Venture Capitalists Raising Your Rent?”



Rents have skyrocketed, and, according to the Zumper National Rent Report March 2016, the most expensive rental market in the U.S. is San Francisco, while both Oakland and San Jose are tied for No. 4.

A major benefactor from this boom has been the real estate investment community:

  • Office space is in high demand, which keeps market vacancies low and rental rates increasing.
  • New developments around the Bay Area and large tenant improvements have driven construction costs to sky-high levels.
  • High-tech salaries and supply-constrained housing markets have helped drive rent growth by 10-20 percent year over year for the past three years in many submarkets.

This has led to high-water marks in pricing for sales in most markets, much shorter time-frames to realize returns and, as the party really got going, a willingness to take on more risk for similar returns.

The venture capital investment market has cooled significantly over the past two quarters; less capital is being deployed, down rounds are the new normal and hiring plans have been put on ice. The growth-at-all-costs-mentality has changed tone to lowering the burn and getting to profitability ASAP.

Some of this recent boom’s media darlings, including HomeJoy, Zenefits and Theranos, have been publicly torn apart because of bad business models, reckless founders or remiss boards.

And if this is the case for VC, it’s only a matter of time until we start seeing the impact in the Bay Area commercial real estate markets. The party might not be completely over for CRE, but the lights just came on, and the punch just ran out.



On the real estate side, we are starting to feel the impact of the slowing of VC investment on transactions, pricing and market sentiment. The start of 2016 saw one of the largest backlogs of supply teed up to hit the market as owners looked to exit many deals at high prices prior to the markets changing. In Q1, we saw pricing reset by 5-15 percent across the Bay Area.

Bid pools have been smaller than in recent years, and many investors seem fatigued. This is largely the case across the office market as compared with the multifamily and retail product types, which are not yet materially affected.

Investors seem more hesitant to do deals with prolonged business plans, reflecting uncertainty with regards to market stamina through 2017-2019. There is definitely a flight to quality, and investors’ No. 1 metric has shifted from levered IRR to upfront yield.

Despite the slowdown in VC, it’s not all doom and gloom for the SF Bay Area commercial real estate market. This is a healthy, necessary process that happens and because of more cautious debt practices with lower loan-to-values (LTVs), we are unlikely to see the requirement to sell at any scale.

Long-term, I’m bullish on the Bay Area; we are currently at the center of the technological revolution, and I believe that innovation, job growth and wages will continue to increase.

The resetting hasn’t yet completely occurred in the Bay Area, but I believe it should over the coming 6-18 months. Eventually, it will allow for new investing and development opportunities.

Some major themes investors should keep in mind for the Bay Area:

  • Affordability issues: For many people, the Bay Area has become too darn expensive to rent. This, coupled with the not-in-my-backyard (NIMBY) attitude, has not allowed sufficient multifamily and affordable housing developments to be built in necessary markets. This will need to be addressed in the near future or we will see much more competition for living and working in other technology markets like Austin, Los Angeles, Seattle and Denver.
  • On-demand workers: This massive group of ad hoc contractors are doing jobs mostly for wealthy technology employees. It is not clear that (1) many of these jobs will scale outside of Silicon Valley to less affluent cities and (2) these jobs will exist as more tasks become automated – i.e. Uber drivers are driving themselves out of a job.
  • Self-driving cars: Silicon Valley is the new Detroit – in a good way. Every major car company (Tesla, GM, Ford) now has an R&D department here, and the big technology companies (Apple, Google, Uber) are creating their own solutions. This could definitely have an impact on how and where people live and work.
  • Virtual reality: The next big wave of major technology companies seems to be in the virtual reality/augmented reality space. There is a lot of money and smart people focused on this space and a strong belief that virtual reality will be having its “iPhone” moment in the near future. This will impact how people live, work, connect, and get entertainment.

About Thomas Foley

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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