No Bursting This Bubble

by Terrence Jones, Senior Broker Associate

Could it be that our current, crazed market represents a paradigm shift where demand forever outpaces supply?

The owners of existing rent controlled apartment buildings in San Francisco have seen three strong years of consistently rising rents and ever-increasing property values for their buildings. And that’s great, right? According to RealPage, as of the second quarter of 2013, San Francisco has now moved into the number-one metro market position in the entire country for rent increases with a hefty 7.8% annualized rent growth. When this rent growth is combined with the rent control rules in San Francisco, owners here are in one of the few markets where a vacancy is a reason to pop the champagne cork.

The big question is, will the party stop when rents go flat—or even drop? Many have suggested we are in another dot-com-like bubble, as we saw in the early 2000’s, and that we should be prepared to feel the pain of the bubble popping. There are others who feel we may have stepped over a threshold toward an upward trend that shows no sign of stopping. This group sees a paradigm shift to a new San Francisco rental reality. They believe that rents will continue their upward trend and reach world-record levels. They feel the world has discovered that San Francisco is a great place to live and work, and there will be no turning back on rents.

Let’s look at some of what the bubble advocates have recently been suggesting about a coming end to the good times for San Francisco. Recent articles and headlines from all different kinds of publications have predicted doom for San Francisco: “Bearish Ken Rosen Growls About Tech” from the San Francisco Business Times; “Vulnerable San Francisco Ignores Growing Tech Bubble Talk” from the San Francisco Bay Guardian; and “Shades of ’99: New Data Shows the Tech Boom Is Looking More and More like a Bubble” from Business Insider.

A Tale of Two Tech Booms
Despite the gloom of the above articles, I don’t think the bubble is ready to burst. Let’s start with a simple supply and demand analysis of the market. There are effectively no plans to create rent controlled apartment units in San Francisco outside the few below-market units in the pipeline attached to new construction. We can therefore make an assumption that there will not be significant growth of supply in the market for the foreseeable future.

That takes care of supply, so what about demand? In general, rents tend to move in step with new job creation. New office leases and expansion of existing company leases are one predictor of new jobs for the city. If we look at new and expansion leases (excluding renewals) we see an interesting story.

The top-10 leases in terms of square feet leased (either new or expansion leases) for the largest square footage, as reported in the San Francisco Business Times for 2013, are as follows:

As we look at this list, it is interesting to note the depth of companies signing new leases. Gone are the days of market-share or advertising-driven dot-com companies, who dominated the market during the last bubble. Many of those companies had business models that derived 100% of their income from advertising or future revenue based on market share.

A landlord friend of mine distinctly remembered that time:

One aspect of the dot-com fiasco (in the early 2000s) was that many of the enterprises had as their primary business objective the capture of “market share.” They did not have a business model that promoted income but rather captured an ever-increasing percentage of market share. Using that business model, they paid operating expenses primarily out of capital dollars, since the revenue stream was weak or non-existent. When the capital market weakened, the enterprise failed and creditors (including landlords) were left holding the bag. The market (both commercial and residential) reacted accordingly as the demand decreased. In the long term, it was but a downward “blip” on a market that recovered. The short-term investor was vulnerable, as were businesses that expanded in the belief that the dot-com expansion would not end.

Today, of the companies in the list below, only Google gets the lion’s share of its revenue from web advertising and market share. (I am willing to bet that probably 80% of all people in this state have a free Google email account.) At the end of 2013, Google noted that 91% of their revenue was derived from advertising.
The tech boom of the early 2000’s was susceptible to the popping bubble factor more than the companies that are successful today because the new jobs at that time were mostly at companies whose sole business plan was to provide a vehicle for web advertising. (If you remember, this was the single focus of Yahoo at the time.)

If you look closer at Google’s last three years of revenue, you will notice that each year they have actually been decreasing their web advertising revenue and increasing their other revenue. Perhaps all those PhDs on the bus from San Francisco to Mountain View are helping the company evolve to a less bubble-oriented strategy as a way to help keep their jobs. There are many new initiatives at Google, like their robotics program, their extending life expectancy program, the infamous Google Glass, the Google self-driving car, Google Shopping, Google Chrome, and many other diversification plans. I am willing to bet their future plans will not rely on advertising to keep the magic bus rolling.

Outside Google, we can see significant job growth in the biotech, healthcare, financial and software sectors as well. Many of these companies, like Kaiser and Visa, are mature, long-established companies—a far cry from the start-ups we saw in the early 2000’s. If 2014’s new and expanding leases continue along this trend, we will likely see a continued increase in jobs, which will increase the demand for apartments, which will inevitably increase rents.

If we switch gears and look beyond the tangible factor of the job growth that has led to rent growth and we look at the quality of life issues that are also drawing young people to San Francisco, we see another interesting factor in our demand analysis. San Francisco has mild weather, a growing sports and food culture, and proximity to wine country and beaches. It is easy to see why companies are moving to the Bay Area. They want to be where young people—their employee base—want to live.

For me, I see the glass as half full. The long-kept secret is out and everyone knows it: San Francisco is a great place to live and work. We are in the middle of a paradigm shift where San Francisco continues to lead the world in technology, business and, yes, rents. I don’t see that ending any time soon.

Terrence Jones is a senior broker associate with TRI Commercial and specializes in the marketing and sale of investment properties. His business specialty is San Francisco rent controlled apartments. He has extensive experience with properties with special circumstances. He can be contacted at 415-786-2216 or by email at @terrenceojones

Original Article