Commercial Real Estate Rents Rise Throughout Silicon Valley

Higher sales prices, shrinkin inventories, and growing construction costs are creating urgency for business looking for commecial space

 5-4-3-2-1 Liftoff!  That thundering you hear is the sound of lease rates on Silicon Valley commercial real estate leaving the launching pad and climbing back toward sustainable levels.  No one expects rents to go through the stratosphere, but after being exceptionally low for the past five years or so, lease rates on commercial real estate are due for a significant rise.  Business owners and property investors who are sitting on the sidelines trying to time the market would be well advised not to wait any longer.

Let’s turn back the calendar a few years to understand what is going on.  Following decades of steady appreciation in property values and healthy rental levels, the dot-com explosion of the mid- to late-1990s sent commercial real estate rents through the roof.  The belief that almost any idea involving the Internet was a money-maker created a tremendous demand for commercial space in Silicon Valley by venture capital-based dot-com startups.

But as so often happens, when the dot-com bubble burst in 2001, the overheated market cooled off quickly, driving rents down. Enormous amounts of inventory—at one point as much as 60 million square feet of space by some estimates—stood vacant. It was a renter’s market; companies leasing space felt they had the upper hand in negotiations with property owners.

Today, there are clear signs the commercial real estate market has come back into balance, after the rollercoaster ride of the past decade.

  • Lincoln Property just purchased the four-building, 15-acre former Acer Computer campus on Trimble Road in San Jose for $27 million—handing Apollo Real Estate a tidy $8 million profit on the property it had bought less than a year earlier for $19 million.
  • A joint venture between Westbrook Partners and Four Corners Properties just laid out $94 million for Montague Park in San Jose, providing the previous owners a $19 million profit in just 15 months.
  • Significant rent increases of up to 30 percent have taken place over the past 12 months—with the upward trend especially noticeable on incubator spaces of 5,000 square feet or smaller.

“The evidence is indisputable,” said Ralph Borelli. “Big real estate companies are buying again in Silicon Valley. The bottom of the market for commercial real estate in the Valley was most likely reached in 2004 or early 2005. The rebound began in earnest last year, and this is fueling the rise in rents now being felt throughout the Valley.”

Multiple Contributing Factors

What is causing the recent increases in property values and rents? In Borelli’s opinion, there are several contributing factors:

  • Strengthening job market—According to the Association of Bay Area Governments (ABAG), the South Bay experienced significantly stronger job growth than had been expected in 2006, increasing by 1.8%. The San Jose area outperformed California and the nation, and in fact only trailed the combined San Francisco/San Mateo/Marin area and Solano County in the creation of new jobs last year. ABAG expects the upswing to continue in 2007, with the South Bay predicted to add another 11,500 jobs—many in the technology sector.
  • Rapidly decreasing inventories—With the job market on the rise, planning departments have approved the conversion of obsolete commercial and industrial property into residential space. Perhaps 25 percent of the vacant standing inventory has been or will be torn down for new housing by leading homebuilders such as KB Home, according to Borelli. At the same time, big-name businesses such as Google, Yahoo, and Apple have collectively purchased millions of square feet of space over the past several years—effectively removing these buildings from the rental base. This has decreased the vacancy rate for office space from 20 percent or more to approximately 10 percent, according to CoStar Group, the number one provider of information services to commercial real estate professionals in the U.S. and U.K. Industrial and “flex” space still shows slightly higher vacancy rates, but is definitely trending lower.
  • Limited land—The Valley floor is largely built out. Unlike in the wide-open Sacramento area or the Central Valley, Silicon Valley has natural geographic obstacles to growth—the foothills on either side of the Valley—placing a finite limit on where building can be done. Open space regulations have slowed growth on hillsides, and areas such as San Jose’s Coyote Valley are still being held for future development. With so little vacant land available, land prices can’t help but increase.
  • Rising construction costs—The cost of construction has also risen. It is simply more expensive today to build buildings than it was a decade ago. And the cost of new construction is considerably higher than renovating existing commercial/industrial space.

“The wild swings of the dot-com period are behind us,” Borelli remarked.  “The most educated guess is that rents will quickly return to “pre-bubble” rates, as property owners look to get their economics back into line.  Meanwhile, property values will resume their slow, but steady climb-making Silicon Valley commercial real estate a very good long-term investment.”

Important Implications for Business Owners

As business owners look to manage occupancy costs in the coming months and years, they have several viable options.

  • Purchase space-Smaller companies and professional firms now have the same option of owning their own space as larger corporations.  At business condominiums such as Borelli Investment Company’s Junction Office Center on Junction Avenue near Brokaw Road in San Jose, down payments start at $29,900 with 90 percent financing available from the SBA.  Sales prices for brand new office condos in the $10 million Junction renovation are actually below the replacement cost if that space had to be built from scratch.  Further, business owners can take advantage of significant tax write-offs, and also enjoy the potential appreciation predicted for Valley real estate.
  • Lease quality Class B space-Rents on much of the Class A space that has changed hands at large premiums over the past couple of years have already jumped.  Now is the time to look for quality Class B incubator office space (5,000 square feet or less) and sign longer-term agreements that lock-in lease rates.

“As more property changes hands at increased prices, rental rates and property values are going to continue to climb,” Borelli commented. “The risk of less predictable markets is largely behind us. The time for businesses to act is now.”