Kicking off 2011: The bifurcated market

| January 5, 2011 | 1 Comment

A recent SF Business Times article covered a topic that I have written on extensively– the strength seen in a few select core submarkets, specifically in this case downtown Palo Alto.  The article claimed that many in the real estate industry were concerned that the large block of sublease space made available in downtown Palo Alto by Facebook at the worst of the downturn would be hard for the market to swallow.  Their 50,000 sf or so of total space was leased up in very short order at pretty solid rents, which absolutely met my expectations.  As grim as the market was at that moment, as slow as leasing activity was, I was personally very confident that this space would be easily absorbed. 

This split in the market was also covered last month in a Wall Street Journal article discussing the uneven recovery, and specifically focusing on some of the recent big deals in Palo Alto and Mountain View.  

I think that one could easily miss the real driver of this split market from reading the press coverage.  It is expected in any market recovery that the “best” markets will bounce back first.   What we are seeing now, though is overwhelmingly focused in the core areas along transit and near amenities.  This is a very focused flight-to-quality, and the fact that rents in the most sought-after markets are actually higher now than before the crash just doesn’t fit a normal model.  Despite my previous skepticism about the influence of transit, I am forced to admit that this is clearly a major driver.   Makes one wonder where these submarkets would be right now were it not for the Great Recession.  

So, with vacancies in these core locations sinking and rates rising, what happens to the rest of the market?  I’ve been waiting to see some significant spill-over for a while, and I’m frankly surprised that it hasn’t already started.  I think that the current spread between Class A and Class B office/R&D rents– not to mention vacancy rates– is unsustainable.  Either the high tide will pull these Class B boats off the rocks, or we’ll see some snap-back in rents at the top of the market.  In my opinion, increased activity in the lower-cost markets is inevitable, though rent gains may be nominal (rents may even have room to track down further).  I would not be surprised to see a modest pull-back– at least a flattening– in the rents we’ve seen along the transit corridor, but I suspect that we’re seeing a pattern that will sustain itself for the long haul.

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