How the Silicon Valley Office Market Ebbs and Flows

SAN JOSE—Certainly a key indicator for the commercial real estate sector is job growth. And while such growth has slowed compared to a few years ago due to the fact the market appears beyond typical full employment, the San Jose metro statistical area continues to add jobs.

“Year-over-year, the San Jose MSA added 24,200 non-farm positions, while unemployment has tumbled to a mere 2.5%, compared to the national figure of 3.8%,” says Julie Leiker, Cushman & Wakefield’s Silicon Valley market director.

Despite this, Silicon Valley’s office and R&D sectors revealed a sluggish start to 2019, after having combined for a solid 2.85 million square feet of occupancy growth in 2018—largely stemming from the office sector, according to Cushman & Wakefield’s latest market report. While the office market did continue its growth trend, reporting another 269,000 square feet of positive net absorption in the first quarter, the R&D sector finished with a negative 265,000 square feet, leading to a virtual wash between the two sectors. Notably, both sectors maintain very healthy single-digit vacancies coupled with rent growth, while demand remains strong.

“Historically, the early part of the year can start slow in the Silicon Valley commercial real estate market and that is exactly what happened in 2019,” said Leiker. “Not unexpectedly, the performance of Silicon Valley’s R&D sector in the first quarter was lackluster when compared to its substantial second-half growth trends of 2018. That said, R&D vacancy is still under 10%, the percentage of sublease space is dropping to now 17.6% of market availability and asking rents continue to climb.”

The report noted that the addition of the 546,000-square-foot HPE Campus in the Stanford Research Park was a significant contributor to the level of R&D occupancy loss in the first quarter.

“Meanwhile, office vacancy continues to dip further into single-digit territory now at 9.3%, down from 9.6% at year-end 2018,” Leiker adds. “However, sublease space in this sector rose yet again, now accounting for nearly a third, 32.4%, of total office availability.”

According to the report, the most significant new office sublease put on the market was a block of 162,000 square feet from 8X8 at Coleman Highline. And though not yet included in vacancy statistics, the report identified another sublease block now being marketed, Splunk’s sublease of 150,000 square feet at Santana Row in West San Jose. The 300,000-square-foot building is still under construction and will be ready for occupancy in November 2019.

“Typically the first quarter of a year can be on the slower side with activity picking up in the second and third quarters, which we expect to occur this year as there are, in fact, expectations that several large deals have already or are about to be signed,” says Gregory Davies, senior vice president with Cushman & Wakefield in San Jose. “Furthermore, we are currently tracking a very robust 11.8 million square feet of active office/R&D tenant requirements, which is up from the 10.5 million square feet last quarter. We feel this increase in demand will transition to activity in coming quarters.”

Average asking rents for both Silicon Valley’s office and R&D markets continued to climb during the first quarter. Office rents rose to $4.64 per square foot on a monthly full-service basis, up 10 cents from $4.54 per square foot in the fourth quarter. R&D rents grew to $2.54 per square foot on a monthly triple net basis, a strong increase from the fourth quarter level of $2.41 per square foot. R&D rents have grown by a whopping 16.5% year-over-year, from $2.18 per square foot.

“Despite strong activity, office rents have remained relatively flat with slight upticks in select markets. This is largely due to the fact that sublease space has continued to represent a significant portion of total availability which forces direct space to compete with aggressive sublease rents. The end result is high volumes of leasing at more modest rent growth,” says Drew Arvay, managing director with Cushman & Wakefield in San Jose. “Sublease space has begun to dwindle in the R&D sector, previously accounting for well over 20% of market availability last year, and has since fallen to 17%. This trend will reduce the effect that low price sublease space has had on overall market pricing, much like we’re seeing in the office sector.”

Notably, the northern Silicon Valley cities continue to outperform all other market averages with Palo Alto at $6.88 per square foot, Menlo Park at $4.63 per square foot and Mountain View at $4.32 per square foot for R&D space. New construction continues to advance the Silicon Valley real estate landscape, in terms of design and functionality as well as activity. It also remains a market focal point.

The report shows new office product under construction currently totals 4.4 million square feet, all being built on a speculative basis, and with 3.2 million square feet or nearly three-fourths already pre-leased. Meanwhile, new R&D product under construction totals 2.9 million square feet, split into 1.8 million square feet of build-to-suit and 1.1 million square feet of speculative product. Half of the speculative R&D space is pre-leased, leaving just 530,000 square feet currently unaccounted for in that sector. Of the total 7.3 million square feet under construction across both office/R&D sectors, 5.57 million square feet or 76% (more than three-fourths) is already committed.

“Capital markets activity in Silicon Valley held strong through the first quarter of 2019, as investor optimism and appetite for tech-driven real estate remains hearty. Historical pricing highs have been shattered on the western side of the Valley and the Peninsula, particularly in areas that are served by Caltrain. Of note, the first quarter also saw a surge in activity particularly in the North San Jose submarket,” says Eric Fox, executive managing director with the firm’s capital markets group in San Jose. “Treasury rates have settled significantly lower at the end of the quarter versus their peak in late 2018, and accordingly real estate debt has remained low priced and plentiful.”

Notably, there were also two user sales cracking the top R&D sale transactions, including Roche Molecular Systems acquiring its existing 312,000-square-foot campus in Santa Clara, while another significant user transaction was Intuitive Surgical’s purchase of a 47,000-square-foot building in Sunnyvale for $640 per square foot: “a high watermark for R&D user sales in Sunnyvale,” says Fox.

Robert Sammons, senior director for Cushman & Wakefield’s Northern California research, concurs with other experts that the slow start is not cause for alarm. Moreover, he predicts tenant demand will reach well into next year.

“A slow start to the year for the Silicon Valley office and R&D sectors certainly has a dramatic tone to it. In fact, the market just ebbed again somewhat, particularly on the R&D side, after near-record levels of leasing activity recorded in 2018,” Sammons tells GlobeSt.com. “However, this is not all that uncommon, and we need only reflect back to 2018 which also had a softer ‘ebb-ish’ start, again namely on the R&D side, but finished the year with exceptional growth. Silicon Valley remains a dominant tech location, and significant pre-leasing along with a deep bench of tenants searching for additional space will drive the market for the remainder of 2019 and into 2020.”