THE RECENT OFFICE LEASES SIGNED BY ARTIFICIAL INTELLIGENCE (AI) COMPANIES AND FUTURE DEMAND FROM OTHER ACTIVE AI COMPANIES IN THE MARKET ARE A WELCOME TAILWIND FOR THE BATTERED SAN FRANCISCO MARKET; THE TECH SUBSECTOR IS STILL UNLIKELY TO BE ENOUGH TO CARRY THE MARKET TO SMOOTHER WATERS FOR THE TIME BEING.

In the following joint piece authored by Savills and CompStak, we explore the state of the San Francisco office market and its evolving tech landscape. In Q4 2023, office availability surged to a new high of 32.2 million square feet (msf) – up over 300.0% from Q4 2019, just before the start of the pandemic. Despite this, some have been cautiously optimistic due to the recent explosive growth in artificial intelligence (AI) investment, which has recently begun spilling over into demand for office space. Many consider San Francisco the “AI capital of the world” as it is already home to many companies’ headquarters. As they grow, the city may be well positioned to be the AI epicenter, securing its title as the world’s top AI tech city. However, it will require more than AI demand alone to achieve equilibrium in San Francisco, and we will explore other important factors influencing office market dynamics.

Artificial Intelligence Signals an Evolution in the San Francisco Tech Ecosystem

As big tech contracts its office footprint with limited leasing activity and returns space to the market through subleases and expiring leases, AI companies are taking advantage of the discounted, pre-built and furnished sublet space available.

Since 2020, almost 1.0 msf of office leases have been signed by AI companies with over 15,000 square feet (sf) in San Francisco, of which one lease in China Basin by OpenAI consisted of almost 0.5 msf. Among the notable transactions listed, all but one is made up of subleases given back by other technology companies such as Slack, Uber, and Okta, Inc. In addition to the lease transactions completed to date, there are more AI firms actively in the market with large space requirements.

AI is emerging at a unique time in San Francisco. Before the pandemic, office availability was in the single digits at 9.5%, and companies leased space years in advance in hopes that they’d have the room they needed to expand in the city. As of Q4 2023, availability has risen to a record high of 36.7%. Of that total space available, 8.8 msf is made up of sublease space, and 79.4% has been returned to the market by tech tenants.

Companies in a position to grow and lease office space are taking advantage of weakened office market dynamics. Astute tenants recognize the value proposition intrinsic in subleases, from discounted rental rates (compared to direct market rates) to capital cost avoidance (for spaces that have already been built out and furnished).

AI Accounts for Lion’s Share of Recent VC Funding in San Francisco

A key component to the growth trajectory of AI is funding from venture capital (VC), which allows these companies to increase their workforce and lease office space. The AI companies that have recently leased space and are noted above have also received venture capital funding since the start of the pandemic, totaling over $13 billion dollars.

While the broader tech industry has seen a recent decline in VC funding, data from 2023 indicates that investors are bullish on the artificial intelligence and machine learning (AI & ML) vertical. AI & ML is key to the innovation occurring in various industries, from autonomous vehicles to predictive analytics. In our analysis of the top 100 tech VC deals in 2023 for companies headquartered in San Francisco, we uncovered a heft of investments in the sector.

Due to the level of investments received by OpenAI and Anthropic in 2023, the AI & ML vertical far outpaced any other sector in terms of total dollars raised. They also outpaced other verticals in terms of total deals completed within the top 100. OpenAI secured an extraordinary $10.0 billion in January—the third-largest fundraising round for technology in over a decade. This was promptly followed by an additional $0.3 billion in April 2023. Similarly, Anthropic’s fundraising totaled $6.6 billion including $450.0 million in May, $100.0 million in August, their highest investment of $4.0 billion in September, and $2.0 billion in October. AI & ML raised $16.9 billion in OpenAI’s and Anthropic’s 2023 funding and an additional $2.0 billion across 19 other deals. SaaS raised the second most in funding dollars with $2.2 billion across 15 deals, and HealthTech raised $1.9 billion across 12 deals completed in the top 100.

San Francisco Technology Employment Still Leads Other Major Markets

Despite the headwinds of higher interest rates, mortgage maturities, and remote work trends, positive signs for the office market can be seen in the actual level of technology employment, particularly in San Francisco. The number of people employed in technology¹ in San Francisco’s Metropolitan Division is up more than 13.5% from February 2020 and down a comparatively smaller 4.8% from its pre-pandemic peak through December 2023.

This growth far outpaces the rate of growth seen in other markets. In Boston, technology employment is up by merely 1.9%, while the surrounding Bay Area and Washington, D.C., are each up 1.0% since February 2020. Compared to San Francisco, the number of technology employees in the Los Angeles and New York City markets has fallen by 9.4% and 2.7%, respectively, from February 2020. While current office space utilization remains below historic levels, this level of technology employment above pre-pandemic could boost office demand going forward with any positive change in return to office trends.

San Francisco’s Population is on the Rise

While San Francisco’s overall technology employment is above prepandemic levels, office occupancy and population growth have not surprisingly trended downward, but things may be on the upswing. San Francisco County’s population reached a trough between the end of 2020 and most of 2021 but has since seen its population modestly returning. Although the tech sector’s embrace of remote work earlier in the pandemic led to increasing moves away from the city, Placer AI data reflects a positive change in the second half of 2023.

Placer, which uses cellular data to analyze population trends, provides a timely snapshot of San Francisco County’s monthly population, as well as the 12-month average, to show the overall trend. San Francisco’s population is not likely to return to pre-pandemic levels in the near term, but it is trending in the right direction.

As the market stands today, San Francisco remains a giant in comparison to the size of most American cities and a top source of human capital, especially when it comes to the highly educated talent needed for tech sector labor. If the city’s population continues to climb, the return to work and office occupancy levels may likely increase.

San Francisco’s Upcoming Lease Expirations Mirror Gateway Markets Overall

With record availability already reached in San Francisco and other major gateway markets, all eyes are also on upcoming lease expirations. While some tenants have already made decisions regarding their space, a considerable segment of the market has yet to determine its future space requirements. Coinciding with a significant wave of loan maturities, these expirations are noteworthy because tenants may elect to contract or relocate at the time of renewal. The office market in San Francisco demonstrates a continued decrease in transaction size and lease term lengths, with both metrics experiencing a substantial decline from 2019 to 2023, down by 42.6% and 15.7%, respectively. According to CompStak’s data, the next two years (2024-2025) could be a turning point as it will be a peak time for lease expirations in San Francisco and in gateway markets overall.

Around 30% of the existing leased office space in San Francisco is poised to expire by the end of 2025. The highest year for expirations, both for all leases in general and specifically within the technology sector, is 2025. This share of lease expirations somewhat outpaces the level in gateway markets where 30.0% of current leased space will expire by the end of 2025. Significantly, a substantial portion of these leases set to expire in this timeframe were signed prior to 2020 in San Francisco and other gateway markets, with 84.9% in San Francisco and 85.9% in gateway markets. In San Francisco, 32% of leases set to expire by the end of 2025 were signed in 2019 and 2018, during the previous market peak, according to CompStak.

Maturing CMBS Loan Volume in San Francisco has Moderate Exposure to Technology Tenants

According to Trepp data, there is currently $12.2 billion in CMBS outstanding for office properties in San Francisco. Within the total universe of outstanding CMBS loans, technology tenants account for 25% of leased space in those buildings based on the top five largest tenants overall. About 46% of the $12.2 billion in outstanding CMBS loans will mature over the next two years (through year-end 2025). For these near-term loan maturities, technology tenants account for 17% of leased space in these properties based on the top five largest tenants, which is lower exposure than exists for the total universe of CMBS debt outstanding in San Francisco. Trepp data also revealed while expiring leases from tech technology tenants are of concern to the market due to their risk of downsizing or vacating space, just 6% of these properties’ leased space is exposed to technology leases (based on the top five largest tenants) that will expire in these next two years. Nonetheless, if the decline in office demand hasn’t bottomed out yet and more tech companies continue downsizing or leaving their spaces in the coming years, these loans could still face the threat of declining cash flow.

Looking Forward

• The rapid growth trajectory of artificial intelligence companies is a positive for the San Francisco market which is hungry for new (or fresh) sources of demand. However, it will take time and millions of square feet in leasing activity before the city can recover from the impact of the pandemic and the greater tech industry correction.
• The post-pandemic surge in tech employment solidifies San Francisco’s status as a premier tech hub, distinguishing it from other major markets and presenting an opportunity for the office market to rebound from the pandemic’s impact over the long term.
• The next two years will yield a significant share of leases expiring in the San Francisco market and ultimately the lease rollover could be an ongoing headwind for the office availability level and falling transaction sizes and lease terms.
• Even with only moderate exposure to buildings with tech tenants, office loan distress is expected to rise even more in 2024, leading to more foreclosures and rapid sales, which may put downward pressure on asking and effective rental rates.
• 2024 opened with the fourth consecutive interest rate pause and much like CRE in general, expansion of investment in and subsequent office demand from AI and the vitality of San Francisco’s office market in general will be shaped by upcoming rate decisions through the rest of the year.

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