What Investors Look For In A Place Like San Francisco

San Francisco is among the top markets for investors around the world, but a slowdown in job growth, a decrease in tech valuations and a lack of good opportunities have some investors pulling back and taking more careful approaches.

There are plenty of strong qualities in San Francisco that will keep it as a top metro for investing, especially for those who invest in down and up cycles, such as STRS Ohio. STRS Ohio acquisitions director Eric Newberg said his firm, which manages a pension fund, looks for quality. San Francisco has a very educated workforce, several colleges and universities, and strong job growth. It also is the tech and venture capital of the world.

A lot of companies are migrating up from Silicon Valley and many do not have a strong presence in San Francisco, which will only change over a matter of time, Newberg said.

“I’ve lived in New York, Chicago and Washington, and I don’t think there’s a better place to have amazing jobs for people around the world. [San Francisco] has great access to art, education and is so close to world-class jobs … It’s also a quick flight to LA. And there are endless things to do in the Bay Area,” Newberg said.

Given all these qualities as well as strong barriers to entry, StepStone Global partner Brendan MacDonald said San Francisco should maintain its position as a global gateway market and sought-after destination for global capital allocators.

Nearly a third of institutional capital comes from international sources with China being the most active. China is clamping down on outflows, and it remains to be seen who might fill in the gaps. MacDonald said given the high demand for core real estate in markets like the San Francisco Bay Area, he expects no material adverse impact on pricing or investment activity barring a shift in local fundamentals or global capital markets.

Why Investors Are Pulling Back

A slowdown in San Francisco's market is pushing some investors to take a wait-and-see approach. Tech company valuations are down from the exuberant levels in the past several years, MacDonald said. Capital markets are still fluid and long-awaited Bay Area IPO prospects like Uber and Airbnb could return cash to private equity firms and create more growth capital.

“Nevertheless, negative volatility in the public markets could close the window and require further belt-tightening from unprofitable, VC-funded companies,” MacDonald said.

Cap rates are decreasing and are below 5% for office and below 4% for apartments, according to MacDonald. With the supply pipeline kicked in and rising interest rates, further compression will be unlikely.

San Francisco has had a great run for the past five years, but current valuations and liquidity make it hard to find deep value opportunities, MacDonald said. This has led to his firm not being particularly active in the market lately.

StepStone works with experienced operators and investment managers to recapitalize holdings and add value to assets. The firm invests across the capital structure in both control and minority interests and can invest at asset or entity level. StepStone also is an active allocator of primary capital to real estate fund managers on behalf of advisory clients and will co-invest in discrete transactions alongside these managers.

Rent growth is slowing for all types of products since rent growth cannot keep growing at 9% to 10%. Rents are growing about 3% to 5%, which is still beating inflation, according to Newberg.

Newberg is not concerned about short-term slowdown because his firm looks at 10- to 30-year holds. His firm likes assets near transportation infrastructure, like Caltrain and BART.

“If we see an asset that makes sense and is well-located, the product type is viable long term, is surrounded by a lot of amenities and close to transportation, the cycle doesn’t matter as much,” Newberg said.

STRS Ohio does not have any particular mandates and does not go through advisers. It typically waits to find assets that work for the firm. For the most part it invests in existing buildings while teaming up with local experts familiar with San Francisco or other metros for residential opportunities. It has assets in other West Coast metros like Seattle and Los Angeles, as well as a few assets in San Diego.

STRS Ohio is adding value to its existing portfolio by reviewing what it has and working to increase overall revenue. It is looking for opportunities to team up with a partner to add apartments or additional retail in a traditional strip center.

That has meant selling assets to improve its portfolio. STRS Ohio bought 44 Montgomery in 1997 and has maintained it with high occupancy, but it is selling this asset after 20 years. It has a significant amount of office assets a few blocks from this building, including One California and Foundry 1, and the portfolio manager needed to sell one of the assets due to concentration issues, Newberg said. Eastdil is marketing the property.

Learn more about what investors seek at our San Francisco Capital Markets Forum on March 23.