SoMa So Good for Startups… Again

Technically speaking, a Web entrepreneur can work anywhere with an Internet connection.

But if a startup wants to attract the best and brightest engineering talent from the Millennial generation (those born roughly between 1977 and 2000), certain amenities help. These include trendy urban digs, preferably in an airy, light-filled brick-and-timber building that’s walking distance to plentiful options for coffee, takeout and transit.

Perhaps those preferences explain why San Francisco’s South of Market (SoMa) district, the hub of the last dot-com boom, is seeing a renaissance. In the past six months, local commercial real estate firms say they’ve seen a surge in demand for office space, with prices rising at a faster clip than even market bulls had predicted.

“We all thought this would be a very slow recovery with [California] unemployment still at 12%,” says Michael Covarrubias, CEO of San Francisco-based real estate developer TMG Partners. “But rents have moved much faster than anyone thought.”

These days, commercial landlords say the price for SoMa space runs close to $35 per square foot annually, up about 40% since the depths of the financial crisis in 2008 and 2009. At current prices, a startup might pay about $3,000 a month for a space large enough to accommodate four or five people without any large equipment.

Of course, it’s not four-person startups that are sucking up most of the supply. TMG in September closed on what was reportedly the largest San Francisco office lease in five years, renting 270,000 square feet in the southeast corner of SoMa to social gaming juggernaut Zynga Game Network. A few blocks away, user-generated review site Yelp closed on two stories of prime commercial space to house its expanding staff. Up the street, Twitter is said to be seeking much larger digs for its new headquarters and its growing need of space.

Landlords, most of whom are old enough to remember the last boom and bust, are optimistic that this time tenants will stay in place.

“These companies are different from that round of companies that were part of the dot-com bust. Those were 20-year olds whose idea was: ‘If we run out of money, we’ll raise more money,’” Covarrubias says. “This wave of companies is much better heeled. Zynga, for instance, is a profitable company with a serious revenue stream.”

There are also changes in the ways companies plan out their space needs. With so many employees telecommuting at least part-time, for instance, the amount of office space allotted to each person has been coming down.

In the past, 250 square feet of office space per person was the norm. Now it’s more common to see 175 or so, says Jim Ellis, managing principal at Ellis Partners, a commercial real estate developer that manages several properties in SoMa. There’s also less demand for private offices within buildings and more demand for open areas that lend themselves to collaboration—perhaps a sign of a generational change.

“The Millennial generation, they’re plugged into technology 24/7,” Ellis says. “They want to come to a place to collaborate and exchange ideas and really to socialize because so much of their time is spent in front of a screen.”

The Millennial generation, they’re plugged into technology 24/7. They want to come to a place to collaborate and exchange ideas and really to socialize because so much of their time is spent in front of a screen

Jim EllisManaging PrincipalEllis Partners

But with demand on the rise, and no major supply of new commercial space in the near-term pipeline, landlords don’t expect prices to stay static.

“There’s always this point in a recovering leasing market that once all the good space has been taken, people start clamoring for what’s left over so they can secure their growth plans for the next three to five years. We are in the midst of that occurring,” Ellis says.

That said, the price-per-square foot in the most sought-after buildings is still only about half the price it was at peak of the dot-com mania more than a decade ago. And new tenants, while willing to spend for a location that they believe will attract top talent, are less likely to pay the rent with venture capitalists’ money.

“This to me is really very different from the 2000 bubble,” Ellis says. “These companies all have for the most part pretty viable business plans. They actually have top line, and they actually are producing cash.”

Landlords are in a position to know something about the financial condition of their tenants. The lease process involves due diligence that is probably a bit more rigorous that what has reportedly taken place in some angel funding rounds. While it’s not standard practice, landlords have been known to take equity stakes in the companies to which they rent space.

Granted, they don’t usually get a hit. Greg Flynn, a San Francisco commercial property owner active in the neighborhood during the last dot-com cycle, says he had stock in many of his tenants, but didn’t make any big returns.

Still, as most were paying top rents anyway, the stock was more meant to be “icing on the cake,” he says.

Others had more luck. Covarrubias, for instance, rented space to Salesforce.com years ago, and had a stock position in the company that turned out to be quite lucrative.

“We try to be more than a landlord. We try to partner when we do these big expansions,” Covarrubias says. “So if we can either buy some stock or get options to buy stock and help the company grow, we think that’s a good thing.”

Not everyone goes along. For instance, TMG was also the landlord for what’s been reported as the largest SoMa lease in recent years, renting about 270,000 square feet to Zynga. The company, which has been profitable for a few years, wasn’t looking to sell him shares, says Covarrubias, who adds, “But you can bet I asked.”