Craig Sakuma and Greg Lok are the founders of Deal Decor, a seven-person e-commerce company based in San Francisco that sells discounted furniture directly from overseas manufacturers. 

In the early days, the founders worked from home to save money. But having recently hired a full-time developer, and a full-time marketing manager, the pair decided it was time to find office space. They had three criteria: The space needed to be reasonably priced, close to the center of the city, and big enough to accomodate a photo studio.

But even in the historically budget-friendly neighborhoods of Brisbane and South San Francisco--neither of which are particularly close to the center of the city--prices hovered around $3 per square foot.

It was enough to make them reconsider whether they needed an office after all.

For real estate experts, this should come as no surprise: Commercial real estate rates are booming in urban areas where technology companies have set up shop.

The Start-up Factor

The rent increase has been particularly high in a few specific neighborhoods. In San Francisco's SOMA district, for instance, commercial real estate prices are up 16% since last year, according to research compiled by Transwestern, a national commercial real estate services firm. In Silicon Alley--New York City's tech epicenter near Union Square--prices have surged 8%. Rents in Chicago's River North neighborhood, future home to a new Google office (not to mention hundreds of start-ups), grew 4% in a year. And in Silicon Beach (comprised of Santa Monica and Venice Beach), rents climbed more than 6%.

But the heart of Silicon Valley in downtown Palo Alto has seen the most dramatic rise in prices for Class A office space: In the last five years, asking prices have ballooned nearly 43%.

In the end, Sakuma and Lok turned to Craigslist, the tried-and-true source for penny-pinching residential renters. They found a former warehouse in the Dogpatch, an up-and-coming industrial neighborhood in San Francisco. For $1,170 per month, the start-up now has 1,300 square feet, including industrial-sized elevators, which come in handy when doing photo shoots with furniture.

"We might not be able to go down to Market Street where Twitter is--it's just crazy expensive--but at the same time, we get to still be in the city," Sakumo says. "You have to be a little creative to find some of the best deals."

One major factor that drives commercial real estate rents is the unemployment rate, says Arty Maharajh, a senior research analyst in Transwestern's Los Angeles office. As the number goes down and companies fill more desks, the premium on space goes up. While the unemployment rate remains high in much of the rest of country, it's comparatively lower in start-up-rich tech clusters. The San Francisco metro area, for example, added 13,000 new tech jobs in the second half of 2012. The unadjusted unemployment rate is 7.3%, compared to the country's 8.6% rate and California's 10.9% rate.

The boom in commercial real estate is a positive sign that start-ups are creating jobs for the country. The downside is that it makes it more expensive to hire new employees.

It's a trend many real estate experts have seen before in tech-focused areas. "I would compare this to the late 90s run-up," says Edward F. Del Beccaro, managing director of Transwestern's Walnut Creek, California, office. "People are starting to say there will be a bursting of the bubble."

Bootstrappers Hit the Hardest

Venture-backed start-ups in these tech clusters may not have noticed the rise in rents. "It's such a small percentage of their total cash outlay that their investors don't care," says Richard Brenner, president and CEO of The Brenner Group, which provides financial advisory services to technology companies in Silicon Valley. "Rent is not that much of a factor for a high-tech venture backed start-up. Even if it doubles it's not that big of a deal." 

But for early-stage and seed-level start-ups, keeping an eye on expenses like rent is absolutely critical to survival. "These guys are very cash-strapped and they watch every penny more carefully," Brenner says. "They're concerned about it. Fifty cents a month means something to them."

The recent rise in rates compounds a general problem among bootstrapped start-ups: Commercial leases can extend up to five years. But most founders can't anticipate staffing requirements for five months, let alone five years.

"The challenge is that it's very difficult to make a long-term fixed real estate commitment early on in your company's lifecycle," says Ryan Simonetti, co-founder of Sentry Centers, a New York-based start-up that leases out executive conference rooms. His company has gone from three employees to 100 in three years. "If I went and entered into a five-year lease three years ago, I probably would have taken 1,000 square feet, and we would have long-outgrown that space. I think a lot of young and growing companies are facing a similar challenge."

Simonetti and his partner, Christopher Kelly, are now working on a new concept, which will offer office space for fast-growing companies on a short-term basis.

But when it came time to close the deal on an office on Park Avenue South in Manhattan, their future landlord re-traded the founders up $5 per square foot from the original price. "What happened? It's like what everyone says: 'the market conditions have changed, prices are up,'" Simonetti says. "We were on Park Ave South, and that area has seen a tremendous increase over the last 12 to 18 months."

For now, Simonetti and his partner have given up on New York. They have their eyes on office space in Washington, D.C.

Published on: Aug 30, 2012