Cost-cutting tenants have dumped 1.2 million square feet of unwanted office space on the sublease market since July 1, the latest sign that San Francisco’s economy is slowing amid a national recession and credit crisis.

The trend has accelerated over the last 60 days as some 170 companies sought to unload 685,000 square feet of space, according to a report from Colliers International. A total of 2 million square feet of sublease space is available in the greater downtown — enough to accommodate about 8,000 workers. About 35 percent of the available sublease space is already vacant.

The influx of unwanted space shows generally that downtown San Francisco employers are shedding workers and postponing expansion plans. Of the total 2 million square feet, 1 million is in the north financial district and nearly 400,000 is in the south financial district. The tech-heavy South of Market has held up better, with tenants looking to sublease 236,000 square feet, according to a Grubb & Ellis report.

The slowdown is being felt most keenly at the top of the market: the financial services companies and law firms that occupy the city’s most desirable suites. During the first week of December, two private equity firms, the Carlyle Group and Behrman Capital, announced they were scaling back operations in San Francisco. Behrman Capital is seeking a tenant to sublease 5,275 square feet on the 36th floor of 4 Embarcadero Center. Carlyle is seeking a subtenant to take on its 7,181-square-foot office on the 34th floor of 555 California St. While these are small blocks of space, 18 months ago they would have leased at $80 a square foot on a direct basis. As sublease space, they are unlikely to bring in much more than $45 a square foot.

“There are no longer tenants looking to pay huge dollars for anything,” said Matt Hart, corporate managing director at the tenant rep brokerage Studley. “It was private equity, legal, hedge funds and venture — all four of those are essentially gone from the market.”

The buildings with the biggest availability of sublease space include 333 Bush St. with 227,866 square feet, 275 Battery St. with 102,000 square feet, 199 Fremont St. with 101,000 square feet, and 4 Embarcadero Center with 71,000 square feet.

Striking bargains

Some of the sublease opportunities are quickly being seized. At 4 Embarcadero Center, Washington, D.C., law firm Hogan and Hartson LLP paid $43 a square foot for 22,134 square feet on the 22nd floor that was previously occupied by Stockbridge Real Estate Funds, which had leased space for about $80 a square foot in 2007. On the 23rd floor of One Market, the private equity firm Vector Capital subleased 16,000 square feet from Pequot Capital Management in a deal in the $40s — less than half what the space would have leased for a year ago on a direct basis. Vector is moving from the 19th floor at 456 Montgomery St.

One of the prize tenants in the market right now, law firm Reed Smith LLP, is a likely contender to take over the sleek space at 101 Second St., formerly occupied by the failed law firm Thelen LLP.

With new top-notch sublease options coming on the market weekly, the spread between the price of view space and non-view space has narrowed. At the height of the rent bubble, view space was attracting $25 a square foot more than non-view space; now that has dropped to about $8 a square foot, with water view blocks going for $55 a square foot and city view suites leasing at closer to $35.

“We are finally heading back to the fundamentals of supply and demand driving prices,” said Hart.

CB Richard Ellis’ Phil Tippett, one of San Francisco’s top landlord brokers, said sublease space works for smaller tenants with more nimble requirements.

“For the well-established tenant the sublease market is not necessarily a great solution unless they have a short-term need,” said Tippett. “It’s good for new-entry tenants who want to do a quick test of the waters.”

More pain

But for property owners, the pain may get much worse. Studley’s Hart estimates that San Francisco’s financial services firms still have significant excess space. Financial services represent about 20 percent of the central business district, occupying some 6 million square feet. But currently the hard-hit sector is looking to sublease just 300,000 square feet, or 5 percent of the total market share. Hart said many large financial institutions are still sitting on blocks of unused space.

If financial institutions give up another 15 percent of their current footprint, that would add nearly 1 million square feet of availability — and another 2 percent to the total availability rate.

“We could easily be pushing an availability rate of 20 percent in 2009,” said Hart.

Meanwhile, demand seems to get weaker by the day. One top broker said the four largest tenants in the market — Reed Smith LLP, Microsoft, Duane Morris LLP and Salesforce — have pressing requirements for a combined 350,000 square feet square feet. An NAI BT Commercial study shows 3.6 million square feet of lease expirations in 2009, compared with 5 million square feet in 2010.

“From the tenant’s perspective, we think the best supply and demand fundamentals come in late 2009 at the earliest,” Hart said.

The space most likely to languish is shell space, which requires expensive build outs before occupation. Brokers estimate that building out shell space for swanky law firm offices costs about $170 a square foot. Landlords are increasingly willing to pay about $70 of this, meaning the tenant moving into 50,000 square feet of freshly built custom space still must come up with $5 million. Given the increasing number of fully-built out, second generation floors available for the taking, brokers question how many tenants will be willing to spend that money.

“Any shell space in San Francisco is going to sit there through the entire downturn because you can’t justify construction costs,” said Studley’s Barker.

Scott Harper of Colliers International, who represents mostly owners, said the downturn will be mild compared with the dot-com crash of 2000.

“Sublease will rise more in 2009, but we sat here in 2002 with 4.3 million square feet of vacant sublease space and more than 6 million available,” said Harper. “We have a more diversified economic base (now).”

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