Hearts Are Nonetheless In San Francisco—The Bay Space’s Case For A Comeback – Landlord & Tenant – Leases

By VERONICA ROCHA,
DIRECTOR , ARCH + BEAM and JEANNIE
KIM, ASSOCIATE, SHEPPARD
MULLIN

Headlines decrying San Francisco’s recovery
as among the worst in the nation aren’t hard to find. Retail
and hotels being abandoned.A landmark office building sold at
74% of its early 2020 valuation. CRE defaults and impending
maturity dates raising alarm. Regional bank failures lead to
reverberations. The list goes on with local, national, and
even international media focused on the city as an apparent canary
in the coal mine, providing insights into a range of issues
challenging multiple major metropolitan areas around the country in
the aftermath of the global pandemic and in the face of what some
have deemed a “slowcession.”

Current National Trends in Commercial Real Estate

While the media may predict doom and gloom for commercial and
financial districts that once generated not just profits but
vibrant environments for San Francisco and other major metropolitan
cities, economists have different views. Many believe that between
the strength of the American dollar, consumer spending patterns, a
growing labor market, and an uptick in hiring, the U.S. economy
remains quite resilient. In fact, the U.S. economy grew by 2%
during the first quarter of 2023. Though some might argue this
reflects a sluggish economy, the figure indicates that the U.S. has
avoided a recession through the start of 2023. By the summer, the
Federal Reserve has temporarily paused its aggressive series of
interest rate hikes, but the national and global economies are not
yet in the clear. In reality, domestic inflation, which is
decreasing slowly, must be further tamed.

Turning to national CRE trends, of the five major CRE asset
types, industrial real property demand remained strong throughout
the pandemic, with vacancy rates topping at about 6%. Similarly,
demand for multifamily CRE has been high, with vacancies as low as
4%. But the market for office buildings has been struggling in the
wake of the pandemic and continues to be clouded by uncertainty
regarding longer-term utility and tenant demand with almost $1.4
trillion of commercial office mortgages set to mature in 2023 and
2024.

San Francisco & the Greater Bay Area

In the years leading up to the pandemic, the San Francisco Bay
Area boasted one of the strongest economies in the world. With a
pre-pandemic city population peak of 883,600 residents, housing
prices that surpassed much of the world’s major metropolitan
regions, thriving labor markets, and substantial economic activity,
the Bay Area certainly made its mark. Since the pandemic, though,
many are commenting on the Bay Area’s recovery as it goes
through a normal period of course correction, even as other
national and global economies are performing similarly after an
unprecedented disruption to a historically long period of growth
and expansion. As remote work and reduced business travel have
become the norm, everyone from CEOs of Fortune 500 companies to
small business owners who once relied on the bustling foot traffic
in business and financial districts is trying to adapt.

With office work responsible for 72% of San Francisco’s
gross domestic product,1the elimination of more than
650,000 jobs since 2020 has had a profound impact on the regional
office market. By January 2023, the region had recovered these job
losses and briefly exceeded pre-pandemic levels, only to experience
layoffs in the tech sector that lowered the employment levels to
0.3% below pre-pandemic levels. Even with the tech sector layoffs,
which many deem an inevitable correction from rapid, pre-pandemic
growth, job growth in so-called knowledge industries (including
R&D, technology, and legal, among others) remained positive at
a 2.8% growth rate. Service, leisure, and hospitality sectors have
been slower to recover notwithstanding demand for workers.

Earlier this spring, San Francisco Mayor London Breed
and City Supervisor Aaron Peskin introduced legislation aimed at
addressing underutilized office space and the lack of affordable
housing options by allowing commercially zoned properties to apply
for conversion to residential or mixed-use projects.

Additionally, unlike other major metropolitan areas in the U.S.,
46% of San Francisco residents worked from home or remotely in
2021, compared to only 21% of Californians and 18% of American
office workers. These numbers indicate that due to the high levels
of remote-eligible jobs and industries that call the Bay Area home,
fully remote and hybrid environments are not likely to go away
soon, making the region more susceptible to the longer-lasting
effects of remote work. This is reflected in the continuing
decrease in demand for commercial office space in the region
despite gains in job growth. Major metropolitan cities and regions
around the country are not immune to the ongoing struggles of
office CRE, but the epidemic has been highlighted in the San
Francisco office market, which hit a new high vacancy rate of 31.6%
in the second quarter of 2023.2

But don’t let the headlines and statistics fool
you—the greater Bay Area still has plenty to offer. The tech,
biotech, and biopharma sectors in the region are continuing to
achieve unparalleled milestones in innovation, notwithstanding
funding and profitability challenges in the current economic
environment. In Silicon Valley, key tech giants are at the
forefront of disruptive artificial-intelligence research and
development. About 50 miles away from San Francisco’s failed
Westfield mall, Westfield’s Valley Fair mall (in the heart of
Silicon Valley) is thriving, having recently completed a massive
expansion by any measure—square footage, roster of retail,
restaurant and food offerings, and non-shopping, “experiential
retail” attractions. Similarly, the East Bay remains focused
on efforts to strengthen its position as a manufacturing hub for
biosciences, clean tech, goods movements, and machinery as higher
education institutions like the University of California, Berkeley
in the East Bay and Stanford University in Silicon Valley serve as
incubators of innovation. Moreover, enough sectors that call the
Bay Area home require employees to work on-site—in labs
conducting research and clinical trials, building prototypes, or
creating hardware. For these reasons and more, experts are not yet
ready to give up on San Francisco or the surrounding Bay Area.

If San Francisco can adapt quickly and reshape its downtown
office landscape, which currently is facing a vacancy rate of
approximately 30%, the city may be able to save
itself.3Local leaders must now reverse the effects of
the decline in retail, hospitality, and small business patronage,
which is contributing to losses in business tax revenue.

Distressed CRE: Opportunities & Challenges

One potential solution involves partnerships between the public
and private sectors to generate creative and viable solutions to
adapt and reuse distressed commercial real estate assets. With
public support from local governments and planning commissions,
developers around the country have successfully converted
commercial properties such as vacant skyscrapers into multifamily
towers, big-box retail stores and vacant department stores into
co-living spaces or fulfillment centers for online retailers, and
warehouses and old factories into corporate headquarters and data
centers.4These adaptive reuse projects each have unique
opportunities and challenges, such as parking ratio requirements,
noncompete language in existing leases, physical and technological
challenges, plumbing capacity or air hygiene issues, zoning
restrictions, and financing. But adaptive reuse is becoming a more
attractive option because cultural shifts such as long-term remote
and hybrid work environments and consumer spending habits could
lead to reductions in demand for office space ranging from 10%-20%
and retail space ranging from 15%-17%.5

With past success in adaptive reuse of commercial property, San
Francisco is jumping on the adaptive reuse trend. Earlier this
spring, San Francisco Mayor London Breed and City Supervisor Aaron
Peskin introduced legislation aimed at addressing underutilized
office space and the lack of affordable housing options by allowing
commercially zoned properties to apply for conversion to
residential or mixed-use projects. Under the proposed program, the
city intends to amend its planning code to support existing
businesses and attract new ones to the targeted downtown
neighborhoods, and to direct the San Francisco Building Official
and Fire Code Official to prepare alternative standards to address
technical infeasibilities and design challenges associated with
converting existing commercial buildings to residential use.

Implementation of adaptive reuse projects in the Bay Area will
surely prove to be challenging. Construction costs in the region
remain exorbitantly high, and the demand for the types of adaptive
reuse projects that have proved successful or promising in other
areas of the country, including hospitality and retail, remains
depressed. However, demand for housing, especially more affordable
housing options, remains high in San Francisco. The mere fact that
local leaders are willing to remove the barriers to conversion in
an effort to address the economic and cultural challenges
inhibiting post-pandemic recovery efforts for the city’s
downtown and financial districts is an encouraging step. As new
types of technology emerge, the San Francisco Bay Area must be sure
not to miss the coming opportunities to show the world it can and
will continue to support and attract the next generation of
innovators and inventors, investors, and communities to impart
positive change in the world.

Originally published in Gordon Brothers

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