Commercial real estate lenders and investors have not yet returned to San Francisco’s beleaguered office market, but the city is seeing a handful of green shoots that could bode well for a longer-term recovery.
There continues to be a significant disconnect between the city’s employment rate and its vacancy rate, according to Alexander Quinn, director of research for Northern California at Chicago-based advisory JLL.
At the end of the first quarter, San Francisco’s direct vacancy rate stood at 19.2 percent while its sublease vacancy was at 7.2 percent. In contrast, the city had an unemployment rate of 2.8 percent at the end of January, according to JLL research. Prior to the start of the covid pandemic in 2020, the city’s office sector had a vacancy rate of about 5.5 percent and an unemployment rate of 2.7 percent.
“The increase in vacancies in San Francisco is the most significant increase in vacancies in the US office sector,” Quinn said. “While this is a dramatic shift, it is not an indication of total employment activity in the Bay Area. It is an indication of how work is being done.”
While market participants are watching what is going on closely, tepid transaction activity means there has not been much clarity on where pricing might end up.
“The biggest debate is where is the bottom, if we have reached it and what does that mean? From a capital markets side, we don’t know where pricing will stand, but we are starting to get an idea,” Quinn discussed. “On the demand side, the question is being driven by companies that are trying to figure out if they want to be in the office again.”
Sector under pressure
Office properties in San Francisco, like other major metros, are seeing various degrees of distress. A June 23 report from New York-based data and analytics provider MSCI tracked about $18.325 billion of outstanding distress in the sector as of the end of May, with about $42.79 billion in potential distress in the pipeline.
The report comes as MSCI tracked an increase in distressed sales in May. “By the end of the first quarter, the balance of distress in the US commercial real estate market had grown to $63.7 billion. Nearly 10 percent of this value was added during the first three months of the year, when inflows of newly troubled assets exceeded workouts by more than $5.7 billion.”
MSCI also broke down current distress levels by city. Manhattan, with 19 percent of the most distressed sales seen to date, had about $2.6 billion in volume. San Francisco was ranked at number 8, with $177 billion in distressed volume, or about 4 percent of the market.
There are several loans on well-known San Francisco office properties which have been transferred to special servicing or are now in default, with distress tied to declining occupancy numbers, according to New York-headquartered data provider Trepp.
Pockets of financing
There remains capital available for some office deals in the city. Gantry, a San Francisco-based advisory, recently lined up $8.2 million in permanent financing for an 18,000-square-foot brick and timber office building at 499 Jackson Street in the city’s Jackson Square Historic District. The 30-year, fixed-rate loan was funded by a life insurance company on behalf of an undisclosed private investor.
According to Gantry’s Tom Dao, the firm was able to line up financing for a number of reasons, including strong sponsorship and management as well as historic performance. The property has also undergone seismic upgrades and has strong current occupancy.
“Once we agreed on a plan of execution, arranging the financing was not difficult. We work closely with our clients to fully understand the financing request and to formulate a financing strategy. This helps us filter out all the noise and distractions from headline news and present a financeable story,” Dao said.
The stability of the rent roll at 499 Jackson Street was a critical factor in securing the loan in a market where the future use of other office uses is uncertain. “This property is nearly fully occupied or has tenant interests for every space. This owner was willing to invest in great design and improvements. With the addition of PostScript on the ground floor the building tenants will be able to enjoy the luxurious offering that is unique for this building,” he added.
The bottom line is that lenders and investors are still active in San Francisco if the deal makes sense. “The lenders have always been very willing to look at anything in San Francisco except for office and hospitality products in the current economic environment. If the economics of the loan makes sense, we can normally structure a deal that works,” Dao pointed out.
By lender type, the firm believes the most stability right now is with insurance company lenders.
“They don’t require deposit relationships that many banks and credit unions require. With insurance companies we can lock in the interest rate at application, which takes away the rate uncertainties,” Gao said. The firm also has a roughly $18 billion servicing portfolio, comprised mainly of insurance company loans. “Our ability to deliver and get a loan funded is a crucial service we provide to our clients.”
Rise in leasing
Despite a sustained work from home culture in the city, JLL is tracking an increase in leasing activity, albeit at a slow pace. “What we are seeing now is what I would articulate as a bottom or near-bottom of the market and we are starting to see a recovery of tenancy,” Quinn said. “A lot of that is being driven by AI companies, which have been actively pursuing office space in the San Francisco market.”
The firm is expecting to see this increase in AI leasing reflected in the second quarter and beyond. “These companies will likely transact by the end of the year,” he said.
Over the past year, the mantra of the office has been the flight to quality. “This means having a compelling reason to be back in the office is important,” Quinn continued. “This is about the location of offices and their sustainability. It used to be that you could be pretty complacent as an office owner in San Francisco and have a vacancy rate of less than 5 percent. But that is no longer the case. Office owners need to provide amenities like gyms and conference rooms.”
The buildings that are doing the best are trophy assets that have water views or views of the city’s skyline, the Bay Bridge or the Golden Gate Bridge.
“There are also modernized class A buildings that have good amenities packages and great lobbies,” Quinn said. “We are seeing the most pain in class C offices and the question for employees is do they want to go back into a cubicle with no amenities or do they want to stay at home. The answer for employees who are in class C offices is that they want to stay at home,” Quinn said. “That is the reason why higher-quality spaces with amenities are generally doing better.”
Quinn believes there could be a return to the mean in the city’s office sector, citing the example of the rise and fall in e-commerce.
“If you look at e-commerce market share during the pandemic, you will see that it shot up. But then you can see that it eventually dropped back to its normal growth trajectory,” Quinn noted. “We are now seeing a reversion to the mean. There will be a growing number of remote workers, but not the massive swing that everyone is going to work from home. We are going to get back to a normal line in which 4 to 10 percent of all workers will be working from home and that will stabilize the market.”