San Francisco’s real estate reset is already happening

San Francisco’s prophesied real estate reset—a revaluation of buildings that could bludgeon the city’s budget—has started to take root.

Last year, the city projected a $720 million two-year deficit due in large part to the negative revenue impacts caused by the shift to remote work and the hit to commercial real estate.

When it came time to actually pass the budget, however, what resulted was a year of record spending, with city leaders plugging the gap by shifting around sources of revenue and pulling from its financial reserves. 

But those tactics have not changed the underlying calculus leading to years of anticipated shortfalls expected to rise to $1 billion by 2026. Moreover, increasing signs of stress are showing up in the numbers.

The city’s transfer tax revenue—which is directly tied to the sale of buildings—has fallen off a cliff due to far fewer commercial properties trading hands. Home sales in San Francisco, which provide a smaller portion of transfer tax revenue, have also dropped from their 2021 peak.  

In the last fiscal year, San Francisco pulled in $186 million in transfer tax revenue—the lowest number in more than a decade, according to Ted Egan, the city’s chief economist.

Egan said the last time the transfer tax was lower was all the way back in 2010, when the city earned just $135 million from that source in the wake of the Great Recession. 

The revenue that came in for 2022-23 was more than $100 million lower than the prior budget projections made by the city. 

Compare that with 2021-22, when the city earned $520 million in transfer tax, buoyed by major property sales like the purchase of PG&E’s former Downtown headquarters for $800 million and the $1 billion sale of the Exchange in Mission Bay. 

Although transfer tax is considered a volatile source of income for the city because of its heavy reliance on large commercial properties trading hands, it has been an increasingly common tool in recent years to pad San Francisco’s budget.  

A number of local ballot measures, including 2010’s Prop. N, 2016’s Prop. W and 2020’s Prop. I, have progressively raised the transfer tax rate on expensive properties. Currently, the transfer tax rate for properties over $10 million is 5.5%-6%, higher than the top rate of any other major city in California.   

“We haven't seen numbers like this since the Great Recession,” Egan said. “It’s always been very volatile, but the revenue stream is getting increasingly reliant on sales of a few properties, and that increases its volatility even further.”

But these declines in value aren’t just hitting the city when buildings trade hands. An increasing number of property owners are filing for temporary reductions in their assessed value, which means a property tax discount.

All told, 2,873 property assessment appeals in San Francisco were filed to the assessment appeals board in the fiscal year ending in July, reflecting more than $60 billion in total property values. The number of applications during the last fiscal year was at its highest level in nearly a decade.

San Francisco property tax revenue is currently projected to fall between this year and next, and the city is expecting to refund around $167 million in property taxes over the next two years because of successful assessment appeals. Updated numbers from the Controller’s Office are expected later this year. 

Uncertainty about the commercial real estate market, difficulties getting financing through traditional channels, sharp interest rates and what Egan terms a “lack of price discovery” has slowed the market for transactions to a crawl. 

Essentially, the lack of properties trading hands in the current market means few data points—“comps” in real estate terms—to help accurately price future deals. What deals are in the works are often coming in at prices lower than the city’s assessed value, which means a decline in incoming property tax revenue.

“We’re going to start to see these property sales having an effect on the market and perhaps accelerating the process of this sort of Downtown reset we’re all expecting,” Egan said. “I don't think we've reached the bottom yet. I think when we reach the bottom is when things start moving at the bottom.”

Property taxes are the single largest source of revenue for San Francisco, earning more than $2 billion annually to pay for city services like street cleaning, public health programs and law enforcement. 

Cyrus Sanandaji, the founder and CEO of San Francisco developer Presidio Bay Ventures, put together an analysis of nine major buildings that have traded hands this year or are expected to sell in the near future, along with their estimated market values. He calculated the property tax the owners would pay the city both before and after the sale. 

In some cases, the new property owners would pay even more in taxes in part because Prop. 13 restricts annual appreciation to 2%, which creates a mismatch between market values and assessed values for long-held properties. In the case of 180 Howard St., which is expected to sell for around $62 million, a new owner would pay more in taxes because the previous owner was a government entity that was exempted. 

Egan also pointed out that properties are reassessed when new construction happens, so buildings getting major improvements will also see their value—and tax bill—tick up. 

The Office of the Assessor-Recorder argued that the city’s assessment roll—San Francisco’s total record of taxable property—has remained relatively stable, even through the current economic challenges, because of the impact of Prop. 13 and the diversity of real estate in the city. 

“We are expecting slower roll growth in the coming year and assessment appeals and the continued effects of the pandemic on commercial real estate downtown are top of mind for our office as we prepare for and manage our workload in the year ahead and beyond,” the Assessor-Recorder’s Office said in a statement. 

By and large, though, the drop in values means lower revenue for the city. For 550 California, which is expected to sell for less than half of its 2005 price, the city stands to lose nearly $1.4 million in property tax revenue based on the current assessed value, according to Sanandaji’s analysis. 

The North Park office complex in Jackson Square is also rumored to be testing the market at a two-thirds discount to the $245 million it was purchased for back in 2018. If the property changed hands at that price, the city would stand to lose $2.1 million in property tax revenue. 

Personally, the major drop in market values has provided a rare opportunity for Sanandaji. Presidio Bay Ventures recently purchased a mostly vacant 11-story office building at 60 Spear St. for $40.9 million, a 60% discount from the $107 million paid by Clarion Partners in 2014.

While the sale means a shot in the arm for transfer tax, it also translates to $975,000 less in property tax revenue for San Francisco annually. Presidio Bay plans to pour tens of millions in upgrades into the property, which will include amenities like a spa, gym, rooftop bar and restaurant. Sanandaji’s bet is to leverage the building’s low cost to create a top-tier office space that stands out from the competition. 

While alluding to the real challenges San Francisco faces, Sanandaji underscored the “perception and disconnect” that many investors have about the city. Among the positives he listed were the Bay Area’s central place in the venture capital world and the positive performance of big tech companies in the public markets.

“Perception is driving investment and divestment decisions among people that aren’t here," Sanandaji said. "They’re on the East Coast or abroad.”  

Sanandaji also referenced the fact that major institutional investors like Goldman Sachs and BentallGreenOak have started the process of raising billions to specifically invest in distressed real estate assets as a sign things will eventually turn around. 

“Sooner than later, the numbers will go from $200 to $400 (per square foot), then $400 to $600, and before you know it, we’re back at $1,000,” Sanandaji said. “I don’t have a crystal ball to tell you exactly when, but I know that over a 10-year period, that’s going to happen.”

The picture in the short-term is a bit more clear: “It’s ugly for the city, for sure,” Sanandaji said.