A combination of high interest rates, lower office utilization, and the retreat of major institutional investors from San Francisco’s commercial real estate market have conspired to create a once-in-a-lifetime situation.
While most observers see a crisis, a particular set of bargain hunters see an opportunity they cannot pass up.
In the last two years, office buyers have been snapping up recently renovated buildings that, in some cases, are going for a quarter of the pre-pandemic price.
Some buyers are wealthy San Franciscans banding together to bet long on the city they love. Others are outsiders entering the market for the first time. Either way, the vast majority are paying all cash for debt-free positions and the potential for all the financial upside when the city bounces back.
“Our basic bet is that the market will greatly improve over the next five to 10 years,” said Greg Flynn, a local billionaire businessman who just partnered with another family-run real estate firm, Ellis Partners, to purchase a five-story Class B office building at 631 Howard St. for $36.4 million.
According to public records, the sale price was approximately 42% less than the $62 million paid by Atlanta-based Invesco in 2014. When the building was first marketed for sale earlier this year, the sellers were reportedly seeking a price north of $43 million.
Baked into the math is the fact that the property is fully leased to the likes of Finix, a software company, and SC Johnson, the maker of brands such as Glade and Windex. And although both tenants’ leases expire next year, the building’s location (on a major thoroughfare), Goldilocks size (not too big, not too small), and ready-to move-in interiors make it resilient in a downturn, Flynn said.
“Even if the office rebound turns out to only be a moderate one, we still do well,” he said. “Not only are we opportunistic investors who think it’s a good time in the cycle to buy, but also we feel like we have a civic obligation to participate in this city’s recovery.”
His company, Flynn Properties, has been on the hunt for deals, reportedly missing out this year on another office building on Townsend Street. The firm last year snapped up the historic Huntington Hotel in Nob Hill for more than 50% off and is renovating the property with an eye toward reopening it in 2025.
In San Francisco-based Ellis Partners — run by siblings Jim and Melinda, whose father, Hal Ellis, was one of the most well-known figures in U.S. real estate history — Flynn found partners with a similar mentality: They’re able to stomach the pain in the short run because they believe things will get better.
“The real question is when?” Jim Ellis said during a recent walkthrough of the SoMa property, which was built in 1929 and features a classic Art-Deco exterior with large windows that filters in natural light. Inside, Finix’s office space is a modern, three-level, open-floor design with more communal gathering space than desks.
The two companies decided to split the bill on 631 Howard so that both had more capital to invest in other projects across the city.
During the good times, it would have been less likely for investors like Ellis Partners and Flynn Properties to pool funds and split ownership since institutional debt was easier to attain, Ellis explained. But as the capital markets have dried up, more “syndications” are emerging from competitive bidding processes as winners.
“Sellers who are ready to take their losses are more focused than ever on vetting buyers’ ability to execute and perform [on their bid],” Ellis said.
That means a buyer’s track record and cash flow matter more than ever.
“Especially in this market, [sellers] don’t want things to blow up in escrow and then have to put their property back on the market,” he said. “The price will deteriorate even more.”
‘Cheap doesn’t always mean value’
At the offices of 989 Market St., perched atop a ground-floor Blick Art Materials store in Mid-Market that caters to arts students, long strips of ripped paint on the wall behind the lobby desk have yet to be covered.
There, the outlines of a “Z” — the logo of the building’s sole office tenant, Zendesk — are faintly visible. In October, the customer-service software company will complete its long-awaited move up the street to 181 Fremont St., where it has subleased 40,000 square feet of brand-new office space from Meta.
That sort of high-profile departure might have scared off other buyers. But Peter Horn of BH Properties — a Los Angeles-based company with a hankering for properties “with significant vacancy” — didn’t sound bothered.
During a walkthrough of the space on the day his company’s reported $13.5 million deal for the building closed, Horn, who joined BH in February, spoke about beating out local, high net-worth syndicates in the bidding process for 989 Market.
“You start to see the same names pop up over and over again,” he said of a small cadre of local office buyers. “They’re the ones who’ve been doing this for a while, and they really understand the market.”
When the six-story Class B property last changed hands a decade ago, it sold for nearly five times as much: $61.3 million.
“Cheap doesn’t always mean value,” Horn added. “If you still have to pump in a bunch of capital to bring the place to market, then it’s not that great of a deal.”
Since the outgoing tenant will leave behind five floors of high-quality minimalist improvements designed by architectural firm Gensler, the property won’t require much fixing up in order to start leasing again, Horn said.
“This office space offering will be competitive today, not two years from now,” Horn said, adding that BH intends to carve up the building to accommodate multiple tenants, as opposed to just one. “When the money is tight, tenants prefer turnkey spaces.”
Like the Flynn and Ellis partnership, BH Properties is betting that the small- to medium-size office market, between 10,000 and 20,000 square feet, will bounce back faster than the big-box spaces that are driving San Francisco’s record-high office vacancy.
And even if the leases don’t come right away, BH Properties isn’t going to panic and bolt, Horn says, explaining that his firm’s all-equity position means it won’t be beholden to lenders.
“Dedicated and discretionary capital can afford to be patient,” he said.
‘Real friends show up early’
To be clear, not all lenders are out on the San Francisco office market. But those who are active are inclined to make smaller bets than the financing deals of the previous decade.
For example, ASB Real Estate Investments, which sold 989 Market to BH Properties under pressure from its lender, unloaded another office building this month at 795 Folsom St. According to property records, Alaska-based Fountainhead Development group borrowed from First National Bank of Alaska to execute the $48.3 million deal, less than half the $109.6 million the building last sold for, in 2013.
Meanwhile, at San Francisco’s famed California Street corridor, a private commercial real estate credit manager called Prime Finance helped the local group of Redco and GCI Contractors close in May on a $28.5 million deal for the eight-story tower at 300 California St., according to property records. A decade ago, the building traded for $58 million.
Having done business in the city for more than three decades, Flynn is not immune to being on the wrong end of the real estate cycle. In 2019, his firm partnered with Gem Realty to purchase an office building at 222 Kearny St. in Union Square. Last year, the Chicago-based partner reportedly defaulted on a $23 million commercial loan originated by Goldman Sachs.
“When you get the timing right, you can do many things wrong and still end up fine,” Flynn said of the debt position at 222 Kearny. “But when you get the timing wrong, you can do a lot of things right and still have an impossible situation on your hands.”
Chad Arkoff, who oversees Flynn’s real estate practice, said institutional investors are more “demanding” since they are focused on recouping loans. Local groups, on the other hand, can “see a property for what it can be” and serve as better stewards during a down cycle.
Years down the line, he said, those investors will come back once the data show that San Francisco’s office market is on the upswing again.
“Most people like to show up to a party late, since they know it’ll be well underway,” Arkoff said. “But real friends show up early and help set up.”