San Francisco braces for epic commercial real estate crash

Imagine a slow-moving train coming towards you. The lights are shining, the horn is blaring, but it’s just far enough in the distance that the risk doesn’t seem real just yet. 

That’s a fitting-enough analogy for the state of San Francisco's commercial real estate market, which is tilting towards a collapse in property values, leaving the city, its budget and its ability to provide services tied to the tracks. 

The root of this—of course—is the pandemic and the way that it has completely transformed work patterns in the city, hollowing out a downtown core that once accounted for most of San Francisco’s GDP, 70% of its sales tax revenue and 40% of the city’s jobs. And there’s an uneasy feeling among a coalition of business groups that city leaders are sleepwalking into an economic calamity with far-reaching consequences.

Signal lights of the city’s tenuous fiscal future are starting to flash. Major tech employers like Yelp and Airbnb have fled or gone fully remote, leading to mass office vacancies. A swath of commercial landlords are seeking massive reductions in their assessed property values—and associated tax bills. And a recent report from the Urban Displacement Project ranked the city’s downtown recovery as dead last among more than 60 cities across North America. 

It’s no secret that office vacancies are high in SF’s downtown. But even as the pandemic wanes, an already-troubling outlook for downtown could only get worse. 

That’s because a slew of office leases signed at the height of the city’s economic boom are poised to expire over the next few years, further inflating vacancies and diminishing what the office towers that draw the city’s skyline are worth. There’s currently more than 25 million square feet of commercial space available for lease or sublease in the city, the equivalent of about 35 Transamerica Pyramids sitting empty. 

“We’re way above anything that was happening in the Great Recession and dot-com era days,” said Jay Shaffer, a co-founder and principal at Colton Commercial & Partners. “We have this shadow market of sublease availability in seemingly uncharted territories. And sublease inventory is still rising.” 

Citing data from real estate firm JLL, SF’s chief economist Ted Egan tagged future vacancies, in a worst case scenario, as high as 53% in the Jackson Square area and 43% in the mid-Market area in 2024 as the clock runs out on office leases.

The current vacancy epidemic cuts across buildings of all sizes and price ranges in San Francisco’s downtown core, from the struggling mid-Market area to the sparkling office towers of the East Cut. 

For example, 415 Natoma, a 653,900 sq foot office tower owned by Brookfield Properties that was the sole ground-up office project to deliver in San Francisco in 2021, currently has just one announced lease: 20,000 square feet taken by “remote-first” startup Thumbtack. Nearby office towers 123 Mission (Juul Labs, Inc.), 50 Fremont (Salesforce.com, Inc.) and 199 Fremont (CalSTRS) were each at least 30% vacant, according to CoStar data, along with a constellation of other big office buildings.  

A few large buildings, like 550 California St. and 455 Market St, were placed on the market in recent months at deep discounts to what they would have fetched before the pandemic, but were eventually pulled when offers came in that were even lower than those already-discounted prices.

In the case of 550 California St., a downtown office tower owned by Wells Fargo, bids came in at 60% to 70% under what the building would have sold for in 2019, real estate brokers said. 

The risk of a San Francisco real estate collapse is palpable enough that it’s caught the attention of at least one Wall Street hedge fund—and not in a good way. 

Dan McNamara, founder of New York hedge fund Polpo Capital, became known for the lucrative short bets he made against regional malls run into the ground by e-commerce and Amazon. 

Now, McNamara is eyeing the commercial office market for another short bet, and San Francisco is near the top of his list. McNamara started his firm last year to take advantage of what he considers to be mispricings in the commercial mortgage-backed securities (CMBS) market.

“We thought there was a unique opportunity to take advantage of the impending distress within the commercial real estate market,” McNamara said. “San Francisco has been an amazing example of this; we’ve had all these tech companies that have been driving office space usage for the past 20 years. But we believe that’s changed forever.”

A report published in November by the Institute of Taxation and Economic Policy (ITEP) calculated that San Francisco could see a short-term decline in commercial property values of up to 43%, the highest projected in the study.

The logic is obvious: San Francisco’s software-dominant economy pivoted easily away from offices during the pandemic, and has little incentive to return. 

In some ways, the city is a victim of its own success by creating an economic model so heavily dependent on tech in the aftermath of the Great Recession, said Wade Rose, president of the business advocacy group Advance SF.

“We initiated the growth of an economic sector that could pivot on a dime,” Rose said. “So they closed down fast and exposed this vulnerability.”

Lenders have taken a dim view of the office market and that’s doubly true for slow-to-recover San Francisco, leaving fewer options for refinancing. 

“It's frozen,” McNamara said of current market conditions. “I do believe San Francisco is the most challenging office market today partly due to the fact they became oversupplied very quickly when the model changed to hybrid.”

The properties most at risk are mid- to lower-tier buildings purchased near the peak of the market. Commercial real estate insiders say that those property owners are negotiating with lenders to avoid foreclosure, but that it may be sooner rather than later before the dam starts to break.

McNamara sees refinancing issues leading to defaults, delinquencies and a class of unoccupied “zombie-type buildings.” That may be already starting to happen.

Of the some 200 large properties identified by CoStar as “high vacancy,” at least three have defaulted on their 2021 property tax bills, according to a city tax database. Those include a property at 25 Taylor St. formerly occupied by the coworking firm WeWork, and a 1182 Market St. property formerly owned by the local real estate giant Shorenstein Properties.

Other building owners are asking the city to cut their tax bills on the grounds that their buildings have lost much of their value—as much as half, in some cases.  

It’s not unusual for landlords to ask for revisions to their tax bills in an economic downturn. But the pandemic’s impact on real estate was dramatic enough that the city’s assessor-recorder, Joaquin Torres, took the step of surveying property owners and calculating a temporary property value reduction of $2.89 billion, out of $328.5 billion in total assessed value, in the last fiscal year. He said it’s too soon to know what the longer-term impact will be.

“We just don’t know yet,” Torres said. “It's a wait-and-see approach right now as we continue to defend the values that we have.”

The pandemic has already eroded the city’s business and sales taxes, both of which are reliant on downtown commuters. A hit to the city’s biggest source of tax revenue—property taxes—could be even more devastating. 

Because of Prop. 13, San Francisco has some protection from a sudden collapse in property tax revenue. That 1978 law, which limited when properties can be reassessed for tax purposes to the point of sale and restricted annual appreciation to 2%, has the effect of stabilizing property tax rolls in a downturn. 

Older buildings—even ones worth tens of millions at market prices—can pay taxes based on decades-old valuations. By contrast, newer towers spun up or sold during the last decade’s development frenzy contribute staggering sums to the city’s rolls, helping to drive property tax revenue in the city’s general fund north of $2.3 billion in the 2020-2021 fiscal year. 

But no one seems to have clear answers on what the pandemic will do to that cash cow. And the city’s own forecasts are looking increasingly out of step with reality as tech’s remote-dominant office culture metastasizes into a state of permanence.  

The city’s most recent budget forecasts estimate that office workers will telecommute 33% of the time when an in-person return to the office stabilizes.​​​​ That number seems strikingly optimistic compared to data from key card company Kastle Systems indicating that SF’s downtown offices are only about 30% full. 

Rose suggested that the infusion of federal stimulus funds during the pandemic may have lulled city leaders into a false sense of financial security.

“The city didn’t have to fire anybody and there wasn’t so much immediate pain felt,” Rose said. “There’s a propensity to say, don’t make it worse than it is.”

Rose sees an inflection point when leases expire, buildings are revalued, budgets are slashed and the problem can no longer be ignored. 

The city’s budget office expects property tax revenues to continue to grow. But Howard Chernick, an economics professor at Hunter College and co-author of the report that forecast an up to 43% decline in SF’s property values, paints a much worse picture: His team sees a decline of up to 15% in property tax collections amounting to a roughly 4% drop in total revenues.

Based on the most recent numbers, that would mean a decline of roughly $240 million annually. And because tax revenues on average increased steadily each year since the Great Recession, any drop could be painful for a city that banks on growth to pay for an array of services and a workforce of roughly 35,000. 

Local legislators are only beginning to get their arms around the problem. Supervisor Catherine Stefani sent a letter of inquiry asking budget officials to quantify declining demand for commercial space, while Supervisor Ahsha Safai plans to hold a hearing to brainstorm ways to bring workers back downtown. 

“Do we need to have an honest conversation about the current tax structure?” said Safai. “We need to be putting everything on the table.” 

Business and community groups are urging the city to take more action, arguing that policymakers must drastically remake downtown into a hub for arts, music and culture with outdoor spaces for visitors and commuters to gather outside of offices. 

But most of those ideas are firmly in the realm of the hypothetical, and it’s unclear what may happen when they collide with the city’s bureaucracy: For example, a $6 million budget allocation for the downtown-focused Economic Core Recovery Program was subject to intense scrutiny by the Board of Supervisors before its approval.  

When compared to the investment that cities like New York or Chicago are making to revitalize their downtowns, San Francisco’s effort barely registers.

The city has much to lose as federal funds that fortified its budget through the pandemic dry up. Some with a stake in downtown’s future are worried that time is running out. 

“It's within our power to stop or divert the train and meet it ahead of its collision point,” said SF Chamber of Commerce CEO Rodney Fong. “But that work has to start now, because the sooner you start it, the fewer days of discomfort you're going to have.”

Editor's Note: This story has been updated to reflect ownership changes in the properties at 25 Taylor St. and 1182 Market St.