United States: Hearts Are Still In San Francisco—The Bay Area's Case For A Comeback

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.

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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