Finance  ·  Distress

San Francisco Leans Into AI and Conversions to Aid a Painful Recovery

Meanwhile, the shock of URW handing back the keys on its Westfield mall continues to reverberate


San Francisco’s commercial real estate distress reached earthquake levels in June, and the aftershocks may be felt well into the future. Still, the roiled market there might find some calm in one booming industry in particular and in the promise of property conversions. 

The most recent negative headlines started when the city’s largest mall and two of its biggest hotels halted debt payments on properties that have contended with declining revenues due to persistent challenges related to the pandemic. Beyond retail, San Francisco has struggled more than any other large U.S. city in its office market recovery amid increased homelessness and crime that have caused multiple businesses to close or move.

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“With less commuting workers and with less tourism it brings trouble, and that trouble can be exacerbated with the higher interest rates and higher cost of capital,” said Lu Chen, a senior economist at Moody’s Analytics based in the company’s San Francisco office. “It has a snowball effect with people feeling less safe when they’re surrounded by less crowds when they walk on the street, and it makes some of the homelessness and public safety issues more obvious.”

A Moody’s report released June 23 showed the San Francisco metropolitan area has $2.4 billion of commercial mortgage-backed securities tied to office loans maturing through 2024, the fourth-highest total nationally behind just New York, Chicago and Los Angeles — each of which is a much bigger office market. The majority of this office debt (62.7 percent) faces a “double whammy,” according to Moody’s, of low debt yields that make refinancing loans “a significant challenge” coupled with “the stark reality” of looming lease expirations creating even worse conditions for net operating income at these properties. 

As for retail, the situation reached a boiling point when Unibail-Rodamco-Westfield (URW) announced on June 12 that it was handing back the keys to a $558 million CMBS loan tied to its downtown Westfield San Francisco Centre (SFC). The company, which co-owns the mall with Brookfield Asset Management, cited a 43 percent decline in foot traffic in 2022 compared to 2019 and “challenging operating conditions in Downtown San Francisco” as reasons for its decision to transfer management to its lenders, Deutsche Bank (DB) and JPMorgan Chase (JPM), which subsequently appointed a receiver to operate the property.

Occupancy at the 1.2 million-square-foot regional mall in San Francisco’s Union Square neighborhood fell to 52.8 percent at the end of 2022 compared to 72.9 percent in 2021, according to a recent commentary from master servicer Wells Fargo provided by CRED iQ. In addition to retail space, the Westfield SFC property also includes 241,155 square feet of office space on floors five through eight of the Emporium building. Office tenants Crunchyroll (71,614 square feet) and software company TrustArc (28,217 square feet) vacated at the end of their leases last year. 

The Westfield loan was transferred to special servicing with Pacific Life Insurance Company acting as the special servicer. 

Marc McDevitt, senior managing director at CRED iQ, noted that while URW had indicated plans to exit the U.S. retail market beginning in early 2021, there was hope in the CMBS world that there could be a successful redevelopment of SFC similar to the Santa Anita Mall in Southern California. Related Companies is redeveloping that mall into 4,000 apartments. 

“The expectation was that the keys to SFC would exchange hands one way or another — either through an opportunistic divesting sale or via a strategic mortgage default if performance continued to lag or deteriorate,” McDevitt said. “A severe lack of foot traffic and meaningful commerce in San Francisco, and more specifically within the Union Square submarket and along Market Street, precluded the possibility of a successful transaction similar to the sale of the Santa Ana Mall last year.” 

Foot traffic in Downtown San Francisco was just 29 percent of pre-pandemic levels in June, according to cellphone data released July 3 by Apollo Global Management, which means San Francisco lags far behind other major cities like New York (71 percent), and Chicago (56 percent). The city’s office vacancy rate hit a record-high 31.8 percent in the second quarter, according to preliminary data released by CBRE in late June. 

The mounting challenges to San Francisco’s office market were cited by Park Hotels & Resorts when the real estate investment trust announced in early June a halt to debt payments owed on a $725 million nonrecourse commercial mortgage-backed securities loan backing two San Francisco hotels. The planned removal of the CMBS loan scheduled to mature in November 2023 securing the 1,921-room Hilton San Francisco Union Square and the 1,024-room Parc 55 San Francisco is part of the REIT’s overall strategy to reduce its exposure in San Francisco.

In addition to record-high office vacancy, Park Hotels also cited a weaker than expected convention calendar in the city through 2027 and “concerns over street conditions” as key aspects of its decision to hand the keys back to its lenders. The Hilton Union Square, which is San Francisco’s largest hotel, was shuttered for 14 months at the beginning of the COVID-19 pandemic before reopening in May 2021. Parc 55, which closed for two years before reopening in May 2022, is San Francisco’s fourth-largest hotel.

Park Hotels’ bleak outlook for San Francisco is also shared by Shlomo Chopp, a CRE restructuring veteran who recently launched Terra Strategies, an asset management firm that targets investments in undervalued properties. Chopp said that while he is generally open to seeking yield opportunities in all property sectors across the country, he is staying clear of San Francisco for now.

“The city is trying to figure out things on multiple levels and how they deal with very unique challenges which are business challenges, social challenges and political challenges,” Chopp said. “I don’t think the issues with San Francisco are directly correlated to issues in other markets.” 

More than two dozen retail stores have shuttered in Downtown San Francisco since the onset of the pandemic, including Nordstrom, which announced in May it was closing two locations at the Westfield mall and a discount outlet on Market Street. In October 2021, Walgreens cited an increase in retail thefts as part of its decision to close five of its San Francisco stores, although the drugstore chain’s chief financial officer, James Kehoe, later backtracked on the impact shoplifting had on the move. Concerns about the city being too lenient on shoplifting and other petty crimes prompted a successful recall election of progressive district attorney Chesa Boudin in June 2022. 

Vacant offices and public safety concerns in San Francisco have trickled down as well to its mass transit system, Bay Area Rapid Transit, which is facing a projected operating deficit of between $140 million and $300 million for the 2024-25 fiscal year due to declining ridership. 

Chen noted that San Francisco is near the bottom of the top 10 U.S. cities in terms of physical office occupancy measured by security firm Kastle Systems’s swipe-card data. She attributed that largely to the city’s economy being driven by technology companies that are more receptive to remote work than other industries. San Francisco’s computer and mathematical occupation statistics are more than twice the national average at 6.9 percent of local area employment, according to Chen, with only about 30 percent of these workers in the office now. She said many of these tech companies had taken up space in older Class B properties prior to the pandemic. 

While San Francisco’s office market faces challenges with such a tech-focused economy, Chen said the city also has a unique opportunity to fill the void with a number of artificial intelligence companies now surging in the city. These include OpenAI, which developed ChatGPT and leased nearly 100,000 square feet in the Mission District during late 2020. 

Chen noted that $10.7 billion of venture capital has been invested in generative AI startups in 2023 so far, with the investment activity centered largely on firms concentrated in the Bay Area. 

“The AI industry tends to collaborate and they tend to center around where other AI companies are,” Chen said. “There are pockets of the city that can grow and expand prosperity to the neighboring area.”

John Manning, senior vice president and head of production for the Western region at brokerage firm Marcus & Millichap (MMI) Capital Corporation (MMCC), grew up in San Francisco and is taking a long-term view of the city despite its myriad near-term challenges. Manning noted that San Francisco has had a roller coaster ride for much of its history, including the dot-com crash of the early 2000s and the Global Financial Crisis, but has managed to persevere each time

“There is so much wealth here, so it isn’t like Detroit after much of the auto industry left or Akron, Ohio, after it shut down the tire factory,” said Manning, noting that many thriving companies remain in the Bay Area. “The overall macroeconomic environment here is really good, and with that positivity I think that the rising tide will fix the boats in downtown.”

Manning said MMCC is close to the finish line on facilitating a distressed loan deal in San Francisco, although he could not provide specifics. Going forward, he said there are opportunities for office-to-residential conversions with some properties that could help address San Francisco’s affordable housing challenges and add more foot traffic downtown to aid retail businesses. He also sees potential for some of the Bay Area’s major colleges such as Stanford and the University of California-Berkeley opening downtown satellite campuses down the line.

“If there’s a high vacancy rate and the buildings aren’t worth much, someone will seize on that opportunity,” Manning said. “Opportunity abhors a vacuum.” 

Andrew Coen can be reached at