Standards raise alarm over the stability of San Francisco’s commercial real estate

Lenders to San Francisco’s beleaguered commercial real estate market are bracing for billions of dollars in debt default after the owners of the city’s largest mall and largest hotel defaulted on loans and handed back the keys to what was once the city’s most valuable property.

This week, Westfield and Brookfield Properties announced they had defaulted on a $558 million loan secured against San Francisco’s sprawling downtown mall that they have owned since 2002, and would surrender the premises to their lenders.

Days earlier, New York-listed Park Hotels & Resorts said it expects to turn over ownership of two of San Francisco̵[ads1]7;s premier hotels — the Hilton Union Square and Parc 55 — after it defaulted on a $725 million loan dollars. The hotels were valued at more than $1.5 billion when the loan was issued in 2016, suggesting the owners believe their value has more than halved.

The major defaults were the latest in a series of distress signals from landlords of offices, hotels, apartment buildings and retailers in San Francisco. The city has struggled with a steep decline in tourism and business travel since the coronavirus pandemic, layoffs at tech companies, an exodus of residents and international scrutiny over crime, drug use and homelessness.

Park Hotel CEO Thomas Baltimore said, “San Francisco’s road to recovery remains clouded and prolonged by major challenges”, including “concerns about street conditions”.

Westfield shopping center has been half-empty after brands such as Nordstrom left, in part because of “suppressing criminal activity” and because downtown foot traffic has not recovered from the pandemic. Westfield said sales fell sharply between December 2019 and 2022, compared with an average increase in sales at its other US malls.

The defaults could spark a fire sale of commercial property in the city, as lenders rush to offload assets at deep discounts to reduce exposure and protect bondholders. In many cases, major commercial real estate lenders in San Francisco, which include JPMorgan, Deutsche Bank, Wells Fargo and Bank of America, syndicated the real estate debt via commercial mortgage-backed securities. Bondholders could take a hit as falling property prices have left some of the loans underwater – meaning the asset is worth less than the value of the loan – according to economists.

This repricing could trigger a ripple effect that makes it harder for property owners to refinance their debt as banks become even more cautious about lending. Some US banks have reduced their exposure to the commercial real estate market after the recent turmoil in the regional banking industry – and the prospect of losses is particularly acute in San Francisco.

“We have reached a turning point where we have seen a lot of [broader economy] headlines are unfolding in the San Francisco market,” said Lonnie Hendry, head of commercial real estate at Trepp, a data provider. “The dominoes have fallen much faster in San Francisco than they have elsewhere.”

A guest stands in front of the Hilton Union Square

Park Hotels & Resorts says it expects to turn over ownership of the Hilton Union Square. . .

The Parc 55 hotel in San Francisco

and the Parc 55 hotel © Justin Sullivan/Getty Images

In San Francisco’s financial district, some office towers have changed hands in recent months for a quarter of the price they were marketed at three years ago. WeWork defaulted on a $240 million loan for its tower at 600 California Street in April. Elsewhere downtown, Elon Musk’s Twitter stopped paying rent in November, forcing the landlord to default on a $400 million loan.

Since San Francisco’s economic situation remains uncertain, the price reduction may have longer to go. “Even if you can buy a building today at 50 cents on the dollar relative to the loan balance, that doesn’t mean it’s a home run purchase,” Hendry said. “We don’t know the floor yet.”

Wells Fargo has among the largest exposures to commercial real estate in San Francisco, with about $34 billion in loans outstanding in California, according to filings. The state accounted for the largest share of its total outstanding loans of $155 billion at the end of 2022 (the bank does not report figures by city). Nearly $14 billion of Bank of America’s $73 billion in total outstanding commercial real estate loans are in California. At First Republic, which collapsed in May after a bank run and was acquired by JPMorgan, about $12 billion of its total $35 billion of commercial real estate loans were made in the San Francisco Bay Area, according to filings for 2022. Deutsche Bank originated loans to Westfield mall in 2016, while Park Hotels’ mortgage is serviced by Wells Fargo and was originally underwritten by JPMorgan.

Data from rating agency Moody’s showed that 50 percent of CMBS office loans maturing in 2024 are at risk of default.

“This is a situation where there really is a loss of faith, at least temporarily, in certain assets in the market,” Moody’s senior economist Thomas LaSalvia said. “It’s going to be a hit across the board,” he said of commercial real estate lenders.

Just outside of San Francisco in the greater Bay Area, tech giants including Google and Meta have sublet parts of their huge offices. An executive at a firm that offers defaulted CMBS loans said it had created an “uncomfortable position” for landlords and lenders who have loans secured against the campuses. “If they’re not using the space, it’s logical to conclude that they won’t renew the lease and you have a big problem getting down the track, but you can’t do anything until the lease expires,” the person said.

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The city is exposed to a decline in technology and the transition to remote working, leading to less demand for office space.

A top executive at a major global real estate lender said San Francisco’s office market would experience more distress than other parts of the commercial real estate market. He said there would be “refinancing challenges” when loans mature on empty offices.

“Obviously the assets won’t be worth more than the debt balances even if they put in more money then [landlords will] ask yourself, is it better to just hand the asset back to the lender?”

Office vacancies have risen to 30 percent in San Francisco, the highest of any major US city. Hotels in San Francisco have also been particularly hard hit. The city has an average daily room rate of $207, which is below 2019 levels – one of only two major US cities where rates have not increased. Hotel bookings in San Francisco have been affected by a drop in the number of travelers from China and as security concerns have caused business conventions to move.

Club Quarters, a business hotel owned by Blackstone Group, has been delinquent on a $274 million loan since 2020. The Huntington Hotel, a historic luxury hotel in Nob Hill, defaulted on a $56 million loan from Deutsche Bank last year and was subsequently sold at forced auction for approximately half of the loan.

More than 20 other San Francisco hotels have CMBS loans maturing in the next two years, according to real estate data provider CoStar; 15 of these are on the lender’s “watch list”, meaning they have missed repayments or are likely to miss future payments.

The accelerating number of defaults across multiple real estate asset classes has raised concerns about a drop in city tax revenue that could lead to a “doomsday loop” — an economic and social spiral that becomes impossible to reverse. Large office buildings that are sold at deeply discounted prices would quickly eat up a crucial part of the city’s tax base. San Francisco has projected a $780 million budget deficit over the next two years, which will affect their ability to provide public services or offer incentives to businesses to help revitalize downtown.

Owners of some of San Francisco’s iconic buildings such as the Transamerica Pyramid and Uber’s Mission Bay headquarters have petitioned the city to lower their tax burden as the value of their properties has fallen.

“The concern for San Francisco is that it’s losing its critical mass,” said LaSalvia at Moody’s. He said there was a “snowball effect” where departing retailers and technology companies lead to an even greater reduction in foot traffic, increasing the risk to remaining tenants and owners, who are then more likely to default.

“Once you get below that point where the vibrancy that attracts tourists, workers and shoppers is gone, it’s very hard to come back from,” he said.

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