To spend a week in San Francisco these days is to experience a city, one of the world's priciest real estate markets, still searching for its footing.

A recent Monday was quiet as the city's predominately stay-at-home workforce has largely abandoned its once-bustling streets. Buses heading downtown that had once been crammed to capacity drove past with empty seats, and light-rail station platforms were sparse during what used to be a 5 p.m. rush hour.

It was no different Friday, when the city's downtown area again felt barren, with nonexistent lunch lines and an eerie emptiness that only used to come when tech workers would venture off to the Burning Man festival every year on Labor Day weekend. That void has fueled incessant talk over rising crime, homelessness, empty offices and big-name retail operators pulling out and moving elsewhere.

If there is one day that San Francisco feels like its old self it is Wednesday, the one day of the week when an increasing number of companies can be counted upon to mandate workers be in the office. The amount of Bay Bridge traffic on a recent morning was almost back to pre-pandemic 2020 levels as employees honked in bumper-to-bumper routes and maneuvered their way to work. The line outside one of the downtown Mendocino Farms, a popular lunch spot among tech and financial services workers, was nearly out the door, echoing a typical lunch hour in the run-up to the pandemic's 2020 outbreak.

Wednesdays give hope to civic and business leaders that the city can pull out of its so-called Doom Loop, where empty offices lead to restaurant and retail closings, which in turn prompt more companies to move out of the city, perpetuating a downward spiral. Leaders can point to Wednesday's bustle to remind that San Francisco is a city that has experienced many booms and busts, and has always come back bigger. It's an ethos epitomized by the region's dominant technology industry, always ready to jump on the next big thing.

Antoni Rosinol is one such optimist. The co-founder of artificial intelligence startup Stack AI , he intentionally embraced San Francisco at a time when others were leaving.

"We always had a city like New York in mind, but just recently came up with a decision to stay here in San Francisco," the Boston native said.

He said he and his co-founder, Bernardo Aceituno, wanted to be in a place where they could rub elbows and share knowledge with other AI specialists: "The decision to choose San Francisco was clear because all of the people and talent and the rest of the tech community are here. A lot of people have left the city, but the AI community can help revive it a bit since it's strong enough to see that kind of renaissance."

Still, as much as Rosinol believes in the power of in-person, face-to-face interactions, it remains to be seen if the larger tech industry comes around.

"The No. 1 issue is returning to the office," Colin Yasukochi, executive director of CBRE’s Tech Insights Center, said in an interview. "We need more people to come back to the office more days per week to help sustain demand. There is the possibility that companies have overcorrected on the contraction side, so as employees come back more days a week, there could be pent-up demand in the market. All of that hinges on the overall economy, though, and we need to see that start to turn around."

The uncertain recovery has made it tough for the Bay Area to rebuild the momentum that made it one of the most desirable real estate markets in the decade leading up to the pandemic. It was home to the world's largest tech companies. The office vacancy rate was so low that tenants would compete over full-building leases for developments that had yet to secure construction permits, let alone break ground. And it posted some of the fastest-rising office rents in the nation.

San Francisco's meteoric rise on the global commercial real estate stage kicked off in the years leading out of the Great Recession. Early-stage startups such as Airbnb, Uber, Slack and Twitter reshaped how the world traveled, communicated and lived, attracting billions of dollars in venture capital. Those startups grew into tech giants, gobbling large chunks of office space. They built affluent workforces that bolstered the city's economy and catapulted it to become one of the most expensive places to live and work.

When the pandemic struck, those same tech companies locked up their offices and sent their employees to work remotely. That set up San Francisco's commercial real estate market for what has been one of the most painful contractions in its history, plagued by record-high sublease availability, arrested leasing activity and a hospitality market that is struggling to kick back into gear.

San Francisco's sharp decline alarmed many of the tech leaders who contributed to its rise.

Billionaire Elon Musk, owner of X Corp., the tech firm formerly known as Twitter, has described the city as “post-apocalyptic,” claiming many X employees “feel unsafe” coming to work at the company's headquarters in the Mid-Market neighborhood and posted “you could literally film a Walking Dead episode in downtown SF.”

And John Kilroy, the CEO of Kilroy Realty and one of San Francisco's largest office landlords, on the developer's recent earnings call likened the city to a drug addict who “hit bottom” and wants to change.

Even so, stakeholders such as Kilroy, Musk, developers, hotel operators and tenants point to a handful of brightening spots on the city's economic landscape as San Francisco begins to piece itself back together.

"For the city itself, it's pretty obvious that something has gone terribly wrong," Rosinol, the Stack AI co-founder. "There are brand-new buildings but then the streets are pretty screwed, and it's pretty surprising that it is in such a state given how much economic movement is here. Even with all of that, San Francisco still has something you don't find easily anywhere else in the world. It has that hacker mentality at the forefront of new technology with a concentration of talent and companies that is unique to the city. There was no other place for us to build what we're building."

Despite growing momentum among tech companies such as Rosinol's that are leasing and in the market for more space, San Francisco is struggling to fight back against pandemic-related trends such as remote work that has left much of the city's downtown gutted and unlikely to return to pre-Covid traffic levels without a change in market dynamics.

Remote work is "a big and obviously a primary driver for our office vacancy rate," Ted Egan, the city's chief economist, said in an interview. "We've gone from having one of the lowest to one of the highest vacancy rates in the country, and that's mostly because we have a lot of tech companies in our office market and a strong reliance on public transit for getting people downtown. There used to be so much tech demand and people in the Bay Area, and that has been a major source of prosperity for the city, but that may not be the case anymore, since the question now is how much space they really need and will keep."

If there is a green shoot of life these days it is the recent surge in investor interest in artificial intelligence.

Over the past three months, artificial intelligence firms have signed nearly a dozen deals for office space in and around downtown San Francisco, underscoring the rising value of those companies.

San Francisco-based Anthropic is finalizing a sublease agreement with professional messaging platform Slack to take over its entire former headquarters space at 500 Howard St., which parent company Salesforce decided to offload last year as part of a broader cost-cutting effort. Once signed, the roughly 240,000-square-foot deal will mark one of the largest office leases to be signed since the beginning of the pandemic.

ChatGPT creator OpenAI is said to be in talks with Uber to take over about 200,000 square feet of the rideshare giant's headquarters space in San Francisco's Mission Bay neighborhood. The AI firm is looking to quadruple its current 500-person workforce, a goal that could result in the company eventually stretching its real estate footprint to as much as 500,000 square feet. Cloud-based AI firm Hive nearly tripled its office footprint in downtown San Francisco after finalizing a deal to sublease nearly 60,000 square feet from fellow tech company Okta to relocate its headquarters to 100 First St.

Those expansions have been helped by the nearly 50% leap in venture capital funding reported over the first half of the year, according to Raise Commercial Real Estate. About 30% of that $82 billion pool has been directed to fund AI companies.

Speaking of some of the smaller bursts of leasing that are beginning to flare up across the city's previously stagnant office market, CBRE’s Yasukochi said. "The biggest connection to positive demand is AI companies and some other smaller- to medium-sized tech companies looking to grow their footprints. It ultimately needs to be more broad-based to put a meaningful recovery in place and we need more tech companies — not just AI. But overall we’re starting to see the market stabilize and there are signs of increased future activity in the market that could start to build into a recovery."

article

3 Min Read

August 16, 2023 09:41 AM

Artificial Intelligence Firms Spark Optimism for San Francisco Office Demand

Leases by fast-growing tech companies are reigniting the city's dormant real estate market.

Katie Burke

Social

Average asking rents have fallen to about $57 per square foot from the $75-per-square-foot average reported in mid-2019, according to CoStar data. Plummeting rates have been a stark reversal of the city's 140% rent growth spurt throughout the decade leading to the pandemic, a run-up that far outweighed the national growth average of about 40% over the same time.

After avoiding cutting rents for as long as possible, office property owners are coming to terms with the depressed leasing landscape, maintaining asking rates as best they can while offering previously unheard-of concessions such as higher tenant improvement allowances and longer rent-free periods.

While any recovery may be slow, there are indicators that hint the worst of the city's vacancy, demand, leasing and property valuation woes have bottomed out. Tenant demand is starting to increase, according to Yasukochi, a trend that should translate into stronger leasing activity throughout the remainder of the year and into 2024. What’s more, the amount of vacated, unwanted office space added to the city's already flooded market is slowing as more people gradually return to in-person work.

On the walk to work from his home in Nob Hill to CBRE’s office downtown, Yasukochi said he's noticed office workers gradually returning and buses beginning to fill. He pointed out there are more pedestrians waiting to cross at some of the larger intersections.

"If you’re walking into the office in the middle of the week, this year at least, it feels a lot more crowded," he said. "Downtown on a Monday or Friday when there’s hardly anyone there, it feels less vibrant and you're more concerned about having fewer people around. But it's starting to feel like it's more concentrated than it was pre-pandemic, especially around the [central business district area.] It's creating some semblance of pre-pandemic normalcy."

While the scene in certain pockets of downtown San Francisco might appear more populated, the city's daytime workforce is still a far cry from what it was prior to the pandemic. Even with the latest return-to-office initiatives among companies such as Google and Salesforce, office occupancy has yet to crack 50%, according to data from Kastle Systems, which has tracked badge swipes in the nation's 10 largest markets since the beginning of the pandemic.

For the week ended Aug. 28, San Francisco buildings had one of the lowest utilization rates, at less than 42%, according to the data.

While there are signs of optimism, the blocks of empty storefronts and the absence of typical city noises underscore how far the city has to go before it resembles anything close to what San Francisco was prior to the 2020 lockdown. One of the biggest hurdles to contend with is what to do now that remote and flexible work appears to have become permanent fixtures in the city's economy.

One obstacle to restoring San Francisco's downtown workforce is addressing headache-inducing commutes, a significant deterrent to getting employees back to the office on a regular schedule and a major issue even before the pandemic's outbreak.

During the economic boom period that started around 2010, the high cost of housing across the region meant some San Francisco workers lived hours from their offices downtown, so traffic coming into and out of the city would build long before and after the typical rush-hour slogs. The pandemic provided employees with the chance to avoid the trek, and few have proved willing to revert back to the way it was.

San Francisco reported $485 million less in business tax revenue in 2021, a drop Egan said results from the city's large population of workers that are now able to operate remotely. Dwindling foot traffic has resulted in a slew of small-business closings that used to be reliant on the population of nearby office workers, which in turn has meant fewer people are visiting the city because it feels far emptier than it was before.

But it isn't just the office workers who have yet to return in full force. The city's downtown tourist population is now a fraction of what it used to be, with fewer than 21.3 million visitors last year compared to 2019's more than 26 million. The typical crowds of business travelers milling around the Moscone Center convention hall are gone, as are the international travelers who used to wander about the Ferry Building.

Though trending upward, hotel occupancy and average nightly rates across the city are still far below pre-pandemic levels, curbed by the lack of business once generated by a bustling convention schedule and a reliable stream of international travelers who have yet to make their return.

Anna Marie Presutti, vice president and general manager of the Hotel Nikko San Francisco near Union Square, said she's always described the business mix for her hotel as a three-legged stool that relies on convention business, the individual business traveler, and international visitors.

"Right now, unfortunately, none of those are performing well," she told CoStar News.

On weekends, her hotel sees a lot of leisure travelers who typically stay for a few days. Some are making their way down the coast, while others may visit the city as a pit stop before other destinations such as Las Vegas or Yosemite National Park. The hotel is also bringing in a bit of self-contained corporate business, generating some event revenue and providing the hotel a bit of a base, she said.

Even then, it is a far cry from the days before COVID-19 when larger corporate events such as Salesforce's annual Dreamforce convention would book any and every available hotel room.

Business travel to San Francisco has been closely linked with its return-to-office rate, said Brett Allor, senior director of market strategy and research at San Francisco Travel, the city's tourism promotion arm. That's not far off from other major metropolitan areas, but it's having a significant effect on travel to the city.

About 400,000 room nights have been booked as part of the city's convention calendar for next year, Allor said, less than half the annual 850,000 room-night average reported prior to the pandemic. He attributed the lack of convention activity to event cancellations, some of which happened before the pandemic because of cost and concerns over safety and street conditions.

Several conventions, such as Oracle's OpenWorld, have relocated to other cities such as Las Vegas.

"That's going to be an ongoing struggle," he said, adding that he sees improvement as he rides his bike to the city for the three days a week he's in the office. "I know the things the mayor and governor are doing are having an impact, but it's just hard to communicate that out."

For now, San Francisco Travel is focused on digging up any potential source of business to keep the city's convention calendar from drying up. It is working with officials in other cities that have convention centers undergoing renovations, such as Austin, Texas, and Denver, Colorado, to relocate some organizations' events, Allor said.

Despite the challenged forecast, San Francisco's ability to bounce back has Jon Bortz, chairman and CEO of Pebblebrook Hotel Trust, confident in the market's long-term viability.

When the Bethesda, Maryland-based hotel real estate investment trust started investing in the San Francisco area at the height of the Great Recession in 2010, Bortz said it was betting the burgeoning tech and life sciences industries would lead a rebound.

Even with the city's current troubles that were allowed to fester because of mismanagement and poor policies, the hotel executive said, many stakeholders are committed to its success because they have already invested "enormous" capital. He adds that Pebblebrook, for instance, has amassed a portfolio of eight hotels totaling nearly 1,700 rooms across the city.

Bortz views the widespread layoff and contraction news over the past year as part of the city's economic cycle.

"It just creates the next wave of new businesses being created, and ultimately the growth in some of them because they'll be successful with new technologies," he said. He points to growth in areas such as biotech and AI as indicative of San Francisco's boom-bust, failure-success culture.

To be clear, Bortz said, the city has plenty of issues it needs to address such as crime and homelessness, but progress has been made. A challenging financing climate has made it tough for Pebblebrook to acquire any new hotel properties — either in San Francisco or any other urban market across the country — but if it was his own money, Bortz said he would absolutely invest in what he considers to be the city's imminent rebound.

San Francisco has great fundamentals with an "incredible economic base," all of which is centered on innovation, he said. "So how can one come to a conclusion that that's not going to recover?"

Alex Holton considers the challenges facing the city to all be temporary sticking points that are far outweighed by its benefits and opportunities for success.

The principal of Canopy Project Management, a small San Francisco-based firm that has worked on headquarters projects for Silicon Valley giants such as Samsara and Andreessen Horowitz, said the recent groundswell of negativity has been too focused on issues that have always played a role in the city's cost-benefit equation.

"Those were ignored when the streets were bustling and everyone was making a lot of money," Holton said of concerns such as homelessness or retail vacancies. "If you live in San Francisco and are here for the day to day, I get that there are certain areas that are bad, but by and large, there are a lot of positive things about the city. We've all been through a couple of real estate cycles and believe the city will rebound. It's just a matter of time."

And that time could be coming sooner than most naysayers have predicted. While the city is still tangled in headlines declaring it overwhelmed with homeless encampments and a free-for-all for criminals, there are signs emerging that San Francisco's recovery — as uneven as it is — is gaining momentum.

Handfuls of new businesses from restaurants to nightlife venues are choosing to open new outposts downtown. Event programming such as outdoor fitness classes or movies in the park are drawing people to the greater Financial District area throughout the week. A growing pool of large employers such as Salesforce and Google are mandating more in-office days each week, meaning the tech buses that used to crowd the city's streets are once again popping up on the morning and evening commute routes.

"The Bay Area in and of itself is still an amazing place to live and work," Holton said. "We all want to be here. San Francisco is a beautiful city with an amazing climate, and there's no question that it will soon be bustling and fantastic again."

As for Stack AI's Rosinol, he said he's banking on the city's rebound, too, especially when it comes to recruiting new employees and convincing them the commute into the San Francisco office is worth it. The company, in the early stages of hiring its first few engineers, is working from coworking space in the downtown area as it builds up its workforce and transitions to a more in-person schedule.

"The more in-person days you have, the better, especially in the early stages of building a company," Rosinol said. "There are benefits to working side by side, but it's been hard to convince people to come. Statistically speaking, startups that stay in San Francisco have a better chance of succeeding than if they leave. Now we just have to believe that there are changes that could spark some motivation for everyone to come back."

Even some of the city's largest office landlords such as Brookfield Properties and Boston Properties remain committed to San Francisco, betting that the city's real estate market is just cycling through its typical boom-bust pattern.

"This is the fourth cycle I've been through where San Francisco has been down and out, but it always comes back," Brookfield CEO Brian Kingston recently told Bloomberg TV. "Longer term, there are a lot of reasons to be bullish on San Francisco. It is really the center for a lot of intellectual property within the United States and is a fantastic market to live and work in. It's going through some challenges now, but any forecast looking five, 10, 15 years down the road, technology is going to be a bigger part of our lives than it is today, and San Francisco is the center of excellence for that."