Higher hotel occupancy and rates, driven in large part by a robust citywide convention schedule, had made San Francisco a target for hotel investors looking to buy into a high-barrier-to-entry market.
But more recently, a combination of higher cost of capital, lower overall demand, a wide bid-ask gap on pricing and distressed hotels in the news has investors taking a step back, at least for the time being.
Pebblebrook Hotel Trust Chairman and CEO Jon Bortz has both a long-term outlook on the health of the San Francisco hotel market and clear eyes on its current challenges.
San Francisco has been a market of interest for Bortz for decades, from his time leading real estate investment trust LaSalle Hotel Properties through his current role at Pebblebrook, which owns eight hotels in the city.
Pebblebrook acquired its first San Francisco property in June 2010, the Sir Francis Drake Hotel, now the Beacon Grand, for $90 million. It was a long-term hold for the REIT, which sold it in early 2021 for $157.6 million of net proceeds.
“We had a view that San Francisco was going to enter a strong growth phase driven by these creative inventions in technology and how that technology would be used,” he said, adding it was also a time when people were drawn to cities for the restaurants, museum, retail and culture.
Like many other hotel REITs, Pebblebrook currently sees better uses for its capital doing things other than buying hotels. However, while Pebblebrook is not in the position to buy in San Francisco, Bortz said that’s where he would invest.
“If it was me and my personal money and I was investing in hotels and I had a five- to 10-year horizon, I’d be buying in San Francisco,” he said.
Not all potential investors agree with him, and much of that has to do with negative perceptions of the city, driven in part by recent news headlines.
Distressed Hotels
In June, hotel real estate investment trust Park Hotels & Resorts stated it ended payments toward a $725 million non-recourse loan it had for the 1,921-key Hilton San Francisco Union Square and the 1,024-key Parc 55 San Francisco. The 4.11% interest rate loan is scheduled to mature in November. Park said it intended to work in good faith with its loan’s servicer to determine a path forward, “which is expected to result in ultimate removal of these hotels from its portfolio."
Park President and CEO Thomas Baltimore Jr. said in the news release that it was in shareholders’ best interest for the company to materially reduce its exposure to the San Francisco market.
“Now more than ever, we believe San Francisco’s path to recovery remains clouded and elongated by major challenges — both old and new: record-high office vacancy; concerns over street conditions; lower return to office than peer cities; and a weaker-than-expected citywide convention calendar through 2027 that will negatively impact business and leisure demand and will likely significantly reduce compression in the city for the foreseeable future,” he said. “Unfortunately, the continued burden on our operating results and balance sheet is too significant to warrant continuing to subsidize and own these assets."
In the company’s second-quarter earnings call in early August, Baltimore expected the San Francisco market to recover, not in one to three years as previously thought, but in five to seven.
"It's a market that only has 32,000 rooms, so it will come back," he said. "We'll follow the job growth. We'll follow the opportunities and where we can generate the returns. So, we certainly wouldn't rule out San Francisco."
The two Park hotels together comprise roughly 3,000 rooms in the market, said Michael Bellisario, director of equity research and senior analyst at Baird. Group business is vitally important to fill these hotels. The other issue is both require capital expenditure projects in the near future, and that’s on top of the upcoming loan maturity and need to refinance at a higher interest rate.
“It's an economic decision for them,” Bellisario said.
Park is still negotiating with its lender as the keys haven’t been handed back yet, but it’s a matter of how much that loan needs to be paid back, what refinancing would cost and how far back it needs to be rolled, he said. That math just doesn’t pencil relative to the alternatives of buying back stock, reinvesting in other properties, potential acquisitions and other debt repayments.
“It is not just about San Francisco,” Bellisario said. “It’s about group, those hotels’ CapEx needs and then all the things they could be doing within their portfolio and on the capital allocation front as well.”
What helps Park in this situation is that the loan for the two hotels is a commercial mortgage-back security, Bellisario said. Stopping service on the loan doesn’t risk the company. It’s not bank debt or equity pledges. The collateral is the hotels. If the loan was secured by equity in the company, Park would be stuck with the hotels and wouldn’t have this optionality.
“The worst-case scenario, and maybe it’s an overly simplistic way to think about it, is that you need to save the company, so you cut off an arm or you cut off a hand to save the body, so to speak,” he said. “It’s hard to tell today, but maybe giving back the keys is actually addition by subtraction.”
Transaction Environment
CoStar data shows there have been six San Francisco hotel transactions since the start of the year, with the most expensive deal reaching $65 million for the 134-key Huntington Hotel in Nob Hill. There were 16 transactions in 2022, topping out at $271 million for the 336-room Ritz-Carlton San Francisco as part of the Watermark Lodging Trust portfolio deal.
California-focused hotel broker Atlas Hospitality Group has a lot of clients in the San Francisco Bay Area, and many of them are not looking to buy now, Atlas President Alan Reay said. Prices are not at a level that is attractive enough to make up for the risk, and they don’t expect things to turn around in 12 to 24 months.
The city of San Francisco has high barriers to entry, and it’s difficult to build anything new there, he said. From an investor’s standpoint, that’s a desirable trait, particularly when paired with existing properties that can be acquired at prices below replacement cost.
“Well, you can definitely buy assets at below replacement cost,” he said. “The big question is, how long do you have to carry them?”
Carrying hotels with thousands of rooms in the market can strike a blow to cash flow, and that’s dissuading a lot of investors. The hotels more attractive to buyers now are smaller, with 100 to 200 rooms.
To turn around the deals environment, there needs to be a change in how the city is dealing with crime and homelessness, Reay said. Improvement there will help bring conventions back to the city and business back to the downtown area, he said.
“Without that getting cleaned up, you're not going to have a lot of investor interest until prices hit what is perceived as rock bottom,” he said.
Some investors are interested in buying hotels to convert them to housing, Reay said. There are incentives for cities such as San Francisco to be more open with rules and regulations to create more affordable housing.
Hotel owners who aren’t forced to sell or refinance by their financial circumstances won’t, he said. They know they can likely weather the storm, but they also don’t want to sell at prices below where they value their properties. Buyers, likewise, are waiting for more favorable pricing.
“That sums up the buyer and seller disconnect,” he said. “Sellers want prices that were 2021, ’22, and buyers are saying, ‘Yeah, OK, that’s gone.’”
An Owner's Perspective
When Bortz was CEO of real estate investment trust LaSalle Hotel Properties from 1998 to 2009, the REIT looked at several hotels in San Francisco but never acquired one because the growth opportunities and pricing weren’t right.
Conditions were different in 2010 when Pebblebrook acquired the then-Sir Francis Drake Hotel. The hotel was an attractive investment at the time, Bortz said. When Pebblebrook bought it, the hotel generated revenue of about $40 million annually, part of which came from a Starbucks lease. It had huge operating leverage, though, and the team saw the potential in the market.
Granted, at the time, apartment rents in San Francisco were lower, but the city was still among the more expensive U.S. markets to live in, he said. What Bortz and his team saw in San Francisco was the return that would come from the growth of the technology and life sciences sectors.
“It all had to do with this incredible migration back into the city and the growth of new businesses in the city,” he said. “One of the things we always found appealing about San Francisco was the amount of venture capital that got invested in businesses in the Bay Area.”
It’s also one of the things that Bortz still finds attractive about the market. That’s why he thinks the city will recover, just as it has done in prior downturns, he said. The amount of capital that goes into new businesses in the San Francisco area is about 50% to 60% of the total investment in the U.S.
The culture in the city is also a draw, he said. It’s OK if people fail because they’ll just try again and experiment. In other cities, it’s a disaster when people are laid off. In San Francisco, layoffs lead to a wave of new businesses being created. The latest is the surge in artificial intelligence technology. While it alone won’t be the savior of San Francisco, it’s indicative of the city’s boom/bust cycle.
Pebblebrook currently owns eight hotels in San Francisco, with properties in business districts and tourist areas, including the 1 Hotel San Francisco that opened in June 2022 following a repositioning from the Hotel Vitale. Over the years, Pebblebrook has sold off some of its San Francisco hotels without acquiring more, but that’s not indicative of the company’s feelings about the city, Bortz said.
When Pebblebrook acquired LaSalle in 2018 in a deal valued at $5.2 billion, Pebblebrook more than doubled its hotel portfolio to 66 hotels. It immediately began refining its portfolio, selling five hotels, including the Park Central San Francisco, for a total of $820.8 million in closing the LaSalle deal. It continued a strategic disposition plan over the following years, selling off several San Francisco properties among others.
The deal gave Pebblebrook an oversize exposure to the San Francisco market, making up roughly a quarter of its earnings before interest, taxes, depreciation and amortization, Bortz said. Over time, the company made decisions to reduce its exposure to primarily urban markets and find a better balance between leisure and business demand.
The REIT isn’t interested in buying another hotel in San Francisco, or any other city, right now, Bortz said. At the moment, given market conditions and the company’s stock value, acquisitions are off the table when there are better uses for the company’s capital, such as renovation projects and stock buybacks.
“When we look at values compared to risk-adjusted returns, and we look at our unique opportunity to sell assets and buy our stock back at a big discount, it's impossible to justify any acquisitions, whether they're in cities, whether they're in San Francisco or whether, frankly, they’re resorts,” he said.
San Francisco is the punching bag of America now for its progressive politics, and probably appropriately so, Bortz said. The city tried things out that didn’t work, so now it has to fix it. The politics and policies are changing. The city has a long way still to go to address crime, mental health concerns and homelessness, but it has also come a long way. On a recent trip to the city, he said he saw progress made with parts of the city that look cleaner and safer than they did before the pandemic.
San Francisco has great fundamentals and an incredible economic base, Bortz said. It has investment in technology, AI, bioscience and other industries along with strong educational institutions.
“It is the center of innovation in the world, so how can one come to a conclusion that that's not going to recover?” he asked.