by Zach Drucker
San Francisco’s office space market might not be the first thing you think of when considering industries affected by COVID-19. In fact, for most people, office space would probably be far down on that list—if it makes the cut at all. That’s because many of us take having a healthy office space market for granted. But for large, dense cities like San Francisco, the health of the office space market plays a vital role in keeping the City functioning and the local economy booming.
THE STATE OF SAN FRANCISCO’S OFFICE SPACE MARKET BEFORE COVID-19
At the start of 2020, San Francisco’s office space market owned the title of being the hottest market in the most expensive commercial real estate market in the country. That’s right, San Francisco’s office space market topped that of New York City. According to real estate firm CBRE, average office rents in San Francisco rivaled other global metropolitan powerhouses, including Tokyo, Beijing, Hong Kong, London, and New Delhi (although San Francisco’s $130 per square foot in top buildings was far below a whopping $322 per square foot in Hong Kong).
The point is companies have, for many years, wanted to be in San Francisco. High rent prices combined with limited available office space, however, have made it challenging to expand in or relocate to San Francisco. As demand in office space outpaced supply—especially from the tech industry—it seemed nothing could stop San Francisco’s office space market from reaching new heights.
Not even the recently passed Proposition E worried commercial real estate brokers. Passed in the March 2020 election, Prop E sets a moratorium on office development if state-mandated affordable housing goals are not met. Contrary to the intended goal of the measure, Prop E might actually benefit the commercial real estate industry. As we explained in our March 2020 election recap, many believe Prop E will tighten the market. By restricting new office space from being built, even more pressure will be placed on demand, in turn driving up the price of office space.
In short, prior to COVID-19, San Francisco’s commercial real estate industry appeared unshakeable.
THE IMMEDIATE IMPACT OF COVID-19 ON SAN FRANCISCO’S OFFICE SPACE MARKET
COVID-19 prompted cities across the country to shut down, bringing the national economy to a standstill. Almost immediately, companies knew they were in trouble. Restaurant and retail businesses relying on foot traffic, as well as startups and mid-size companies banking on their next funding round felt an immense and instant impact.
This uncertainty for companies does not bode well for office landlords, whose entire business centers around risk management. Landlords want to bring on financially stable companies that they can help succeed. When faced with a potential economic downturn, landlords will do everything in their power to keep existing tenants, even if that means negotiating with tenants on a variety of concessions, including reducing rent, adding more tenant improvements, or waiving rent all together. It all depends on the tenants needs.
Providing rent relief is different than negotiating new terms on a lease. Negotiating new terms on a lease can only take place in a couple of instances. If a tenant’s lease needs to be renewed, the tenant has the ability to negotiate new terms with a landlord. This is certainly a possibility in our new reality as companies look to downsize or decide they need less office space with much of their employee base working from home. Pauses on construction can also trigger a negotiation of new terms since they delay move-in dates. With occupancy rates in San Francisco dropping from around 90 percent to 10 percent due to COVID-19, you can bet that landlords will be looking to keep their tenants at all costs. If not, they could be operating in the red in no time.
THE ECONOMIC IMPACT OF COVID-19 ON SAN FRANCISCO’S OFFICE SPACE MARKET
As we highlighted in our last policy blog about the impact of COVID-19 on San Francisco’s budget, the City is facing a $1.2 billion to $1.7 billion budget shortfall over the next two years. A majority of this budget shortfall comes from lost tax revenue. With many of the taxes relying on people buying goods (sales tax), visitors staying at hotels (hotel tax), travelers using SFO (airport transfer fee), and other everyday activities of a thriving city, the impact of shelter-in-place will be felt immediately.
In contrast, it will take more time to understand the true impact of the shutdown on revenue from taxes related to office space, including the following.
Property Taxes: Due to the way taxable value is determined under California’s Prop 13, changes in property tax revenue will lag behind other revenue losses. Taxes for the fiscal year are based on the property values from January 1 of the previous year. For example, property taxes for the fiscal year 2019-2020 are based on property values as of January 1, 2019. As lease rates decrease, we could see buildings lose their value. According to findings from San Francisco’s Budget Outlook Update, both the limited (best-case) and extended (worst-case) scenarios project commercial retail property valuations to decline by 20 percent in the fiscal year 2020-2021.
We might also see owners invoke Proposition 8 to temporarily reduce their property taxes. Owners with a high tax basis could apply under Prop 8 to have their taxes temporarily reduced if many of their tenants go under or they incur a high number of vacancies. However, it remains to be seen how many building owners will pursue this path. If invoking Prop 8 does become a trend, localities relying on revenue from property taxes will undoubtedly feel the impact.
Transfer tax: Driven mostly by commercial real estate, property transfers are highly dependent on interest rates, credit availability, and the relative value of San Francisco real estate compared to other investment options. With new office deals paused and construction delayed, transfers have come to a complete halt. That could mean the City misses out on a lot of money. Consistent with the City’s experience during the 2001 and 2008 recessions, San Francisco expects the current year revenue reductions to be between $87.7 million to $117.7 million, according to the 6-Month Report projection. Looking ahead, the best-case scenario has San Francisco returning to prior projections by the fiscal year 2020-2021, while the worst-case scenario has the City at a $62.4 million loss. Fortunately, both scenarios project a return to long-term historical averages by the fiscal year 2021-2022.
Commercial Rents Tax: San Francisco collects a 0.3 percent tax imposed on commercial rents. This poses a problem to the City in the scenario that rent prices start dropping. Unfortunately, that scenario could easily happen.
Note: In June 2018, San Francisco passed Proposition C to fund early care and education by imposing an additional 3.5 percent tax on commercial rents. The City collects this money and stores it in a reserve, but it cannot use any of it until the outcome of the ongoing court fight ends.
Affordable Housing Linkage Fee: In the fall of last year, the Board of Supervisors passed legislation to substantially increase the linkage fee on nonresidential developments. The fee will increase from $28.57 to $69.60 per square foot by 2022. Now, every new office development project will generate a substantial amount of funding for affordable housing. So much so that according to the San Francisco Business Times, the new fee would generate “$400 million to help fund nearly 2,000 homes for low-income, moderate-income, and homeless people during the next seven years.” As construction slows down, the delay could affect a number of affordable housing projects in the pipeline. However, this stoppage should not last long as construction will eventually scale back up.
To adequately fund San Francisco, the office space market needs to remain stable. While the exact impact of COVID-19 on these tax revenue streams might not be felt yet, that could change dramatically in the coming months.
SAN FRANCISCO’S OFFICE SPACE IN THE AGE OF COVID-19
Even before the shelter-in-place went into effect, many tech companies in San Francisco implemented mandatory work-from-home policies. Talking to Buzzfeed News about the decision, Twitter Chief of HR, Jennifer Christie, said, “We might not go back”. She predicted COVID-19 would fundamentally change the way we work. Many companies are seeing productive results from their employees working at home, and they might very well decide to keep part of their workforce at home—especially in the short term, when it might be in the best interest of their employees’ health.
With cities looking to reopen, the decision to work from home will come to the forefront. In San Francisco, it is likely companies, especially in the tech industry, will delay sending employees back to the office until months after the City reopens. This has left many wondering what the office will look like when we stop sheltering in place.
As part of their responsibilities, Mayor London Breed’s Economic Recovery Taskforce will decide how each industry will go back to work. In an interview with the Washington Post, Mayor Breed outlined one of the taskforce’s main goals, which entails working with public health officials to devise guidelines on how each industry can go back to work.
Still, no one has found a definitive solution on the best way to open offices in a reliable and safe manner. We will be entering one of the largest human experiments in history as we look to send people back to work amid COVID-19 concerns. Decisions will need to be made on a number of issues. Referencing Cushman & Wakefield’s steps to ready the workplace, here are a handful of questions companies, policymakers, building owners, and other leaders are currently debating:
Preparing the Workforce:
- Should companies stagger their employee’s start times or split their workforce into different squads that alternate which days they come into the office?
- Who can come into the office? Should the government or businesses be able to bar people at a high risk of contracting COVID-19 from coming into the office, or does that responsibility fall on employees themselves?
- Should buildings have a barrier to entry at the door such as a thermometer check, mask requirements, or QR code with the user’s health status?
- At what point do either of these cross the line of invasion of privacy?
- What’s the safest, most effective, and non-invasive way to administer temperature tests?
Reducing Touch Points and Increasing Cleaning:
- Can landlords automate building technology such as elevators?
- How do you filter the air in the office?
- How often will the office need to be cleaned?
Implementing a Social Distancing Plan:
- How will offices be retrofitted to maintain the six feet rule required by social distancing?
- How do you manage traffic flow in and through the office in a practical yet safe way?
- Can more than more one person be in the bathroom at the same time?
Coming up with answers to these vital questions will be critical to allowing San Francisco to reopen. One thing is for certain: whenever we return to the office, it will look vastly different than before COVID-19.
OFFICE SPACE IS AT THE CENTER OF SAN FRANCISCO’S WELLBEING
COVID-19 has forced us to rethink how we go about our everyday lives—even giving up the office, a vital communal space, in the name of public safety. Office closures not only hurt building employees, including janitors, security teams, and other maintenance staff. They also cause other ripple effects. Industries that provide services to offices, such as caterers, event planners, and convention organizers will also suffer.
Most of all, the decline in business hurts the financial health of the City. For San Francisco to return to pre-COVID-19 numbers, the office space market needs to regain its footing. Time will only tell how San Francisco will come out of this pandemic. Now more than ever, we must rely on our leaders, including those in the tech industry, to guide us toward a better and safer future for all.