Defaults raise alarm over stability of San Francisco’s commercial property

Lenders to San Francisco’s beleaguered commercial real estate market are braced for defaults on billions of dollars of debt after the owners of the city’s largest shopping mall and biggest hotel ceased loan payments and handed back the keys on what was once the city’s most valuable property.

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

Days earlier, New York-listed Park Hotels & Resorts said it expected to hand over ownership of two of its prime San Francisco hotels — the Hilton Union Square and Parc 55 — after it stopped making payments on a $725mn loan. The hotels were valued at more than $1.5bn when the loan was issued in 2016, suggesting that its owners believe their value has more than halved.

The large defaults were the latest in a number of distress signals by landlords of offices, hotels, apartment blocks and retailers in San Francisco. The city has been struggling with a steep decline in tourism and business travel since the coronavirus pandemic, downsizing by technology companies, an exodus of residents, and international scrutiny over crime, drug use and homelessness.

Park Hotels chief executive Thomas Baltimore said: “San Francisco’s path to recovery remains clouded and elongated by major challenges” including “concerns over street conditions”.

The Westfield mall has been half empty after brands like Nordstrom left, in part because of “rampant criminal activity” and as foot traffic downtown has not recovered after the pandemic. Westfield said its sales fell sharply between December 2019 and 2022, compared with an average increase in sales across its other US malls.

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

That repricing could trigger a knock-on effect that makes it harder for property owners to refinance their debts as banks become even more cautious about lending. Some US banks have been reducing their exposure to the commercial real estate market after the recent turmoil in the regional banking industry — and the prospect for losses is particularly acute in San Francisco.

“We’ve hit an inflection point where we’ve seen a lot of the [broader economy] headlines come to fruition in the San Francisco market,” said Lonnie Hendry, head of commercial real estate at Trepp, a data provider. “The dominoes have fallen a lot faster in San Francisco than they have in other places.”

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 $240mn loan for its tower on 600 California Street in April. Elsewhere downtown, Elon Musk’s Twitter stopped paying its rent in November, forcing its landlord to default on a $400mn loan.

As San Francisco’s economic situation remains uncertain, the repricing could have further 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,” said Hendry. “We don’t know the floor yet.”

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

Data from Moody’s, the rating agency, showed that 50 per cent of CMBS office loans that mature in 2024 are at risk of delinquency.

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

Just outside San Francisco in the wider Bay area, tech giants including Google and Meta have put swaths of their vast offices up for sublease. One executive at a firm that services defaulted CMBS loans said it had created an “uncomfortable position” for landlords and lenders that have loans secured against the campuses. “If they’re not using the space then it is logical to infer they will not renew the lease and so you have a major problem coming 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 downturn in tech and the move to remote working, leading to less demand for office space.

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

“It is clear the assets won’t be worth more than the debt balances even if they put in more cash so [landlords will] ask themselves, am I better off just handing the asset back to the lender?”

Office vacancies have risen to 30 per cent in San Francisco, the highest of any big 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 just two large US cities where rates have not increased. Hotel bookings in San Francisco have been susceptible to a drop in travellers from China and as safety concerns have prompted business conventions to relocate.

Club Quarters, a business hotel owned by Blackstone Group, has been delinquent on a $274mn loan since 2020. The Huntington Hotel, a historic luxury hotel in Nob Hill, defaulted on a $56mn loan originated by Deutsche Bank last year and was then later sold at a foreclosure auction for about half the size of the loan.

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

The accelerating number of defaults across multiple property asset classes has raised concerns about a drop in city tax revenues that could fuel a “doom loop” — an economic and social spiral that becomes impossible to reverse. Large office buildings trading at heavily discounted prices would quickly erode a crucial part of the city’s tax base. San Francisco has projected a $780mn budget deficit over the next two years, which will affect its ability to provide public services or offer incentives to businesses to help revitalise 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 plunged.

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

“When you get below the point where that vibrancy that draws tourists, workers and shoppers is gone, that’s really hard to come back from,” he said.