Capitalize
with Compromise

written by
Terrence Jones

With the future unclear for office and retail in San Francisco,
both commercial tenants and buildings owners
benefit from negotiating rents.

Most residential tenants in San Francisco have been stepping up and paying their full rent during the Covid-19 crisis. We have also seen layers of financial support come in for residential tenants, beginning with the $1,200 stimulus checks that started to arrive in April. However, in the same month, many tenants were affected by the massive layoffs in the hotel industry, retail stores, and service businesses like nail salons and restaurants. A large number of these now laid-off tenants only recently got their first unemployment checks. Despite all of this, the net result for many tenants in San Francisco is that they have been able to pay their rent. At this point in mid-June, the shelter-in-place order is starting to lighten up, and some tenants are returning to work. So, it’s likely that most renters will continue to pay their rent.

According to Government and Community Affairs Director Charlie Goss at the San Francisco Apartment Association, “The May owner survey results backed up the general consensus that most residents were paying rent. However, the commercial situation is not quite as cheery. Out of 400 commercial units the survey covered citywide, we saw the following:

57% (231 total) of commercial tenants were unable to pay rent for May.

20% (12 total) of respondents have had commercial tenants permanently close their business, break their lease, or unexpectedly give Notices to Vacate due to COVID-19.

19% (10 total) are granting across-the-board temporary rent reductions for their commercial tenants.

24% (55 total) of respondents do not believe they will ever be able to recoup lost rent.

In the Financial and Union Square districts, we saw that plywood went up on windows and doors were locked when the shelter-in-place order (SIP) was declared on March 16. Many hotels, the Disney store and Morton’s steak house were boarded up. No one was getting on a plane and coming to San Francisco for trade shows. SF Travel is funded by the hotel tax and facilitates corporate travel and hotel stays around trade shows at the Moscone center. SF Travel laid off 60% of its staff and they don’t expect to rehire anyone until January 2021. A client of ours has had his rent payments suspended by Applebee’s. Applebee’s instituted a 3-month rent hiatus through their force majeure lease clause. This may or may not work and some building owners are fighting it in court.

Even Starbucks is asking for rent reductions from all of its landlords. According to a Wall Street Journal article from May 19, 2020, “…in a Starbucks letter, which was reviewed by the Wall Street Journal, an executive said the company ‘will require concessions to support modified operations and adjustments to lease terms and base rent structures, so we can withstand this uncertainty together.’ Many landlords privately fumed over this request, even though Starbucks paid its rent in full for April and May at most of its stores. A company with an $86 billion market capitalization should be able to raise debt or more equity in the capital markets, enabling it to meet its obligations, these landlords said.”

Amazon has encouraged all of its employees who can work from home to do so until October. As of now, service businesses like barbers and nail salons have all been closed for 60 days. The number of home haircut and manicure instruction videos on YouTube are increasing almost exponentially. Even Supervisor Aaron Peskin, a SFAA member, sees the rough situation with retail tenants in San Francisco. He has suggested the city suspend the Commercial Vacancy Tax that he co-authored himself and was voted in by San Francisco voters just last November.

So, what is important in this environment to owners with non-residential units?

Insurance is important—The absolute number one thing owners need to stay on top of is maintaining their property insurance policies. The recent fire at Pier 45 is an example of how a building can be completely destroyed when you least expect it. Currently, there are many people living on the streets. The city of San Francisco’s politicians have chosen to attract and support a vagrant homeless group of people who live on the edge of society. The cause of the massive fire at Pier 43 is still under investigation, but the initial rumors are that the fire was related to transients who were camping on site. It is very difficult for owners to stop them from occupying the nooks and crannies of their buildings (front door stoops, for example). If a drug-addled or mentally ill homeless person starts a fire and your building is destroyed or damaged, your only real remedy is through your insurance coverage.

Occupancy is important—When a property is occupied with a tenant, there is a sense of mutual benefit; what is good for the tenant is also good for the owner. When businesses are open, those tenants keep an eye on the street and the owner’s building. The city has been citing owners who have been tagged by graffiti. This is less likely to happen to buildings with active businesses, with tenants (and customers) who keep taggers away.

But in these uncertain times, how are owners handling requests for rent reduction, abatement, non-payment, and tenants who are closing their shops and businesses? Charlie Goss said, “Owners are being proactive and open to working with their tenants when they can.”

I created several unique tenant categories to help understand and demonstrate the situation better.

“Gold” Tenants—These are tenants who have been operating at 100% during the shelter-in-place. They are maybe doing even better during the pandemic than they were before it hit. Tenants like Home Depot, Lowes, Costco, CVS, Walgreens, Trader Joe’s, Safeway, Whole Foods, BevMo, cannabis outlets, and neighborhood markets have been flourishing. In the last two months, people have been prepping for the end of the world by stocking their pantries, buying cases of wine and other alcohol, and purchasing freezers and filling them up.

“Silver” TenantsLike mushrooms that appear after the rain, this is a group of tenants that will be very quick to come back to life. Medical doctors, dentists, dialysis treatment centers, veterinarians, physical therapists, optometrists, insurance agents, CPAs, bookkeepers, and lawyers all have strong business in good times and bad times. These types of tenants are often well funded, have reserves in their bank accounts, bank credit lines, and have a recurring collection of clients in need of their services. Many of these businesses have been considered essential and have been open during the SIP with minimally interrupted cash flow. Some of these tenants might have problems for now, but for the most part, they will pay their rent and go right back to work as soon as they get the all-clear.

“Bronze” Tenants—These are businesses for which the recovery is less certain and they may not be able to come back as fully functioning San Francisco businesses. Hair salons, nail salons, restaurants, psychiatrists, physical therapy, chiropractors, real estate agents, and massage therapists are less likely to have a lot of cash reserves. Their operations have typically been touch-and-go over the past few years and they survive month-to-month, as long as the clients keep coming. Many of these businesses have been having a tough time operating in San Francisco due to high cost of employees, health care, rent, city taxes and a deteriorating retail market. Businesses like Specialty’s Bakery, Neiman Marcus, Pier 1 Imports, and The Art Institute have already thrown in the towel or filed for bankruptcy protection on the almost inevitable road to liquidation. The big challenge for restaurants, nail salons, and hair salons are the requirements for social distancing that will restrict them to 50% capacity for an undetermined amount of time. This will severely impact how many employees they can have and how much money a business owner of this kind can make—making it difficult to pay rent. In the real estate market, we expect to see less of a sustained downturn, as happened in 2008 – 2010 in San Francisco, and a faster recovery compared to that real estate recession. The volume of home sales and multi-family investment transactions have been down during the SIP order, but values have held. The lack of COVID-19 deaths here in San Francisco, relative to the rest of the country, does seem to be a very positive influence. (See my article in the June issue of SF Apartment Magazine.)

“Lead” Tenants—These businesses are in serious danger of never coming back. The “Amazon effect” was already giving these businesses a tough time. Businesses like retail clothing, vitamin stores, and travel agents. So many of us have been shopping online during the SIP, and it will likely become a permanent habit for many San Francisco consumers. Most medical professionals I have talked to feel there is a significant expectation in the medical community that we will be locked down again for round two of SIP in the fall as experts predict a resurgence of COVID-19. If this happens, we’ll likely see even more failures in this category. The common strategy for owners whose tenants run these businesses is to offer them a deep discount on their rent to keep them from going “dark.” Some of the retail stores around Union Square are being occupied by retailers who will likely reopen, but with a skeleton staff, and they will eventually fail. Other businesses in this category include group exercise studios and gyms. It is going to be a hard sell to switch from your solitary run in the park to a treadmill surrounded by a bunch of sweaty, coughing workout neighbors. 

How are owners handling these different categories? For the Gold tenants, it’s not likely that owners can get more money from their tenants who are benefiting from the crisis or at least not hurting, so most of them are just happy their tenants are doing well. If the lease comes up for renewal, owners may try to get an increase, but they also may not. For the Silver tenants, owners are working with them to try to give rent reductions or rent abatement with the hope that they survive. In the case of the Bronze and Lead tenants, owners have been forced to get creative. I hear it is not uncommon for an owner to ask the tenant to open their business back up and either not pay rent or pay only nominal rent on a month-to-month basis, while the owner attempts to market and re-tenant the space. The goal is to make the building look viable while doing everything you can to swap out a Lead tenant for a Bronze or move from Bronze to Silver tenants. If owners can get a better tenant quickly, without spending too much on tenant improvements, then they are winning the game.

What does the future hold for office and retail in San Francisco? We will continue to see the market evolve under the Coronavirus crisis. For some retail businesses, this will be like the dinosaurs getting wiped out by an asteroid, except this “Extinction Event” would be the result of Amazon followed by COVID-19. For many, it will not be the end, but it will be a changed world. We can be certain of one thing, until we have herd immunity, a test for everyone, or a vaccine, the “new normal” for San Francisco retail will continue as is, and it will be painful to both tenant business owners and building owners. My advice is to do whatever you can to work with your tenants, so you can both survive.

Terrence Jones is a Senior Broker Associate with Corcoran Global Commercial. He can be contacted at (415) 786-2216 or terrence@terrencejonesSF.com.