U.S. Commercial Real Estate Occupancy Rates Were Hit Hard in 2023

Bay Area Leads in Vacancies. Is a recovery ahead in 2024?

Commercial occupancy rates throughout the United States have taken a beating  since the pandemic because of remote working. The San Francisco Bay has experienced the biggest rise in commercial real estate vacancies of any U.S. city or region leading some building owners surrendering to lenders or selling properties at deep discounts to investors.  We checked in with William “Buddy” Rowell, Director, Business Litigation, Fennemore Wendel for insights on the commercial real estate sector in the Bay Area.  

Almost all major San Francisco companies whose leases came due slashed their office space in 2023 due to remote work fueling a record-high vacancy rate of 34% at the end of September. Do you think this trend will slow in 2024?

No, I think this growing vacancy trend in the Bay Area will unfortunately continue through 2024.   

WeWork’s recent bankruptcy filing is a major hit for the Bay Area office market as it leased or purchased nearly 2 million square feet of office space across 32 buildings, representing approximately 2.3% of all the office in the Bay Area. Source: San Francisco Chronicle. Read here.

Additionally, as discussed by Prof. Stijn Van Nieuwerburgh of the Columbia Business School in a recent 60 Minutes interview, many commercial tenants leases are still coming due.  With the trend continuing for remote or hybrid work, many of these tenants will have to make tough “active space decisions” — do they increase or renew at their current footprint, or do they reduce their space?  Prof. Nieuwerburgh describes this as a “trainwreck in slow motion,” anticipating that many commercial tenants will chose to significantly decrease their office footprint, leading to his estimation of a 40% reduction in the value of commercial real estate. View interview (Video | Facebook)

Which leads to the next issue – several building owners in San Francisco surrendered to lenders last year.  Do you see this continuing in 2024 or in your opinion will the volatility begin to level? 

With the anticipated continued increase in vacancies, current high interest rates, and the anticipated slowing of the economy in the first half of 2024 which likely will lead to an increase in defaulting tenants, many commercial properties are or will soon be underwater; accordingly, I don’t foresee a slowing in the immediate future, rather, I foresee a likely steep increase in commercial buildings being surrendered to lenders or being sold at deep discounts.  Recent examples of these deep discounts are: 550 California St, 350 California St, 123 Townsend, and 60 Spear St.  Source: CoStar. Read here.

Is there any silver lining here? 

Yes – for both tenants in the immediate future and for landlords who are willing to bet on the long-game. 

For tenants in the immediate future, there are some great, long-term deals to be had. Commercial landlords are very hungry right now to stabilize their balance sheets, accordingly, there are some great, long-term lease opportunities to be taken advantage of for those business owners who are forward thinking and willing to bet on the economy heating up, starting in the 2^nd half of 2024 with the anticipated drop in interest rates.  Those who make this bet will likely be positioned well for the next 5 to 7 years with fantastic, stable lease terms in Grade A buildings. 

For landlords, the savvy ones know that the best way to make money during any economic downtown is to take calculated risks. Those who have cash and are willing to bet on better days ahead in the commercial real estate market will dump their weaker holdings, while at the same time, acquiring new, better positioned buildings at bargain basement prices; particularly as anticipated interest rate cuts make financing new deals more appetizing for commercial investors and developers. In the Bay Area, which has always been very reliant on the tech industry, I think that is a pretty good bet; especially, with the boom in AI and with many tech companies (Google, Amazon, Meta, Apple, etc.) implementing return-to-office mandates with the realization of the overall value of in-office collaboration. Personally, as someone who has spent his entire life in the Bay Area and grew up in the heart of Silicon Valley (Palo Alto), I would always bet on tech rebounding, which I believe will push up the entire Bay Area economy, including the commercial real estate sector. 

Additionally, conversions of existing commercial buildings present a unique opportunity.  One of the current bright spots in the Bay Area real estate market is multi-family investments, including conversions. With the ever-present housing shortage in the Bay, I believe that this will remain a smart investment opportunity – the housing market will remain hot and with interest rates likely dropping, conversions may become much more palatable.  We’ve already seen San Francisco move in this direction and anticipate that it will spread to other cities in the Bay. Source: Axios Read here.

The industrial market in the Bay Area has also been one of the most stable markets, as average asking rates post-pandemic have continued to climb steadily in the region  Overall, there are some very unique opportunities to repurpose commercial buildings and I believe that the savvy landlords and developers will take advantage of this. Read CBRE Snapshots here.

 Can you share some of the real estate issues you have handled in this volatile market?

I mostly represent commercial landlords and developers and as a litigator, I typically see an uptick in my real estate litigation work several months after the market begins to turn downward.  With the protracted volatility of the commercial real estate market we’ve experienced in the Bay Area, I’ve handled several development deals, including build to suit (“BTS”) deals, which have gone awry because of the dramatic decrease in end-use demand for the anticipated commercial space.  I’ve had an uptick in commercial unlawful detainer matters because my landlord clients can no longer financially carry defaulting tenants, which has also included negotiating work outs for the terminated leases due to threatened bankruptcies by some of the tenants. I’ve also seen an increase in real estate investment partnerships disintegrate due to the financial pressure, which often leads to litigation to unwind the partnership.  I don’t see a slowing of my litigation work anytime soon; but because the San Francisco Bay Area economy is diverse and expansive and because I know there are so many savvy large tenant clients, developers, and commercial landlords in the Bay, I’m very optimistic that my real estate transaction partners at Fennemore Wendel will see an uptick in their work, particularly in land use (including re-zoning of properties), landlord/tenant lease negotiations, and sale/purchase of commercial properties.