Is the glass half empty or half full when it comes to San Francisco’s regeneration and the multifamily and commercial real estate market? The answer will depend on whom you ask. 

 

 

Billionaire Michael Moritz recently issued a scathing indictment of a city that bans plastic straws but permits plastic needles and, according to tallies, there is enough vacant office space in San Francisco for 160,000 employees.

Matthew C. Sheridan, partner and the head of investment sales at Maven paints a rosier outlook for owners and tenants alike. Although recognizing the market has been bruised and battered, he says it is poised to make a comeback.

We discussed this and a range of topics with Matthew in a recent meetup. Edited for length and brevity.

Matthew, it’s been said that when you are down, the only way to go is up, and San Francisco is certainly down but not out. You are optimistic that San Francisco’s multifamily market is on a rebound. Explain why. 

There is no doubt that the city has gone through a rough patch in recent memory and there are systematic problems. I.e., a downtown that has lost its vibe, a fentanyl crisis that has ravaged many neighborhoods, and a very bureaucratic approach in the way the city conducts its business.

However, we have weathered many cycles. San Francisco saw a giant boom during the war years, a huge boom during the gay rights era, and a crazy dot com effect, and it is home to world-class educational institutions, etc. So, you don’t have to be a tea leaf reader to know that San Francisco will bounce back. Buyers know this.

 

We have seen a lot of mom-and-pop owners, in particular, who have gone out of business because one, they could not sustain their livelihoods because of a mountain of rent debt that accrued during the pandemic, and two, San Francisco’s regulatory regime has simply become too complicated and restrictive. But you are saying that there is a fluid nature of buyers and sellers and new buyers want to scoop up properties? And do the numbers support that? 

As for numbers over the last two-year period, there were brisk sales in the small-building sector, meaning buildings with 5-9 units.

 

We can see why San Francisco owners would like to sell their buildings for the reasons cited. But are there compelling reasons to BUY buildings? 

We regularly encounter new first-time investors who are sensing opportunity because sale prices and the rental market had cooled off. A lot of listings sit on the market due to unrealistic pricing, with the seller and or the broker unable to meet the market.  Buyers have to dig deep into the underwriting or disclosures to uncover “finds”  these buyers, however, need to be prepared and ready to move fast, in terms of making an offer and on the right terms.

What we’ve found is that many buildings have been sitting on the market for a protracted period of time and the seller is frustrated. The seller gets impressed when the potential buyer has all their ducks in a row and is ready to move quickly.

As part of this, the buyer needs to have knowledge of the building, and its inner workings. It is helpful to have a contractor walk through and size up the situation so that the would-be buyer does not have to wait a week for a generalized inspection report, a pest inspection report, and the like. They should be able to make a verbal call when they see the property meets their criteria.

The key is to find the right vendors, and the right broker, and, last but not least, tether yourself to an attorney that understands the nuances of landlord-tenant law. Buyers can be exuberant about finding a gem, only to find themselves in legal trouble later on when there is residue or acrimony from the rental relationships. Purchasing an investment property with illegal units is an easy example.

 

Clearly, when properly staged, a vacant building will sell more for one that is tenant-occupied. An easy math figure is that for every $1,000 in rental income that can be realized in a unit, it can sell for $100,000 or more. But vacant properties are hard to come by nowadays. 

You are right that we rarely find a vacant building in San Francisco. Sometimes, we’ll find half-vacant buildings, and this raises some concerns. Lenders generally don’t like a high number of vacancies because of a lender wants to see cash flow and want to verify that units are leased up in the first six months, or hold back funds to finish renovations and lease the units out. Rest assured, the added risk will likely translate to higher interest rates.

 

Tenant buyout agreements are one of our core practices here at Bornstein Law. Have you broached the conversation of buyouts with clients? 

Most of my clients are not super aggressive with buyouts. I am aware of them but they tend to occur in smaller buildings. Of course, there can be payouts for tenants when an owner or a close relative wants to occupy the premises they intend to buy, and these payouts can be substantial.

 

Owner move-in and Relative move-in evictions are different creatures than buyout agreements.  But I think where you are getting at is owners will pay for a vacancy. 

Yes. The city has constructed scenarios that place a high value on long-term tenancies. There is a premium for a vacancy, and tenants know this. I call this “tenant equity.”

 

Our office encounters instances when tenants owe $30, $40, $80K, or more in rent debt. Would you call these “non-performing” units that hinder the sale of the building because the owner wants to part ways because they haven’t been paid rent in 2 years? 

During the heart of the pandemic, this was an issue but less so today because with the moratorium lifted and the courts firing on all cylinders, tenants are now accountable for rent payments.

In general, I estimate that roughly 15% of all tenants in rent control jurisdictions are gaming the system—a system that was designed to preserve affordable housing—and whose actions perpetuate the supply and demand imbalance in housing. These situations include folks who have turned their units into a pied-à-terre, despite owning a home elsewhere or have simply moved out and subletting to another tenant.  During COVID, there were numerous cases I encountered where residents who had the means to pay, simply refused to do so because they were not compelled to do, and just left when they were forced to pay—always intending to exit.

Landlords in these situations, I regret to say, will be burned. And severely burned, despite billions of dollars that the government has offered in rental assistance.

 

We totally agree, and we call this permanently lost income. Landlords have been to our knowledge the only sector of the economy that has been asked to bear the brunt of the pandemic and provide a service for free. As a bit of critique to your statement, San Francisco tenants who are not paying rent can still remain implanted if they provide a convincing argument that failure to pay rent is owed to a COVID-related hardship. 

Let’s talk about mixed-use buildings and how entrepreneurship is bringing new life to neighborhoods to owners. There has been a void to fill in commercial vacancies, and it seems that enterprising business owners have risen to the occasion. 

 

This rebirth has been long in the making because of pent-up demand. With people couped up because of stay-at-home orders and businesses closing their doors, they wanted to spend time out with friends. Commercial tenants that add tremendous value to consumers were all too willing to set up shop in new surroundings, especially with lower rents and more negotiating power. These businesses are serving up the vibrant restaurant, nightlife, and retail scene that consumers are craving.

 

San Francisco has gotten a black eye for the conditions downtown, but in reality, this is not representative of the city, right?

We were thrilled to see the vibrance of new new businesses sprouting up. Take, for instance, pockets of Clement Street, Chestnut Street,  Hayes Valley, 24th Street, Valencia Street, Upper- and Lower Fillmore.

Owners are all too willing to open these new storefronts, to a point. With the pandemic fresh in their minds, building owners do not want to experience another cataclysmic shortfall of income and are looking for signs of longevity and a solid balance sheet.

During our interview, I used the term “cleansing” of businesses, and you said this was too strong a word and unfair. 

Although society has returned to normal, there is a lot of residue from the pandemic and there were many casualties.  We’ve lost a lot of businesses through no fault of their own. They were told to shut down and stop their conveyor belt of revenue. These type of businesses run the gamut. Restaurants and bars told not to serve people food or drinks, even outdoors. Barbers were not able to give haircuts, fitness enthusiasts could not use a gym. Tattoo shops were told they can’t come close to someone that wants to be inked. The list can go on and while some businesses have reinvented themselves and/or were beneficiaries of PPP and other initiatives to keep their businesses afloat, many businesses have not survived the storm, and it is saddening.

While we are encouraged that new ventures have emerged to fill the caricatures of commercial space, the hardships of businesses before them do not escape us. Yet we are already witnessing comeback stories for resilient businesses that are hellbent on getting back on their feet. A global pandemic will not suppress the entrepreneurial spirit.