San Francisco Retail Has Been Booming. So Why Is It Considering Heavy Vacancy Fees?

With store closures skyrocketing and the entire foundation of what retail is shifting, cities across the U.S. are struggling to adapt and keep lights on in shopping districts. 

San Francisco has seemed almost immune: It has only 3% vacancy, comfortably below the national average of 4.5%, according to CoStar data. It sounds rosy, an exception to the sector's woes.

Don’t tell that to the city’s brokers, residents and politicians caught in heated debates on the effectiveness of solutions like taxing the owners of vacant retail properties. A San Francisco supervisor has proposed a steep vacancy fee — $250 a day.

In January, District 8 Supervisor Aaron Peskin called for a vacancy tax of $250 per day on owners of properties that are vacant for six months. To reach either the March 2020 or November 2020 ballot, where it would need a two-thirds vote to pass, Peskin’s proposal still needs to be approved by the Board of Supervisors.

The proposal can feel odd. Retailers in San Francisco had long been buoyed by a relative lack of retail inventory growth, and economic health, according to CoStar Bay Area Director of Market Analytics Jesse Gundersheim.

“A lot of other cities have actually built retail space in the development cycle, whereas San Francisco really has not built a lot,” Gundersheim said. “The other factor is that demand for retail space is holding up a little better than some other markets because of the dynamically growing economy.”

San Francisco continues to enjoy that same booming economy, with job growth so far this year at nearly twice the national average. But many commercial real estate professionals and city officials, including Colliers International Executive Vice President Julie Taylor, agree San Francisco’s retail sector is far from as healthy as 3% vacancy implies. Many disagree on why that is and what to do about it.

“A lot of these spaces that appear leased are available,” said Taylor, who considers pop-ups, subleasing and imminently vacant spaces increasingly ubiquitous in San Francisco. “And 3% is not an accurate count even if you were only counting the space that was vacant.”

City officials and commercial real estate firms alike still cite that figure, which is well below the national vacancy rate average, but both often only focus on a city’s main shopping areas and don’t reflect the retail landscape of the several San Francisco neighborhoods now with double-digit vacancy rates.

The historic North Beach neighborhood is one of the several vacancy-plagued areas the measure is aimed at helping. A survey conducted by the North Beach Business Association, North Beach Neighbors and Telegraph Hill Dwellers found the area’s vacancy rate to be 10.25%, more than double what it was in 2015.

And the city’s retail is now being slowed by a potent combination of nationwide factors, like e-commerce and changing consumer tastes, and a host of city-specific factors — from long permitting waits to increasing homelessness — that have city leaders scrambling to devise solutions.

"There is a shift in momentum," said Gundersheim, who noted that Bay Area retail absorption turned negative in Q1 for the first time in several years.

As online shopping comes close to one-quarter of all retail sales, traditional retail has continued to struggle to find its footing, and it has only been getting worse. So far this year, U.S. retailers have announced over 7,000 store closures, already eclipsing 5,864 closures in all of 2018, according to Coresight Research. Bankruptcies have continued as well, with Payless ShoeSource and Gymboree both filing for Chapter 11 this year and announcing nearly 3,000 store closures combined.

Vacancy tax proponents like Peskin, whose district includes North Beach, say landlords carry as much blame for the city’s retail struggles as factors like retailer bankruptcies, e-commerce, zoning, permitting and homelessness. His plan is to penalize those landlords keeping space vacant in hopes of getting higher rent.

The sort of vacancy tax Peskin proposed has been tried elsewhere, though in a much smaller city and with a less onerous penalty. In 2017, Arlington, Massachusetts, began levying a $400 annual fee on landlords of vacant storefronts and saw vacancies in its Arlington Center fall from 17 to six by year’s end. Other large cities, including New York and Boston, have recently considered using the tool as well.

In San Francisco, where most agree retail has begun to slow, the reaction to Peskin’s proposal ranges from full endorsement to intense skepticism, with many seeing the measure as unfair and ineffective.

"If some of these landlords wanted to lease out their space and thought they could do so by lowering their rents, they would have already done so,” Gundersheim said.

“It’s going to have zero effect on vacancy,” JLL Executive Vice President Ben Lazzareschi said.

Others say a vacancy tax won't solve more significant factors holding retail back. Lazzareschi and Gundersheim pointed to San Francisco’s long and arduous approval process as the problem to work on.

Then there is San Francisco’s limitation on formula retail, which is completely banned in some neighborhoods like North Beach and very difficult to establish in others, such as the Castro. Taylor said one of her listings, a long-vacant 14K SF building at 2390 Market St. in Upper Market, has been very difficult to fill because of the restriction.

“It's far too large for your local entrepreneur,” Taylor said of 2390 Market St., which has been vacant for two years. “A number of formula retailers have been interested in it, and they've all been terrified of the process.”

Such restrictions, several brokers claim, have deprived neighborhoods of the kind of large anchor tenants needed to revitalize areas.  

The strongest vocal support has come from neighborhood associations. The presidents of the North Beach Business Association and the Hayes Valley Neighborhood Association told the San Francisco Chronicle in January that they support a tax on landlords of vacant storefronts.

Compass Commercial Vice President Ken Colwell, who has a listing on 2253 Market St. in the struggling Upper Market/Castro area, is in agreement with Peskin and neighborhood groups that there is a problem of landlords asking for rents that are too high.

“I think the answers are very neighborhood-specific,” Colwell said. “Overall though, I think the blame rests on landlords. They’re simply asking too high rents for the market conditions.”

Still, landlords insist the wave of shuttered storefronts is from the retail sector’s struggles, as well as unrealistic zoning, especially in North Beach. Giovanni Toracca owns several fully leased commercial properties in the neighborhood, but said the area's vacancies reflect inescapable problems with retail itself.

“They want retail space, and retail is dead,” Toracca said. “They’re saying the landlords are greedy, and if you leave the place empty [Peskin] wants to charge a $250 per day fine, but you can’t even rent it for [that much].”

Asking rents for retail space in North Beach range widely, but average anywhere from $36 to $48 per SF per year, Maven Properties Managing Broker Santino DeRose said.

The struggling Castro neighborhood is another area proponents see benefiting from a vacancy tax, much to the chagrin of many CRE professionals doing business in the area.

A March report from the city’s Budget and Legislative Analyst’s office commissioned by District 8 Supervisor Rafael Mandelman found the Upper Market/Castro area vacancy rate to have risen as much as 5% to as high as 12.9% from 2015 to 2017. Mandelman himself recognizes the vacancy issue but said a vacancy tax requires some study.

"In several different neighborhoods in my district, but particularly Upper Market and Castro, there's a pretty dramatically increasing number of vacancies,” Mandelman said. “A vacancy tax is attractive insofar as it's going to kind of change the cost-benefit calculation for landlords who are either not paying attention or operating with an inflated sense of how much their ground-floor retail space ought to be generating for them.

“It’s not such an attractive thing to the extent it's going to be hitting folks who are really doing the best they can to rent out their space and just cannot find a tenant for it.”

Earlier this year, Mandelman hosted a meeting between Veritas Investments, which is one of his district’s largest landlords, and a group of residents and business leaders. In the meeting, Castro Merchants then-President Daniel Bergerac said businesses had complained of 35-page leases that required thousands of dollars in legal fees for their review, according to The Bay Area Reporter. Veritas Investments did not respond to a request for comment by press time.

For his part, Mandelman is behind legislation that is aimed at shortening the permitting process, the issue he and many others feel is the most urgent problem leading to vacancies.

According to Mandelman and others, one of the most salient bottlenecks in San Francisco’s permitting process are conditional use permits, which are required when a San Francisco property owner wants to use land in a manner not expressly allowed by the relevant zoning district.

The Budget and Legislative Analyst’s report found that the average time between applying for a conditional use permit and approval is nearly a year, and that nowhere in the city was a conditional use permit more commonly necessary than the Upper Market/Castro.

As a result, Mandelman has proposed legislation removing the existing need for conditional use authorization for things like art galleries and restaurants in Upper Market/Castro.

“For something like a restaurant or art gallery, we don't really see the use of a [conditional use permit],” Mandelman said. “Why are we waiting that extra year?”

Mandelman’s proposed ordinance could get a vote from the Board of Supervisors before its August recess, he said.

Streamlining the permitting process in general is a measure many in CRE feel would most effectively ameliorate San Francisco’s rising retail vacancies.

“Instead of penalizing landlords for vacancies, we should focus on how to help retailers and businesses open in this city,” Lazzareschi said.

The mounting costs as potential businesses wait for permits — in addition to San Francisco’s sky-high construction costs — stop many businesses before they even get started, Maven Retail partner Pamela Mendelsohn said.

“People call us saying they want to open [in San Francisco],” Mendelsohn said. “And we say, ‘OK, do you have $300K?’”

That is just to get started, said Mendelsohn, whose brokerage focuses half on retail and half on restaurants. All told, it costs an average of $750K to open a brand-new restaurant in San Francisco, according to an estimate from the Golden Gate Restaurant Association.

To Mendelsohn, Gundersheim and others, streamlined permitting to remove the city’s high cost of entry would be the most effective measure to revitalize San Francisco’s retail sector, especially in struggling districts like the Castro and North Beach, but that still leaves myriad national and market-specific hurdles S.F. retailers are contending with.

On top of the city’s demanding approval process, potential San Francisco retailers are still dealing with the city’s high construction costs, labor shortage, homelessness, limitation on formula retail and changing consumer tastes — all of which will likely continue burdening its retailers, according to Taylor.

“Retail in the city as a whole is far less healthy than it was three or five years ago, even less healthy than it was during the depths of the recession,” Taylor said.

E-commerce's disruption of traditional brick-and-mortar retail has been well-documented, and San Francisco has felt the effects. But Taylor points to San Francisco’s own unique mix of challenges as much more problematic for its retail sector and a better explanation for the rise in vacancies.

“I've definitely had deals die over construction bids,” Taylor said. “And then there's the labor shortage. If you want to open a business, it's extremely difficult to find employees, and if you find them it's extremely expensive to get them to accept a position.”

The city’s extremely tight labor market has also posed a major issue for restaurants and other retailers competing with tech companies and the gig economy for employees. With an unemployment rate below 2% as of May and so many service workers commuting long hours from outside the city, fielding enough quality workers at an affordable rate has proved challenging for retailers.

Taylor and other brokers also say there is a real struggle to fill retail space amid rising homelessness in San Francisco and deteriorating street conditions. The city reports a 30% increase in homelessness since 2017.

“Vacancies create more vacancies, and when you can't fill the vacancies — because the streets are perceived as dangerous by either the tenant or customer or the obstacles to get open are so great — it puts a lot of pressure on the system,” Taylor said.