Is San Francisco A Test Case For Changing Retail Into Office?

Home to one of the country's hottest office markets, San Francisco might have its own specific, miniature version of the national retail-to-industrial trend happening in markets around the U.S.

As other markets see big-box vacancies become industrial properties, San Francisco enters the new decade with a handful of proposals from landlords to convert their downtown retail properties to office spaces, with many concentrated in the signature retail destination of Union Square.

According to retail and office experts alike, many have good reason to want a change.

Not immune to the larger sector's overall troubles, S.F. has seen its fair share of retail vacancies, exacerbated by famously unsanitary street conditions and a cumbersome permitting process. Union Square saw its retail vacancy rate rise 80 basis points year-over-year to 6.1% in Q3 2019, well above the citywide average, according to Cushman & Wakefield. 

Similar to the city's other struggling submarkets like North Beach and Upper Market/Castro, Union Square presents structural challenges, like large spaces often on third floors or higher, that have often made finding long-term retail tenants difficult.

"What we're seeing with the changing nature of retail is that there's just less demand for retail space, even on the ground floor but particularly for some of the larger spaces," Union Square Business Improvement District Executive Director Karin Flood said. "Retailers do not need that much space, and they certainly don't need upper-floor space."

Naturally, says Flood, those issues, combined with the extreme demand for San Francisco office space, give many property owners ample reason to apply for a change with the planning department. 

By Q3 2019 vacancy rate (5.4%) and average asking rent ($86.22 per SF), the Bay Area has the top office market in the nation, according to Colliers International.

"We're one of the only markets across the U.S. to reach an apex of office being more valuable than retail," said JLL Senior Vice President Laura Tinetti, who specializes in retail from JLL's S.F. offices, referring to sale prices per SF. 

Both retail and office properties have sold for big numbers in recent years. Apple's 23.8K SF Union Square store at 300 Post St., for instance, went for $120M, or $5,039 per SF, last year, according to Cushman & Wakefield. But large office buildings in the city have transacted in the thousands of dollars per SF as well while demanding the city's soaring rents.

By around 2017, the planning department began receiving a wave of applications to convert space in San Francisco's Downtown Retail Zoning District, which constitutes most of Union Square, according to legislative aide Lee Hepner, who works with District 3 Supervisor Aaron Peskin.

Fearing a wholesale transformation of San Francisco's premier retail district, Peskin led interim zoning legislation in 2018 that effectively placed a moratorium on such conversions. Last year, he sponsored legislation banning non-retail uses on floors one and two of Union Square buildings but allowing conversion on floors three and higher, subject to conditional use authorization by the planning department.

Now, such conversions will continue, but not as a first resort, according to Hepner. Notwithstanding the profitability of office properties relative to retail, property owners must demonstrate to the planning commission that retail is not viable in upper-floor space they want to convert to office.

"We're OK with allowing for some conversions," Hepner said. "But we do want to have an honest and open conversation about the viability of retail on the upper floors before we allow for a flood of these applications to go through."

Since the moratorium closed and new policy went into effect, some applications — but much less than a flood — have indeed gone through. In December, the planning commission granted conditional use authorization to 146 Geary St. and 220 Post St. for conversions of downtown retail space into offices.

In addition, Westfield San Francisco Centre, the largest urban mall west of the Mississippi River, received permission to move forward with a $75M renovation plan that includes converting 49.9K SF of retail space on floors eight and nine to office.

Outside the Downtown Retail Zoning District and not subject to the new conversion legislation, Crocker Galleria, another S.F. shopping mall, also got authorization to add office space.

Still, planning commissioners remain more reluctant to change uses around Union Square than some would like. Developer City Center Realty Partners hoped to convert floors three through five of 220 Post St. into office but only received an OK to do so on floors four and five. (Planning commissioners balked at turning over half the building into offices, fearing a precedent.) City Center Realty Partners declined to comment.

Flood, who sees much of future Union Square depending on a mix of uses, also says a significant concern is that planning commissioners think differently.

"We're starting to see projects go before the planning commission, and some of the staff is still not convinced," she said.

With ground-floor retail protected, changes to floors three and up of some properties will far from transform Union Square, according to Grosvenor Americas Senior Vice President Mark Purdy, whose company owns several buildings in the Union Square area.

"If you're a stand-alone building, having retail on the third, fourth or fifth floor is a bit challenging," Purdy said. "If you're an owner, like of 220 Post, who is converting their upper floors from retail to office, I don't think in the long-term that's going to make a huge difference. I don't think from the perspective of a shopper walking the streets it's going to be that transformative."

It might even enhance the shopper experience, as long as ground-floor retail remains in good shape, Tinetti says. Before selling the property, previous owners of San Francisco's long-struggling 6X6 mall tried to add occupancy and vitalize future retail by converting nearly 50K SF of it to office.

At any rate, property owners desire for retail-to-office conversions comes down to filling vacancies at least as much as their desire to be office landlords in San Francisco, Tinetti and others say.

In Union Square, "as long as the ground-floor activation of the space remains retail, there is potentially an added benefit with having more daily workers in and around the fabric of the community," Tinetti said. "I think there are some questions around the volatility in the retail market, and there's a desire to stabilize an asset and activate space in general."

Hepner, who worked with Flood and the Union Square BID to help craft last year's zoning legislation, doesn't see anything extreme following it.

"Whether there will be a flood of applications, I kind of doubt it," Hepner said. "Probably more of a steady trickle over the next several years, but we'll see."

Flood, whose organization is about to commence a study on Union Square's vacancies, says she sees much more than just office coming.

"One of the reasons we want to do a study is to see what our district is going to become in the future," Flood said. "I see it becoming more of a mixed-use district, with more hotels, entertainment, restaurants and even some residential coming in, less retail and more of those other things. It's just about how we get there."