JH Explorer in San Francisco: Has the Golden City lost its luster?
Having returned from a recent trip to San Francisco, Portfolio Manager Greg Kuhl discusses why the team is cautious on the local office market.
4 minute read
Key takeaways:
- Office continues to be one of the weakest performing real estate sectors year-to-date.
- While investor sentiment and valuations for US office REITs are weak, San Francisco stands to benefit from growing tech-related demand.
- The team intends to take advantage of opportunities arising from discounted valuations when fundamentals improve.
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An American Housing Survey conducted by the US Census Bureau – highlighted in early October by the San Francisco Chronicle – shows that 8% of the city’s population plans to move away in the next year; the highest percentage for any US city (for comparison, Chicago and New York come in at 5% and 3% respectively).1 Employers are leaving too; office space availability in San Francisco has increased from 10% in 2020 to 37.5% today. This is an unprecedented move even for a market with a well-established ‘boom bust’ history.2 The city is frequently the subject of news articles with headlines like “Can San Francisco Save Itself from the Doom Loop?”, highlighting the quality-of-life challenges associated with homelessness, drug use, mental illness, street crime, and the high cost of living in the area.3
Not all real estate is equal
I recently spent several days in and around San Francisco to gain perspective on this somewhat controversial property market. Commercial real estate consists of various property types, all with unique and sometimes uncorrelated supply and demand fundamentals – San Francisco exemplifies this. For many of the property types we visited, including apartments, industrial, and suburban retail, we would concisely characterise local fundamentals as varying between ‘fine’ and ‘good’. Data centre fundamentals seem even stronger, bordering on ‘great’. Like most of the rest of the US however, office is the outlier to the downside in San Francisco and the greater Bay Area.
Potential opportunities in listed office space when fundamentals improve
Listed office real estate investment trusts (REITs) with heavy exposure to San Francisco including Kilroy Realty (KRC), Hudson Pacific Properties (HPP), and Paramount Group (PGRE) are down between 60-82% from their pre-COVID stock prices, and have materially underperformed listed office peers and the wider listed REITs sector.4
When sentiment is this bad and prices have declined this much, we need to ask ourselves: “Could there be an opportunity here?” After much consideration, our team remains cautious on this small corner of the listed REIT market for a few primary reasons:
- While we acknowledge that the typically higher quality office space owned by listed REITs is significantly outperforming the San Francisco market, there is far too much vacancy and sublease space available for direct landlords to have pricing power anytime soon.
- While there are some “green shoots” in terms of office demand with the recent emergence of new AI-related firms seeking office space, it is still very early days. All of the hope for demand growth in this office market currently seems to rest with AI. This optimism may prove to be well-founded but we would like to see more evidence.
- There are some reasons to think the quality-of-life issues in San Francisco may start to improve, but only time will tell. The city needs to be a desirable place to live and work if it is going to recapture its historical share of tech-related demand.
As always, on the ground diligence is an important part of our team’s investment process. We are well aware of the tech-related boom potential that exists in San Francisco, however, we will only attempt to take advantage of any discounted valuations once it is clearer that fundamentals are improving.
1 SFGATE: More People Want To Leave San Francisco Than Any Other City, Survey Shows; 15 October,2023.
2 CBRE San Francisco/Silicon Valley Office Market Outlook.
3 Wall Street Journal, August 13, 2023.
4 Bloomberg, 14 February 2020 to 13 October 2023, total returns in US dollar terms. References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.
Pricing power: a company has pricing power when it can raise prices regardless of the economic backdrop and not lose out to competitors.
Sublease: when a tenant with an existing lease has physically vacated its space, but continues to owe contractual rent payments to the landlord, in an attempt to recoup some of the rent they are obligated to pay, tenants may have the right to ‘sublease’ their space to another user and collect rent, which can be used to help cover remaining contractual rent obligations.
FTSE Nareit Equity REITs Index (FNRE) includes all US equity REITs not designated as timber REITs or infrastructure REITs.
IMPORTANT INFORMATION
REITs or Real Estate Investment Trusts invest in real estate, through direct ownership of property assets, property shares or mortgages. As they are listed on a stock exchange, REITs are usually highly liquid and trade like shares.
Real estate securities, including Real Estate Investment Trusts (REITs) may be subject to additional risks, including interest rate, management, tax, economic, environmental and concentration risks.
These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. References made to individual securities do not constitute a recommendation to buy, sell or hold any security, investment strategy or market sector, and should not be assumed to be profitable. Janus Henderson Investors, its affiliated advisor, or its employees, may have a position in the securities mentioned.
Past performance does not predict future returns. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.
The information in this article does not qualify as an investment recommendation.
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Important information
Please read the following important information regarding funds related to this article.
- Shares/Units can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
- The Fund is focused towards particular industries or investment themes and may be heavily impacted by factors such as changes in government regulation, increased price competition, technological advancements and other adverse events.
- This Fund may have a particularly concentrated portfolio relative to its investment universe or other funds in its sector. An adverse event impacting even a small number of holdings could create significant volatility or losses for the Fund.
- The Fund invests in real estate investment trusts (REITs) and other companies or funds engaged in property investment, which involve risks above those associated with investing directly in property. In particular, REITs may be subject to less strict regulation than the Fund itself and may experience greater volatility than their underlying assets.
- The Fund may use derivatives with the aim of reducing risk or managing the portfolio more efficiently. However this introduces other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
- In addition to income, this share class may distribute realised and unrealised capital gains and original capital invested. Fees, charges and expenses are also deducted from capital. Both factors may result in capital erosion and reduced potential for capital growth. Investors should also note that distributions of this nature may be treated (and taxable) as income depending on local tax legislation.
Specific risks
- Shares/Units can lose value rapidly, and typically involve higher risks than bonds or money market instruments. The value of your investment may fall as a result.
- Shares of small and mid-size companies can be more volatile than shares of larger companies, and at times it may be difficult to value or to sell shares at desired times and prices, increasing the risk of losses.
- The Fund is focused towards particular industries or investment themes and may be heavily impacted by factors such as changes in government regulation, increased price competition, technological advancements and other adverse events.
- The Fund invests in real estate investment trusts (REITs) and other companies or funds engaged in property investment, which involve risks above those associated with investing directly in property. In particular, REITs may be subject to less strict regulation than the Fund itself and may experience greater volatility than their underlying assets.
- The Fund may use derivatives to help achieve its investment objective. This can result in leverage (higher levels of debt), which can magnify an investment outcome. Gains or losses to the Fund may therefore be greater than the cost of the derivative. Derivatives also introduce other risks, in particular, that a derivative counterparty may not meet its contractual obligations.
- If the Fund holds assets in currencies other than the base currency of the Fund, or you invest in a share/unit class of a different currency to the Fund (unless hedged, i.e. mitigated by taking an offsetting position in a related security), the value of your investment may be impacted by changes in exchange rates.
- When the Fund, or a share/unit class, seeks to mitigate exchange rate movements of a currency relative to the base currency (hedge), the hedging strategy itself may positively or negatively impact the value of the Fund due to differences in short-term interest rates between the currencies.
- Securities within the Fund could become hard to value or to sell at a desired time and price, especially in extreme market conditions when asset prices may be falling, increasing the risk of investment losses.
- Some or all of the ongoing charges may be taken from capital, which may erode capital or reduce potential for capital growth.
- The Fund could lose money if a counterparty with which the Fund trades becomes unwilling or unable to meet its obligations, or as a result of failure or delay in operational processes or the failure of a third party provider.
- In addition to income, this share class may distribute realised and unrealised capital gains and original capital invested. Fees, charges and expenses are also deducted from capital. Both factors may result in capital erosion and reduced potential for capital growth. Investors should also note that distributions of this nature may be treated (and taxable) as income depending on local tax legislation.
Specific risks
4 minute read
Key takeaways:
- Office continues to be one of the weakest performing real estate sectors year-to-date.
- While investor sentiment and valuations for US office REITs are weak, San Francisco stands to benefit from growing tech-related demand.
- The team intends to take advantage of opportunities arising from discounted valuations when fundamentals improve.