Downtown San Francisco, especially in the vicinity of its Union Square shopping hub, remains in the doldrums years after other cities recovered from Covid-era lockdowns. One factor delaying a downtown renaissance is that some key properties are encumbered by securitized mortgages, which are taking time to unwind. These deals, known as single asset single borrower commercial mortgage-backed securities (SASB CMBS), attracted attention earlier this year when the AAA-rated tranche of a New York City deal took a haircut. Shortly thereafter, the Financial Times, the Wall Street Journal, and Bloomberg reported on other AAA-rated SASB CMBS bonds that may face losses. As I discussed in a December 2020 Capital Matters column, these instruments are reminiscent of the failed Residential Mortgage-Backed Securities widely blamed for triggering the 2008 Global Financial Crisis.

San Francisco Centre, a large shopping mall across from the Powell Street cable car turnaround, is the most publicized of the distressed properties. The mall has been losing tenants since Covid-19 struck, with the biggest losses being those of a Nordstrom department store and a multiplex cinema. With those anchors gone, smaller stores have experienced less foot traffic and thus reduced sales, forcing them to close as well. The mall is now only about 30 percent occupied.

San Francisco Centre went into a tailspin due, in large measure, to poor government policy and execution. During Covid, the Bay Area locked down first and maintained severe restrictions for much longer than other regions of the country, delaying a full reopening until June 2021. The city shut down cable car service from March 2020 until the beginning of August 2021. Public health officials and their allies in local media exaggerated the risks from Covid infection to younger healthy individuals. As a result, fewer people returned to downtown San Francisco than other cities long after the official restrictions were relaxed.

During this period, downtown also faced a crime wave exacerbated by state and city initiatives to house homeless individuals in area hotels. Three long blocks from the Centre, a Whole Foods was forced to close after only one year of operation due to a wave of shoplifting incidents and unsafe street conditions outside the supermarket. Ultimately, San Francisco Centre mall security proved unable to protect retailers and customers from the neighborhood’s unsafe street conditions.

Westfield, the mall’s owner, stopped making loan payments in June 2023. San Francisco Centre then went into receivership. The receiver originally planned to auction the mall in November 2024, but this date has now slipped to December. The megamall has not had proactive management for over a year, and most players involved with the mall have little or no incentive to quickly resolve its insolvency. The special servicer of the CMBS deal, who represents bondholder interests when a CMBS loan gets into trouble, receives monthly fees, as does the receiver, and the interim property managers. Attorneys handling the foreclosure are typically paid based on the number of hours worked.

If the mortgage was held by a bank, specific employees would be charged with working out the loan and limiting losses. But with a CMBS, it is bond investors who are on the other end of the transaction. And, in the case of San Francisco Centre, many of the investors have already been wiped out. Due to the mall’s sharp decline in value, investors holding junior bonds cannot expect any proceeds when the property is eventually sold and have been obliged to write off their holdings. The only investors likely to receive any recovery are those holding Class A certificates originally rated AAA. And since investors who buy AAA bonds rarely face defaults, they lack expertise in loan workouts. Further, investors in AAA securities are often large, diversified funds that have little bandwidth to monitor any given portfolio holding. For example, the $5 million that the Victory Core Plus Intermediate Bond Fund (USIBX) invested in DBJPM 2016-SFC Class A represents less than 0.1 percent of the fund’s $5.2 billion portfolio, and fund managers have already marked down the holding to less than half its par value.

Within a short walk of the San Francisco Centre are a pair of large hotels facing foreclosure after defaulting on a mortgage backing another SASB CMBS deal, Hilton USA Trust 2016-SFP. The Hilton San Francisco Union Square and Parc 55 Hotel collectively comprise 2943 rooms, which are vacant most of the time. For the year ended September 30, the two hotels had an occupancy rate of just 45.5 percent despite offering relatively low average room rates. Adverse street conditions have deterred organizers from hosting conventions at the nearby Moscone Center, reducing the number of business travelers. The mortgage has been in default since June 2023, and the hotels are not expected to be sold until next year.

For the mall and hotel properties to return to viability, they will likely have to be reimagined. Outgoing mayor London Breed suggested converting San Francisco Centre into a soccer stadium, while a real estate expert recommended converting the hotels to apartments, given San Francisco’s well-publicized housing shortage. Such pivots will not happen unless and until these parcels are transferred to new owners with the resources and motivation to implement a turnaround plan.

The fact that so many AAA-rated SASB CMBS bonds are now failing and the fact that the volume of new AAA-rated SASB notes continues to be strong is indicative of the failure of Dodd-Frank rating agency reforms. In at least one corner of the structured finance market, the race to the bottom in credit standards continues, with San Francisco and other cities paying the price.