Landlords, Tenants Getting Cooperative In Challenging San Francisco Retail Market

Retail leasing trends in San Francisco have evolved as a result of the distress brought on by the pandemic, with owners giving more consideration to leases that utilize percentage-based rent agreements and generally offering more flexibility and perks to tenants.

The length of leases has shifted and tenant improvement allowances are more generous as the relationship between landlords and tenants has grown more cooperative in the past two years. 

Prior to the pandemic, retail leases in San Francisco were more commonly based on fixed rent, according to CBRE Vice President Alex Sagues, a member of the company’s San Francisco Urban Retail Team, but percentage-based deals are happening more frequently these days.

“Similarly, management agreements were uncommon. When the pandemic changed buying habits and business models, the unpredictability of sales in [the] post-Covid environment has made percentage rent-based leases more common,” Sagues wrote to Bisnow via email. 

Sagues said for retailers, especially those in the restaurant industry, Covid-19 necessitated a long-coming change in the structure of deals — one that he expects to stick around for the long haul, and to expand into other markets, such as New York or Chicago.

Sagues also referred to calculating fixed rent in a post-pandemic environment as a "guessing game."

"How do you know what sales you're gonna do? There are so many changing factors. Pre-Covid you could look to the last 10 to 15 years of other tenant sales, which were predictable, but the last few years things have changed so quickly. So Covid precipitated a change,” Sagues said. 

Sagues added that as a result, the partnership aspect of leasing agreements between retailers and landlords has grown. 

“Rarely are we guessing the right rent that is fair to both parties. And so, what we're seeing now is retail deals, especially food or beverage, where the deals are changing, where there's more partnership, and that means more of the rent is based on sales.” 

Sagues also added that the length of retail leases has shifted somewhat, though most deals are still within the 10-year range. 

“Deals were most commonly 10 years pre-COVID.  Now we are seeing more five-year and more 15-year deals, so [it is] unclear if [the] average term has changed. That said, most leases are still 10 years,” Sagues wrote. 

Colliers Executive Vice President Julie Taylor referred to percentage rent as “one of the tools in our toolbox” but stated that the nature of retail deals in the city isn’t ultimately changing that much, though Covid-19 did allow for some tweaks to the formula when the situation calls for it, and landlords are becoming more open-minded. 

“When there was a ton of uncertainty, it was appropriate to shift leases during that period to percentage rent only, or to sign a lease with a short period of percentage rent only. But we haven't changed the construct of base rent being due,” Taylor said. 

“You know, if anything, it opened the doors to more landlords wanting percentage rent, perhaps in addition to a base rent, so maybe that they know that the lease might have both aspects in play, or in place."

Taylor said one of the biggest challenges for landlords right now is the rise in construction costs and demand for established second-generation space, and that subsequently, because of increased vacancy, landlords are more willing to kick in improvements on raw shell space if it means getting a tenant in the door.

“So, why would anybody take on additional construction, if they could find a space that would serve their needs, that is more finished?" she said.

Taylor’s biggest takeaway is that the city’s retail leasing environment has become one of cooperation.

“I think landlords and tenants have been working together in a more cooperative spirit than I've ever seen in my career, because everybody has realized, you know, the importance of, of putting our streets back together, and, you know, getting new stores to open to replace those that weren't able to survive,” she said.  

JLL Managing Director Ben Lazzareschi stated that in food and beverage retail, deals are becoming more creative, and landlords are more willing to pull strings in the name of securing potential brand appeal for tenants.

“I think we are seeing more concessions and creative deal structures within the food and beverage category. You know, that's a large part of the demand pool in retail leasing,” Lazzareschi said.  

Concessions are especially common for well-known, established brands, he said.

“All of these users look at food and beverage as an amenity. And it also is a strong brand for those assets. So, landlords and developers are putting a premium on the best brands and those great operators in terms of producing strong sales and good credit, and they're willing to make concessions for them that maybe they wouldn’t for others.” 

In other words, bigger and more established brands are more likely to get terms like percentage-based rent when it comes time to draw up the paperwork, because landlords are willing to bank on the success of known quantities.

As a result, it’s getting harder for smaller companies and brands to compete for premium retail space within the city. 

Lazzareschi said that when it comes to granting percentage-based deals, landlords are going to favor known businesses with established track records of success, comparing it to sound investing strategy.

"So, it's not that every single operator gets these opportunities. It's more that the best-in-class operators in each category get those,” he said.