That's one market that's never coming back to its former glory IMO, especially with WFH showing some real staying power in the tech industry. Give it 10 years and I predict virtually all desk jobs will be WFH or hybrid (ignoring, for a moment, whatever effects LLMs will also have on typical desk jobs)
That said, yes FANG and a few of the big big corporations are adamantly trying to get/keep people back in the office. Many of these companies also just finished building multi-billion dollar campuses. Imagine the heads that will roll when they finally admit to themselves that these campuses were a total waste of money, and don't even have much re-sale value because no one needs corporate CRE anymore.
This is more true than I think a lot of people realize, even where I am in fairly rural east coast USA, many of the office buildings in town have been vacant since the pandemic. No one needs these structures anymore. Even traditionally in-person venues like doctors' offices are slowly starting to shift a double digit percentage of their appointments to video calls. The writing is on the wall.
This may age badly, but imho: Long term, the meaningful work will be work that absolutely require in-person presence.
The office space sprawl of today will adjust to small-scale, experimental industry space, with a heavy emphasis on automation and custom engineering (industry v2).
Well after the collapse of today’s inflated commercial real estate.
It’s understandable that doctors haven’t gone all in on WFH. Their profession more or less requires being hands on with patients, but that’s not the only meaningful work there is.
But my work supports businesses that employ people, see patients, and provide robust tax revenues to local communities. That’s meaningful, and it doesn’t require anything more than my office at home.
I think you’re right about industrial spaces. A friend of mine works for a company that creates building automation technology, and even their hardware engineers have automated a lot of the physical testing infrastructure. Not even those teams are in-office every day at his company anymore.
In my friend group, I know four non-tech office workers (as in: they aren’t personally in tech, and also don’t work at a tech company). Two are fully remote, and two are hybrid at about 80% WFH. It’s become way more common even outside of tech.
> especially with WFH showing some real staying power in the tech industry
There is also something to be said about the political environment. White-collar workers, particularly tech workers, aren't popular. Tech jobs in urban centres are on the consensus chopping block. That means the space they occupied, these offices, are obsolete--irrespective of WFH v RTO.
There's a large mortgage company in my area that spent heavily on building a large campus full of amenities right before the pandemic hit. They seem to be having difficulty in filling IT positions as they always have openings posted. The relevant part is that the job postings lean heavily on the value of their campus and its amenities. Perhaps these are ghost jobs or they have high turnover. Either way, they really emphasize the value of their campus. Whoever was behind the initiative to move out of their generic suburban office buildings into a custom built campus is probably sweating bullets now.
It's been heading towards a crisis ever since Covid. Depending on when the Fed lowers rates, the end result will be pushed off for a few more years, but you're going to see lots of buildings given up on. My personal belief is that there's a lot of negotiation behind the scenes as both banks and property owners work out deals to make it seem not as bad. There's also the issue of cities like NYC who rely heavily on office building property taxes for funding.
I've heard it said that banks/property owners aren't super excited to renegotiate to something more reasonable, because having something sitting there vacant unused lets them keep the pretense about the property's value. If they start cutting rents, they risk having to report the loss in expected value, and that would be so horrible that they'd rather just let the property sit.
>If they start cutting rents, they risk having to report the loss in expected value, and that would be so horrible that they'd rather just let the property sit.
This is also why you'll see deals like X months free, because that's a way to say "Look, they're paying the requested rate!" but in reality they're earning less money per month due to the free months. This goes for residential real estate like apartments as well.
Any appraisal would base NOI on Net Effective Rent not Face Rates, so asset book values would not really be affected by shifting more shortfall into rent abatements or tenant improvement allowances.
This is inaccurate. I am in the industry. Appraisals are 100% based on face rates rather than NER and it is common to “buy up” the face rate by offering higher tenant inducements (cash) and free rent. It makes sense too from the bank’s perspective because the loan will be serviced over the life of the loan by the face rate, not the NER. So if the landowner pays up front to have higher cash flows in later years, the bank is fine with that.
There are regional differences in methodology but here in Canada, with institutional clients, we model rent abatements, TIs, and LCs. So no, it is not inaccurate. If you’re a lender that only cares about NOI and not a pension fund establishing a periodic value, you are free to ignore the adjustments below the line. But they are there in any Market Value appraisal.
I am in Canada too. If you are working for a pension fund doing appraisals for their own assets that’s totally different. I am referring to appraisals for lending decisions.
I have pension fund lenders on current projects and past projects and they absolutely did not care about (or even inquire about) incentive packages affecting NER so long as the stabilized NOI meets the debt servicing ratios.
I have dozens and dozens of market value appraisals for projects I’ve done and projects I’ve looked at doing (vendor provided) by appraisers all across the country and I have never, ever seen one that takes into account inducement packages.
Like I say, if you’re a lender that only gives a shit about stabilized NOI, that’s A-Ok. But if I’m signing an appraisal that asserts a Market Value with no extra assumptions or conditions, that market value will account for your free rent and TIs.
Can I ask out of curiosity, are you located in the maritimes?
No, I am located in BC now (Cranbrook) but primary assets in Ontario (link in profile) and working on a project in Alberta at the moment. I did live out near Halifax for a good chunk of Covid and had offers in on projects in Halifax and Sydney. Happy I didn’t get the Halifax projects but still sad I missed the Sydney project.
Nice. I'm also in B.C. now (Vancouver) but spent most of my career so far in Calgary.
I realize the source of confusion here — I said NOI is based on NERs in my first comment when I should have said market value. NOI would indeed typically be stabilized at market face rents, and then we would apply below the line adjustments for off-market rents, abatements, leasing/capital costs, etc.
I believe they bought residential MBSs, which is one of the reasons why mortgage interest rates went so low. They may have bought commercial MBSs, but if they did I don't remember reading about it.
When looking for a cause, none of these bankers or economists seem to get that it can also be seen as a consequence of using debt to fuel the economy. The 1990s were a fairly good time economically in the US, but interest rates were quite a bit higher than people are used to now. Maybe they should figure out why that is, since turning the knob all the way down to zero isn't really viable long term.
> none of these bankers or economists seem to get that it can also be seen as a consequence of using debt to fuel the economy
Solvency is capital-stack agnostic. The debt can make it worse. But the question of how it's financed is being ignored because it isn't particularly pertinent.
What are you talking about? Solvency is defined as the “state of having enough funds or liquid assets to pay all of one's debts”.
Your statement couldn’t be more incorrect. Debt to equity/assets is the key consideration. Too much debt in a capital stack by definition decreases solvency (all else equal)
> Your statement couldn’t be more incorrect. Debt to equity/assets is the key consideration
Oof, HN and its armchair finance.
Solvency is leverage agnostic because it doesn’t directly change with leverage. You don’t cite the source for your quote, but it should be obligations or liabilities, not debt. When liabilities exceed assets, you’re insolvent. Being debt free doesn’t guarantee solvency.
In practice they’re related because interest expense flows through to the income statement. But that is indirect. And you can lever something up infinitely without changing its solvency profile. (You change its risk, which in this sense means the probability is becomes insolvent in the future. Within the context of real estate, where extend and pretend is common, this distinction is highly relevant.)
The CRE problem is not a creature of debt. It’s a function of a previously-useful asset becoming, suddenly, less useful.
I am a past CFA charterholder and spent a number of years doing deep fundamental analysis of public equities so not exactly armchair finance.
I think the disconnect in our discussion is the use of the word agnostic and that capital stack “isn’t particularly relevant”. “All else equal” more debt decreases solvency and less debt increases solvency. It isn’t guaranteed in either direction, but to state that it is agnostic massively downplays the relevancy of debt in the capital stack to solvency. The fact that other variables (productivity of the assets, non-debt liabilities, etc) can also impact solvency doesn’t translate to “capital stack isn’t relevant”. These are directly related and incredibly important to assessing solvency.
> the use of the word agnostic and that capital stack “isn’t particularly relevant”
Consider metrics conventionally considered capital-structure agnostic. All of them are affected to some degree, in practice, by borrowing more or less. (Whether through interest expense or risk perceptions by investors, employees and customers.) Within the context of commercial real estate's size in our economy, whether it's financed with debt or equity is irrelevant to its value drawdown. The root of the problem, as OP suggests, is not in debt.
There is a separate problem in our banking system tied to CRE valuations. That's a debt problem. But that's a derivative of the fundamental problem of the properties' values going down. Those values would have gone down irrespective of how much was borrowed because the properties are being used less. (Nobody is choosing WFH because their office landlord is leveraged.)
>> The CRE problem is not a creature of debt. It’s a function of a previously-useful asset becoming, suddenly, less useful.
While I agree with that, the reason it's become a national economic problem is because of the scale of the problem. I probably would not be as big a deal if interest rates never went so low.
> the reason it's become a national economic problem is because of the scale of the problem. I probably would not be as big a deal if interest rates never went so low
Sure. But that’s about cost of capital. Not debt. If it had all been financed with equity it would be a bit more resilient. But it would still be a massive problem.
There needs to be a large pool of government-backed capital specifically for commercial to residential redevelopment and fast-track zoning approvals for this (somewhere along the line of City of Yes proposal in NYC).
Make it 4-5%, contingent upon (or give additional subsidies for) making significant percentage affordable rentals. Use the cash to cut the centers out of the building to daylight the large floor plates.
Residential rents for much more/ft than commercial so shouldn’t be a problem floating existing commercial mortgages. Maybe there’s even a program to borrow against the future higher stream of income to get non-performing loans current so these banks hold the existing paper instead of taking the write down.
I have a basic question, because I don’t know much about real estate. If we have a brewing commercial real estate crisis, and we have a long-standing housing crisis, why isn’t one the solution for the other? Can’t some real estate developer buy an office building on the cheap and convert it into housing and make a profit? I imagine that local zoning and building codes may not allow for that, but it seems like there’s enough urgency in this issue to resolve those.
There are also serious physical constraints. Most office buildings were not designed to have the number of bathrooms that subdividing into an apartment complex would require for example.
It's more complicated than you think. Office buildings aren't configured like apartment buildings; for example, plumbing and windows/lighting. Also, depending on the local rules, an office-to-housing conversion might require adding more parking.
All these are expensive things to do, because office buildings were built to be office buildings. It's not impossible to convert them to housing, but there aren't as many cases as you'd expect where it makes economic sense to do so.
This is definitely happening (see Calgary as a great example, converting 17-18 buildings from office to residential). Not all buildings can efficiently be converted (floor plate shape/size, etc), and some municipalities are slow to update zoning.
This may work in some situations, but unfortunately commercial building are typically very expensive to convert to residential. Think of an office tower with centralized plumbing and HVAC, with an open floor and no real interior walls. You've got to run plumbing and HVAC everywhere, add real(ish) walls, and depending on the size of the floor plate, there may not even be a good way to get light to the right places.
> I've been hearing about this since at-least 2021. How long will it take for this 'crisis' to come to fruition.
This crisis has been ongoing this year like a slow burn. Investors directly related to these assets know they are making heavy losses
But - this is a full blown crisis in a small segment of real estate of only large cities. As such, this is affecting only a small fraction of investor portfolios. Moreover, the bank lenders who engaged in CRE lending have the backing of a very active Federal Reserve - see SVB.
This is not going to have anywhere close to the kind of impact the US housing crisis had in 2008.
Sure, but thinking back to 2008, the first clear signs of trouble were in like mid 2005, I don't think that was a case of broken clocks being correct twice a day.
I just watched the 2005 Jim Carrey movie Fun with Dick and Jane, about a nuclear family whose father loses his job, pension, and house working at a place like Enron or WorldCom while a CEO resembling Ken Lay played by Alec Baldwin steals the whole pension fund.
Watching it yesterday was a shocker though -- I had forgotten (having been so young) that the 2008 financial crisis had roots so much earlier.
But then I reminisced a little more: this was based on what I recall actually going on at the time. I was a kid at the time, who got his first minimum wage high school job working side by side with a lady who was there because her husband had his pension stolen at WorldCom.
A certain class of elites really got away with a lot then, and were never held to account. Instead, their elite grifting culture just spread wider and wider. We tried in 2011. If you were alive then, you know how big Occupy Wall Street was getting. You remember how big Bernie was.
But they figured out how to use social media to divide us and redirect our anger into right vs left politics instead of ultrarich crooks vs everybody else working hard. Even I had been starting to forget until Jim Carrey shook me out of my millenial reverie.
The youngest kids if they have any political consciousness now it's solely channeled safely into the left vs right pattern, unable to effect meaningful change to the robber baron economy. Smartphones and recommendation algorithms truly were a powerful technology that generated great value after all-- for just a very small elite that can use it to hold off any accountability for their monstrous crimes.
Hard to say. A well run bank with no bad debt on its books can absorb ~0.75% losses on its total lending in a year from income, without hitting any of the regulatory limits that would start to curtail lending. From the article, the US banking system is already above that, so it is in trouble.
From that point on, it's a case of how well the banks can push the can down the road, absorbing small percentages of bad debt every year from profits, versus being forced into insolvency by the FDIC. There is a lot of leeway in this, as long as the bank still has revenue. During much of the eighties the entire US banking system was technically insolvent, but the Fed essentially just papered over it. The Italian and Japanese banking systems managed this for decades - its only an actual loss when the bank recognises it after all, so you get the zombie bank phenomenon.
There is a much better understanding since 2008 of how not to crash a banking system, so I suspect this will continue to be managed out. But if any other sector goes down, or Trump gets elected (since his policies would blow up the entire financial system if actually enacted), then all bets would of course be off.
If I just doubled down and said that 10 months of nothing happening proves there’s no greater likelihood of something happening now, then yes, it’s broken.
Every morning and evening I watch the sun shine through empty office buildings that were just recently completed. I'm not sure how economical it is to keep the lights on.
Both CRE and RRE are doing the Wile E. Coyote levitating thing for now, mostly due to banks and investors being able to delay a reckoning. Used cars got hit first because it's harder to pretend they are a good asset to hold. But it's coming. Enthusiasts of converting CRE will be disappointed because RRE is already overbuilt in some boomtowns. Only truly abandoned CRE will be economical to convert, and that will further delay widespread conversion. The earliest projects will be selected for low risk. The bottom is somewhere below pre-pandemic prices.
I thought that was more actual demand than speculation. Consumers have relatively inelastic demand for cars in general, but 1) their real income took a hit post-COVID and hasn't recovered, and 2) simply being used makes a car cheaper, since they are such poor assets to hold.
How many people need a G-Wagon, or W113, or Porsche 914, or even old Toyota truck? Luxury and bad cheap commuter cars are a quickly depreciating asset, smart money would lease those.
Yes. I disagree that RRE is overbuilt, perhaps in some specific areas but not in general. You are not seeing houses sit empty for 9 months in most cities, and also people need a place to sleep and cook regardless of WFH or not. On the other hand, I think commercial office space is generally overbuilt in all areas. That's a big difference between the two.
This article seems to miss that small and regional banks are less likely to hold the type of assets that are in real trouble. The big problems are the giant downtown office towers. Those loans are more likely to be held by big banks. Or at least I imagine, I don't have any data to back that up
This is a good thing because the rent seekers who own these properties are unwilling to lower their lease terms which is strangling businesses.
There are two tiers of businesses now, those that rent their space and have expensive prices because of it and those that own and don't have to pay rent which shows off as lower prices.
A CRE crises will not affect us the way the GFC did . We may see a few banks go belly up however.
That said, yes FANG and a few of the big big corporations are adamantly trying to get/keep people back in the office. Many of these companies also just finished building multi-billion dollar campuses. Imagine the heads that will roll when they finally admit to themselves that these campuses were a total waste of money, and don't even have much re-sale value because no one needs corporate CRE anymore.
This is more true than I think a lot of people realize, even where I am in fairly rural east coast USA, many of the office buildings in town have been vacant since the pandemic. No one needs these structures anymore. Even traditionally in-person venues like doctors' offices are slowly starting to shift a double digit percentage of their appointments to video calls. The writing is on the wall.
sell sell sell