National Review Online, March 26 2023

A couple of weeks ago I quoted some comments from Thomas Hoenig, a former president of the Kansas City Fed. They date from a few years ago:

“An entire economic system. Around a zero rate. Not only in the U.S. but globally. It’s massive. Now, think of the adjustment process to a new equilibrium at a higher rate. Do you think it’s costless? Do you think that no one will suffer? Do you think there won’t be winners and losers? No way. You have taken your economy and your economic system, and you’ve moved it to an artificially low zero rate. You’ve had people making investments on that basis, people not making investments on that basis, people speculating in new activities, people speculating on derivatives around that, and now you’re going to adjust it back? Well, good luck. It isn’t going to be costless.”

Mispricing money comes with consequences. And the longer that money is mispriced the more uncomfortable those consequences will be. We are now seeing what look to be the early stages of a long, painful period of readjustment.

This is contributing to the tough times now facing commercial real estate (specifically office buildings) a sector that, if things really go south, will be faced with consequences ranging from unknown unknowns, known unknowns, to known knowns. Few of the repercussions will be agreeable, as banks, non-banks, a number of major cities, and who knows who else are likely to discover.

Making matters worse is (or will be) the effect of Covid-19 — and the catastrophic response to it — on the market for office buildings (a true unknown unknown), not to mention the blow to come, in certain places, from regulations flowing from that reliable fount of regulatory idiocy: climate policy. The fact of the matter is that the pandemic — and more specifically, the lockdowns — transformed the possibility of working remotely from a niche to a new work model. The implications for offices have proved . . . awkward.  The same will be true of the imposition of climate-policy driven regulations on office buildings in some leading cities. In effect, these are retrospective, because for all practical purposes, that’s what compelling retrofitting means. I wrote about this in December, quoting from an article in the Financial Times:

In New York, researchers at Columbia and New York University estimate $500bn in office value could be destroyed by 2029 as demand falls and green standards kick in.

Savills estimates the cost of upgrading a building from today’s standards to 2030 requirements to be roughly £40 per sq ft, on top of normal refurbishment costs. Leading landlords in the West End or City of London, charging as much as £100 per sq ft, might be able to absorb the cost. But for owners of buildings in smaller towns, charging more like £20 per sq ft, bearing that cost is impossible.

I added:

[W]e are now faced with the possibility that large numbers of office buildings (particularly older office buildings) must be expensively reworked or be rendered unlettable. With the office market in trouble, the response by many owners will be to walk away from those properties. These will then be left to rot, hitting jobs and tax revenues at the worst possible time, and threatening severe urban blight.

I’ll stick with that forecast. Judging from a couple of recent conversations with people active in the New York office market (anecdata only, but not uninteresting) the danger of buildings being abandoned is real. And if you want to feel in a truly apocalyptic mood, this New York Times account from the 1976 abandonment of (predominantly) residential buildings ought to do the trick. One obvious step to head off this regulatory disaster — other than scrapping the regulations (which will have next to no effect on the climate, of course) altogether — would at least be to strip them of their retrospective element. But cost-benefit analysis has never been a strong point for climate policymakers.

My guess is that the percentage of people working remotely will continue to gradually decrease from levels that (I’ll admit) are higher than I would have expected at this point. One measure of where things stand comes from the weekly Kastle survey, which counts entry swipes at office buildings that pay for the company’s security services. It recently reported that the average occupancy rate in the top ten office markets is just under 50 percent. But this may overstate the extent of the problem, at least in Manhattan. According to this report (from October) in the New York Post, the Kastle survey covers 200 Class-A Manhattan buildings, but:

a Post analysis found that Kastle tracks only one of the city’s 10 largest real estate empires and omits the largest buildings from a second. The largest property companies have the lion’s share of financial and legal tenants, which have more employees on-site than other types of businesses do . . .

The properties missed by Kastle account for more than one-third of the city’s 450 million square-foot office inventory. More important, they comprise perhaps two-thirds of the premier, Class-A trophies with the highest attendance.

The “real” number may be a known unknown, but there can be no doubt that the market still has a long way to go before returning to better health. And the more we look at lower-rated office buildings, the worse the problem appears.

For all that, as stated above, I suspect that the percentage of those working from home (WFH) will fall further for several reasons. These include the reality that, in many cases, it will be hard to incorporate new people into a business without “the office” playing a central role. Second, tougher economic times (yes, they are coming) may make employees think that it’s wise to be seen around the office. Third, human nature is what it is: People typically like to congregate. Fourth, some employers are beginning to trade lower salaries in exchange for WFH. That will make sense for some employees, but others will be wary of setting a lower baseline for future jobs. Fifth, some employees may worry that the employer who learns that their job can be done remotely from, say, Long Island, will quickly realize that it could often be done remotely, and much more cheaply, from Bangalore.

But the erosion of WFH will take time, will be incomplete, and will incorporate hybrid work. Nor is it impossible (on the contrary), that offices outside the more traditional urban cores will have a brighter future than those within them.

None of this promises much immediate relief for the owners of office property in the major urban centers that have established themselves over the years. And that’s before considering what they may have paid for their buildings in the halcyon days when WFH was a meaningless jumble of letters, and prices for office buildings reflected very low interest rates. Moreover, what’s a problem for owners (who will typically have paid much of the price of their buildings with money borrowed at those low rates) is likely to also be a problem for those who lent to, or invested with, them. Making matters more painful still, much of real estate lending is at variable rates, meaning that the effect of higher interest rates will be felt very quickly. To be sure, owners of office property can buy caps on the rates they pay, but the cost of those has risen sharply.

According to Bloomberg (March 1) more than 17 percent of the entire U.S. office supply is vacant and an additional 4.3 percent is available for sublease. Moody’s reported at year-end that even Class A buildings were not quite the safe haven they once were.

Prompted by stories of withdrawals from real estate funds, in December I looked at the state of the market and didn’t see much in the way of comfort. Prices were down, demand was slowing, vacancy rates were rising, fewer mortgages were being issued, and the relative appeal of investing in income-generating REITs (real estate investment trusts) was dwindling as interest rates rose elsewhere. Particularly troubling were the situations in which the REIT was privately held and the alternatives were public and thus generally more easily tradable (the tougher the market the more value investors put on liquidity). Adding to the pain, real estate funds are typically based on appraisals of property value that tend to lag. The other shoe may have fallen, but investors might not yet know it.

Populyst adds:

As of now, it is unlikely that real estate investment firms have sufficiently marked (down) to market the values of their commercial properties. Throughout Manhattan for example, there are empty storefronts where the landlord opted to vacate the property rather than to lower the leasing price. A lower leasing price forces the owner to mark down the value of the property. By contrast, an empty store allows them to hope that things will turn around quickly and to ride out the slump without marking down the property.

Fingers crossed.

Scott Rechler is a director of the New York Fed and, according to a bio published by the New York Fed in January 2022, he’s also:

The chairman and chief executive officer of RXR, one of the largest owners, managers, and developers of real estate and infrastructure in the New York metropolitan region.

[RXR had] an aggregate gross asset value of $20.8 billion, comprising approximately 26.5 million square feet of commercial properties and a multifamily residential portfolio of approximately 7,100 units under operation or development . . .

Here’s the beginning of a tweet thread Rechler sent out on March 22 this year:

There is $1.5T in commercial real estate [CRE] debt maturing in the next 3 years. The bulk of this debt was financed when base interest rates were near zero. This debt needs to be refinanced in an environment where rates are higher, values are lower, & in a market with less liquidity.

The numbers can vary considerably (probably for definitional reasons), but (if you are not blocked by the paywall) Bloomberg provides some helpful detail in a discussion set out here. One of the participants estimates that there is some $4.5 trillion in CRE mortgage debt outstanding (who holds that debt now, I wonder), and that about 15–20 percent of the maturing debt is coming due each year over the next five years, with an average of $500 billion per year. Of course, not all CRE is the same. Neither are all office markets: Miami is not Manhattan.

To repeat, what’s a problem for borrowers can be easily become a problem for lenders.

The Financial Times (February 2, 2023)

Rechler, the chief executive of property developer RXR, is preparing to surrender some of his offices to lenders . . .

“With some of those, I don’t think there’s anything we can do with them,” Rechler said. The only alternative, he explained, was to “give the keys back to the bank” — developer-speak for halting debt payments and relinquishing control of the asset while trying to work out a solution with the lender. “Give the keys back to the bank. And you’ve got to be disciplined about it.”

Amid the gloom, pause to note one small detail in this story:

Rechler, 55, is the bullet-headed scion of a Long Island property fortune built by his grandfather, William, who developed a lightweight folding lawn chair after the second world war.

From lightweight folding lawn chairs to real estate empires. Free markets make a lot possible. It’s also worth noting that Rechler sees some opportunities in the growing office building debacle (my word, not his), and is creating a property-lending arm to fill some of the gaps left by the banks in 2008.

In Rechler’s view, WFH let the “genie . . . out of the bottle.” His project to rank RXR’s holdings is called, rather bleakly, Project Kodak: “Some buildings are film, and some buildings are digital. The ones that are film, you’ve got to be realistic about it.”

One of the things Rechler is realistic about is the feasibility of converting office buildings into residential space. It’s not a quick fix. He also describes one other twist:

Many institutional investors are now desperate to reduce their office exposure. In some cases, Rechler argued, the projects were still viable but their debt ratios had suddenly ballooned because the underlying property valuations have been marked down.

That might be an opportunity for a contrarian, but (once again) it implies a rough ride ahead.

Another sign of trouble to come may be that many smaller banks — a part of the market already in uncomfortable focus following the Silicon Valley Bank collapse — have a fairly high exposure to commercial real estate.

The Financial Times (March 22, 2023)

Thousands of small and medium-sized banks that make up the bulk of US lenders account for about 70 per cent of so-called CRE loans, according to JPMorgan analysts. Most of the products are not repackaged for the asset-backed securitisation markets so remain on banks’ books. CRE loans make up 43 per cent of small banks’ total lending, against just 13 per cent for the biggest banks.

That exposure won’t help the sentiment surrounding those banks, but some comfort ought to come from the fact that they will probably have relatively little exposure to big-city office property. Then again, some smaller cities/suburban areas are seeing signs of difficulty too (don’t get me started on the trouble with malls).

The same report indicates that the same banks may be drawing in their horns when it comes to lending. Something similar is happening in the larger cities, which could bring further woe to the office market.

The FT:

Banks have already begun raising the bar for new loans, with about two-thirds of lenders tightening terms for construction and land development deals by the end of last year, while more than half were also lifting standards for apartment buildings as well as other non-residential commercial properties, according to the Fed’s quarterly survey of senior loan officers.

“It has become more difficult to secure capital, particularly at the types of leverage that real estate investors have historically strived for,” said John Fraser, chair of global structured credit at Tikehau Capital. “That not only puts a damper on real estate development but can have an impact on refinancing.”

Compounding the risks for commercial operators as well as their financiers is a slow market for commercial mortgage-backed securities, which is squeezing the ability of banks to free up lending capital by shifting existing loans off their books, and also reducing the exits available to other sources of funding such as the private markets.

For another twist of the knife:

While banks have been generally more conservative in their lending since the excesses that caused the 2008 financial crisis, falling prices could create problems if banks’ once-modest loan-to-value ratios balloon, said Andrew Scandalios, co-head of JLL Capital Markets. Rising ratios can trigger higher regulatory capital requirements, further squeezing the space for fresh funding.

There’s also the question of non-bank lenders. An estimated ninety-two billion dollars of debt on office buildings owed to non-bank (or shadow banking) lenders falls due this year. And this situation will be worth watching in months to come. Indeed, as I mentioned in November, non-banks are another sector that could come under stress as we revert to more “normal” interest rates. But that too is a topic for another time.

Some investors are taking a grim view of what is coming. Vornado is a major developer of office property in New York City. Its stock is trading about where it was at the turn of this century, and below where it stood when markets bottomed during the global financial crisis. Bloomberg’s index of office property REITs has yet to reach the depths it reached during the global financial crisis, but has crumbled over the last year and is now trading where it was in . . . 1996.

Michele Wucker:

A “gray rhino” is a highly probable, high impact yet all too often neglected threat: kin to both the elephant in the room and the improbable and unforeseeable black swan. Gray rhinos are not random surprises, but occur after a series of warnings and visible evidence.

Extract from the Capital Letter for the week beginning March 20, 2023