December 18, 2023 - 4:00pm
“Survive until ‘25”. That has become the mantra among owners and lenders in the commercial real estate sector. Keep the lights on until 2025 and wait for the cavalry of easier money and a resurgent economy to appear on the horizon. Until then, amid low occupancy and cash burn from high interest rates, wait for rates to come down and for people to return to the office and shopping centres.
Commercial real estate, including multi-family residential real estate, has come to occupy a significant place in large investment portfolios, particularly among private equity and pension funds, which like it for the steady income streams resulting from rents. But the sector has run into difficulty of late. Although the closure of office and retail spaces during the pandemic emptied out city cores, there was initially some expectation that the slump would last only for the duration of the lockdowns. Yet the work-from-home practice has proved tenacious — popular among workers, especially more senior ones, but even with some managers, who are looking to make savings on rental costs.
There remains some debate as to whether the new trend will last. Many are the voices saying that the cooling of the job market will weaken the ability of employees to withstand calls to return to the office. Meanwhile, some economists maintain that WFH is bad for productivity, and that sooner or later firms will be able to make everyone return to their desks — bringing secondary benefits to the CRE holders in the retail ecosystem supporting offices, from sandwich shops to pubs.
One might not want to bank on that, though. Stanford University’s Nick Bloom has been studying work-from-home patterns for years and is convinced that the productivity gains outweigh the losses, while vacancy rates appear to have stabilised at higher levels. In London and the US, office vacancy rates remain at 20-year highs, and new activity is drying up. As a result, not only are revenues down, but so too are the valuations of properties.
So far, none of this has amounted to much. Unlike ordinary residential or shop leases, large leases on commercial real estate run for years, with large tenants sometimes holding leases that run up to 10 years. As for valuations, in such an illiquid market owners can keep a property on the books at above-market value in the hope that prices will return to their previous levels before long. That has enabled investors to defer any potential pain for the time being.
Nevertheless, the longer things continue as they are, the more worry will build. That’s because there is a high degree of leverage in the sector. Borrowing to invest in a property that yielded a steady if unspectacular dividend stream made sense in the days when credit was all but free. But the sharp rise in interest rates over the last year has left the market vulnerable. The mini-crisis among US regional banks earlier this year demonstrated just how much this segment of the financial sector, for instance, was exposed to commercial real estate.
So investors may now be feeling some relief, as central banks appear to be signalling that the days of easy money may come back next year. That’s the cavalry they’ve long awaited. But if for any reason central banks aren’t able to deliver rate cuts as quickly as markets currently anticipate, the next couple years could see things darken. Not a crash, perhaps, but a rolling series of mini-crises similar to the Silicon Valley Bank collapse earlier this year, giving regulators and investors quite a few sleepless nights.
John Rapley is an author and academic who divides his time between London, Johannesburg and Ottawa. His books include Why Empires Fall: Rome, America and the Future of the West (with Peter Heather, Penguin, 2023) and Twilight of the Money Gods: Economics as a religion (Simon & Schuster, 2017).
jarapley
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SubscribeThere is no going back! My firm’s offices top out at about 10% of staff back in the office on any day. Despite the edicts and the free pizza and beer. Remote working is here to stay and AI will eat most desk jobs within 3 years anyway.
If you have children, especially boys. I advise steering them towards skilled manual work, it’s AI proof and will be the highest status and earning sectors in a few years.
Maybe the threat of some sackings (to use the British term) is in order.
Lot of empty store fronts in my town.
In the US, we have new initiatives on converting office space into residential, which a cynic might say aligns quite nicely with the 15-minute cities idea. First, govt comes up with a means of forcing people out of commercial spaces. Then when that “emergency” is over, remote work has taken hold and people don’t want to resume commuting, creating a convenient opening for further social engineering. But only a conspiracy nutter would think such things.
I doubt government at any level (fed, state, local) engineered this problem, but government in Democrat-controlled states will probably be happy to seize this opportunity. So far as converting office towers to residential accommodation goes, I’ve read that’s very difficult, not least because of the different plumbing requirements needed for residential accommodation.
It wouldn’t surprise me, though, if interest rates are eased next year because the supposedly neutral Fed wants to boost the economy to help Biden in the election. That’s a conspiracy theory I’d buy into.
Perhaps the lockdowns were seized on by some as a means of furthering aims that would have taken at least another ten years to come to fruition and found it relatively easy to scare Government ministers into falling into line? Sounds crazy but the whole lockdown thing doesn’t add up. The obscene amounts of money borrowed and lost, the businesses and livelihoods destroyed…. for what?
Like most conspiracy theories, this one requires government to be a lot better at planning years down the road than they have shown themselves to be capable of. If government had the intelligence and wherewithal to pull off something this complicated, surely they could figure out how to handle the migrant crisis or pass a budget without shutting down the government days at a time. I have a firm rule of logic. Never assume a nefarious ulterior motive for a phenomenon when stupidity can explain the same phenomenon, as the former is rare, while the latter is common as dirt.
I figure if the government can’t even cover up a third-rate burglary, most conspiracy theories are a load of crap.
It depends if you believe that the state cares as much about one as it does the other. As Orwell said, “Nothing is efficient in Oceania except the Thought Police”.
Although that reminds me of the great Alan Coren’s thesis that totalitarianism would never work in modern Britain, because nothing ever works in modern Britain.
Good thing that Britain is a democracy, and accordingly doesn’t need Thought Police.
One thing about government I’m sure of, however, is that it will be ready to address the “crisis” with massive amounts of bailout money (our tax dollars) for their favorite oligarchs.
Yes, that’s the thing about conspiracy theories involving governments. Governments are, to all outward appearances, bumblingly incompetent at everything, but conspiracy theorists would have us believe that they exhibit flashes of extreme competence when doing something conspiratorial.
I think your “firm rule” is a more genteel version of the more common: “If you’re not sure whether it’s a conspiracy or a stuff-up, it’s a stuff-up.”