America's big cities are facing major problems.
From sky high interest rates to the reluctance of employees to return.
To their office.
The impact of higher rates and the banking stress is hurting smaller
businesses across the country. Many of which can be summed up
by a controversial new phrase the urban doom loop.
The environment is certainly shifting
on Main Street, and it's weighing on optimism.
Losses at the bank level, reducing the losses to the investors level.
And I think for the city's right, they're going to have this potential,
this urban doom loop.
Columbia Business School
Professor Stijn Van Nieuwerburgh coined the term.
Here's how it all works.
Early in the pandemic, a lot of office sector workers started working from home.
And here we are three years later.
Many of them are still working from home, at least some of the time.
All of that has led to a large reduction in the demand for office.
We see a lot of companies downsizing.
We see a lot of companies not renewing their leases at all and consolidating.
And with this demand decline for office comes declines in the revenues
for the owners of those offices and value declines in these offices.
Declines in property values, reduced property tax revenues for the city.
The cities have to balance their budget.
They now need to cut spending.
But that means less money
for public safety, for sanitation, for transportation,
for education makes the city a less attractive place to live.
People migrate out.
Property values fall more, less money, more people moving out.
And the city gets into an urban doom loop where its fiscal health spirals down.
At the height of the COVID 19 pandemic, remote work policies prompted
many employees to leave their city and move to new states.
These population outflows have long term implications for cities
which rely on tax revenues for funding.
Property tax revenue in New York City is about half of all tax revenue.
Commercial property tax revenue is about 10% of all tax revenue.
So if the value of that falls by 40%, we're talking about a 4% hole
in the budget.
So if New York City's budget is $100 billion per year,
that's a $4 billion shortfall that has to be made up somewhere else.
Rich people pay a disproportionate share of income taxes.
In New York, for example, a few thousand taxpayers are paying half of all taxes.
Migration has become easier
because you can leave the city without leaving your job.
So if a few rich people or families leave, that could leave a large hole
in the budget.
Technology sector has been more permissive to remote work,
so those areas tend to be affected the most.
Think of places like San Francisco, Seattle, West
Coast City, sort of more generally.
The urban doom loop isn't just a theory, it's playing out in the real world,
with landlords finding themselves
financially underwater and regional banks facing a credit crunch.
So when on
the landlords and want to buy a building, typically I'm going to buy it
with a combination of my own money, my equity, and a piece of debt.
Because real estate is such good collateral.
Banks are generally willing to lend a lot of money.
So typically there will be 60, 65, sometimes
even 75% debt and 25% equity.
So that would be a typical
financing structure for a commercial real estate building.
And then typically the debt will be fixed rate.
The only difference is I'm not paying off any principal, which means that
ten years later, when my loan comes, do I need to refinance that loan?
Normally that's not a problem
because normally the value of my office will have gone up these past ten years.
But what if it hasn't?
What if the value of my office has in fact gone down?
So now the bank will look at that office all over again and reassess it.
And to the extent it's
even willing to
give me a new loan, it's going to only want to give me a smaller loan.
So now, as a landlord, I'm going to have to make a tough choice.
Either I come out of pocket and put more money into the deal
because the loan that I'm getting now is smaller than the one I need to repay
ten years ago.
So I put in more equity in the deal
or I walk away and I have the right to do that.
I can send the keys to the lender and just walk.
A lot of the debt is non-recourse, which means the bank has no recourse
to my other assets.
I can just simply take this one else's building that I've borrowed against
and just send the keys to the bank. The bank now owns the building.
So banks
are facing this deterioration in basically the credit quality
of these commercial mortgages that they have on their books.
So these smaller regional banks that have done a lot of local commercial
real estate lending, they're now tightening the screws
on the credit for the local non-real estate firms as well.
That is sort of a traditional credit crunch.
Commercial real estate is a very large asset class.
There's about $5 trillion of commercial real estate out there.
And whether you know it or not, you know, your pension fund might very well
have an exposure to commercial real estate directly or indirectly.
There's also a part of the equity markets
called the Rete market, which is the publicly listed real estate space.
And again, a lot of folks have exposure to that
through a mutual fund, through an exchange traded fund.
And those rates, especially the office reads,
have fallen on hard times in the last several years.
Their stocks are often down 56 and 70%, sometimes
occupancy of office getting to 30% below pre-pandemic levels.
The office sector certainly
is going to experience more pain than any other sector in the next 2 to 4.
Years, with only a small.
Percent of desks occupied around the world five days a week and trillions
of dollars of commercial and office debt
about to come due in the next couple of years.
It really makes you wonder how it's all going.
To shake out.
So are we really doomed?
Or is there a way for cities to pull themselves out of the loop?
The fundamental problem is that we have too much of
the only solution in the long run is to get rid
of some of the excess office we have and repurpose some of that space.
The solution you hear about the most is apartments.
Turns out that that's easier said than done
because a lot of our large offices are very big buildings.
By my own calculations, only about 10% of office
buildings are physically suitable for conversion to apartments.
But that's just one of the options you can think about more medical office space.
You can think about more entertainment spaces, more hotel space.
There's a lot of creative things we could do with the land.
This is nothing new.
Cities have always reinvented themselves throughout the ages, and it's now
basically our next challenge is to get rid of some of that defunct office space.