Commercial property expert calls vacant office space ‘staggering’, warns ‘we’ve never experienced anything as tumultuous as this’

A slow motion crisis is unfolding in the commercial real estate market, thanks to the double whammy of rising interest rates and falling demand for office space following the Covid-19 pandemic.

Joined the What goes up podcast to discuss issues facing the sector.

Below are some highlights of the conversation, which have been condensed and edited for clarity. Click here to listen to the full podcast.

Q. Can you explain to us why this rise in interest rates that we have experienced is so dangerous for this sector?

A. When you talk about these big structures, especially in New York, you get all these buildings there, almost a hundred million square feet of vacant office space. It’s amazing. And you’re like, well, right now we’re in a situation where these buildings are about 45%, 55%, 65% occupied, depending on where they are. And all of a sudden, the cost of capital to support those buildings almost doubled. So you have a double whammy. Occupancy is down, so value is down, there’s less revenue coming in, and the cost of capital has gone up exponentially. So you have a situation where timing has really had a huge impact on the development industry.

The biggest problem right now is because of this, nationwide capital markets have frozen. And the reason they froze is because no one understands the value. We cannot assess price discovery as very few assets traded during this period. No one understands where the bottom is. Therefore, until we reach a certain idea of ​​​​price discovery, we will never get out of it.

Now, what I would like to tell you is that the light at the end of the tunnel appeared just a little while ago, in June, when the OCC, the FDIC and others in the federal government provided political orientation to the industry as a whole. And that policy direction, I think, is very, very important for a number of reasons. First, it shows the government that it is showing leadership on this file because it is an issue that people do not want to touch on because it really can be carcinogenic down the line. It also provides a sense of direction and support to the lending community and borrowers. And in doing that, what happens now is clarity.

Basically what they say is similar to old distressed debt restructuring programs. They say, listen, any asset out there where you have a qualified borrower and you have a quality asset, we will allow you to work with that borrower to make sure that you can recreate the value that was once in that asset itself. And we’ll give you an 18-36 month extension, basically “fake it and extend it”. While what happened in 2009, it was more of a proposal for long-term forward-looking guidance and it really had an impact on SIFIs (systemically important financial institutions). This political orientation is really oriented towards the regional banking system. And if I say that, it is because currently the SIFIs do not have a real large portfolio of real estate debts, probably less than 8% or 7%. While regional banks across the country right now, thousands of them probably have more than 30% to 35% and some even up to 40% of the real estate portfolio. So, these tips gave at least the right assets and the right borrowers a chance to practice at the end of the day.

Q: This “prolong and pretend“The idea seems to me almost like a pejorative term that people use for this kind of advice from the Fed, or this kind of approach to solving this problem. But is that the wrong way to think about it? Is ‘extend and pretend’ actually the way out of this mess?”

A: Let me tell you this: I think a well-known financial guru said it’s not important for the overall economy. And I’m not sure that’s the case. When I think about the impact this has on the regional banking system, basically suburban America, we brought down Silicon Valley Bank, we brought down Signature Bank, we saw First Republic fall. If we have a systemic problem in the regional banking system, the unintended consequences could be catatonic. On top of that, what will happen when real estate values ​​go down? 70% of all US city revenue today comes from real estate. So all of a sudden you start pulling down and grabbing these buildings, the financial tap shuts off, right? All of a sudden, tax revenues go down. Well, what happens is you’re talking about firefighters and policemen and teachers on Main Street in the United States, and at the end of the day, we’ve never been through anything as tumultuous as this. And we have to be very, very careful not to knock over the building that we think is really stable.