Urban centers are struggling with the new work-at-home culture and office-building climate regulations that won’t help the climate but will hurt cities.
The generally accepted wisdom is that so-called Class A office buildings are going to be able to weather the difficulties in the office-building sector better than their lesser brethren. That’s probably right but it doesn’t mean that they will be spared the sector’s woes.
Defaults and vacancies are on the rise at high-end office buildings, in the latest sign that remote work and rising interest rates are spreading pain to more corners of the commercial real-estate market.
For much of the pandemic, buildings in central locations that feature modern amenities fared better than their less-pricey peers. Some even were able to increase rents while older, cheaper buildings saw surging vacancy rates and plummeting values. Now, these so-called class-A properties, whose rents generally fall into a city’s top quartile, are increasingly coming under pressure.
Take 777 South Figueroa St. in downtown Los Angeles. Completed in 1991, the 52-story tower features a lobby with 30-foot ceilings and rose-marble-covered walls, a landscaped plaza, valet parking and concierge services. Many of its tenants are financial companies and law firms, according to data from CoStar Group.
The owner, Brookfield Asset Management, recently defaulted on more than $750 million in debt backing the building and another Los Angeles tower. . . .
Close to 19% of all high-end office space in Manhattan was available for lease in the fourth quarter of 2022, according to brokerage Savills, up from 11.5% in early 2019. . . .
Rising interest rates have hit the entire commercial real-estate sector hard. Higher mortgage costs eat into landlords’ earnings and make it harder to refinance expiring loans. Rising yields on bonds and other securities also make real estate look less profitable in comparison, making buyers more reluctant to pay high prices and pushing down property values. . . .
Analysts expect office defaults to increase as more mortgages that were signed before the pandemic expire. Around $2.6 trillion in commercial mortgages are set to mature between 2023 and 2027, according to Trepp Inc. Many of these loans are held by smaller banks.
The writer of the article goes on to mention the tech sector’s difficulties. Lurking in the background is, of course, the danger of a recession.
The difficulties facing the office sector have also caught the attention of the Daily Telegraph’s Jeremy Warner. One of the issues he raises is the exposure of smaller U.S. banks to commercial real estate. (I wrote a bit about this in the course of my rather gloomy comments on CRE in the most recent Capital Letter.)
Warner:
In the US . . . lending to the commercial real estate sector is dominated by the country’s already vulnerable small and mid-tier banks.
Lending to commercial property accounts for about 40pc of all loans by smaller US banks (defined by the Fed as being those outside the 25 largest by asset size), says Capital Economics’ chief US economist, Paul Ashworth. “These banks account for about 70pc of outstanding loans to the commercial real estate sector.”
They are also the very same banks that are experiencing significant outflows of deposits to higher yielding money market funds. Financing of US commercial real estate is likely to tighten accordingly.
One consolation may be that the smaller banks should have a lower exposure to the major-city-center buildings where much of the current problems are concentrated. On the other hand, there is the small matter of shopping malls . . .
Warner is, of course, right to mention tightening credit conditions, which will represent another turn of the ratchet.
Meanwhile, as I noted yesterday, climate-policy regulations in certain cities, notably New York City, are about to heap higher costs on office buildings, including existing buildings. This is effectively retrospective legislation, and, in certain cases, the retrofitting bill will be too large to be worth paying. That raises the danger that some buildings will simply be abandoned. Given that conversion to residential use is a lengthy process, and will not work with certain office buildings anyway, there’s a clear danger that some blocks will become blighted. Urban blight is, of course, contagious.
Some of the problems affecting the office sector are structural (working from home) and some are, or will be, cyclical. There’s not too much that can be done about either. That’s not the case with climate-policy regulations on New York City’s model. These regulations will make no meaningful difference to the climate. They promise, however, to do considerable damage to the cities in which they are introduced. Ideally, they should be scrapped, but ending the obligation to retrofit would be a good start.