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In Indianapolis, tech giant Salesforce is shedding a quarter of its office space in Indiana’s tallest building, where it has been a core tenant for the past six years. In Atlanta, private investment giant Starwood Capital has defaulted on a $212 million mortgage on a 29-story office tower. And in Baltimore, a landmark building sold for $24 million last month, down about $42 million from 2015.
Across the country, downtown areas, office lots, and shopping malls are in danger of becoming the starting point of a new economic hazard: urban catastrophe. There are fears that a commercial real estate apocalypse could unfold and slow trade, wiping out local tax revenues. Since the pandemic prompted a boom in remote work, centers like New York and San Francisco have drawn attention to themselves with their vacant offices in formerly busy skyscrapers. But many economists are even more concerned about mid-sized cities, which have fewer ways to cushion the blow when a big company cuts office space, a building’s selling price plummets, or downtown turns into a ghost town.
The worst-case scenario would be this: As more people work from home, businesses from Milwaukee to Memphis are reconsidering or pulling out of their leases altogether. This increases vacancy rates and makes it more difficult for landlords to attract new tenants or sell buildings at a good price.
Then homeowners could have trouble paying off their mortgages or other debts. Business districts would dry up, choking on commercial property tax revenues or workers’ wages. Shoppers and tourists would have fewer reasons to go downtown to dine or shop, curbing spending and forcing layoffs at restaurants and retail outlets.
“Once these offices are empty, there are few alternatives and not much after-hours life,” said Stijn Van Nieuwerburgh, a professor of real estate and finance in Columbia University’s Graduate School of Business and one of the authors of an article about it, who coined the phrase ” Urban Doom Loop”. Medium-sized cities “have to bridge a much bigger gap than New York City.” The situation is worse where there are so few other options.” He added, “It’s a slow-motion train wreck.”
Economists warn that such a train wreck is not guaranteed and the spiral has not yet started anywhere. There are several reasons for this: Many cities are still relying on historic amounts of state and local stimulus funds from the 2021 American Rescue Plan, and those funds may not be exhausted for a year or two. A large part of the outstanding commercial and mortgage loans will also only become due in a few years. Additionally, the economy continues to defy all odds, dampening concerns that widespread layoffs or a slump in consumer spending could trigger this dangerous loop.
Still, the Federal Reserve has highlighted commercial real estate as one of the risks to financial stability. And the worrying signs are piling up, often in places that are already at risk. Medium-sized cities have some of the highest rates of office failure, where building loan payments are behind schedule, and the lowest rates of office occupancy.
The average crime rate in the country’s 50 largest metropolitan areas is about 5 percent. But in places like Charlotte, North Carolina, or Hartford, Connecticut, it’s nearly 30 percent, according to real estate analytics firm Trepp.
The average utilization is also around 87 percent. But in Oklahoma City it’s only 71 percent and in Memphis and St. Louis it’s 76 percent.
Experts warn that the trend could easily escalate, especially when real estate is due for refinancing. “You will see some small impacts, but the downpour will still be seen for the next 18 to 24 months,” said Lonnie Hendry, Trepp’s senior vice president. “It’s very early in the cycle.”
The concept of the doom loop emerged last year following research by Van Nieuwerburgh. Next came a kind of excitement that rarely follows scholarly work, with media inquiries pouring in and at least one headline calling Van Nieuwerburgh the “prophet of urban doom”. But all research makes it clear that the vicious circle is nowhere inevitable.
Some cities won’t be affected at all by the downward spiral, while others may experience different levels of damage from vacant commercial space than others, said Tracy Hadden Loh, who specializes in commercial real estate and governance at the Brookings Institution. She pointed out that some cities were already struggling with office vacancies before the pandemic and are therefore not facing an entirely new phenomenon. It also plays a role in how cities have used the grants and when they will be exhausted.
Crucially, certain locations are more exposed than others to skewed tax rules: Chicago and Boston, for example, have large office spaces and rely heavily on property tax revenues. Philadelphia, on the other hand, depends more on commuter payroll taxes than real estate, and that income could dry up if people don’t venture into the office. “It really depends on the city,” Loh said. “The local tax structure is of enormous importance in the United States. It is not possible to make a 100% general statement about any particular class of cities, as each city has its own tailored revenue structure that has evolved over time.”
Yet every day, with every new mortgage default and every non-performing sale of a building, it becomes clear how few solutions there are. In cities big and small, some property owners have tried to convert vacant offices into something entirely different, like apartments, kitchen spaces, or even spas. But these workarounds can be prohibitively expensive if they work at all. In addition, these solutions have not been widely adopted.
Take Minneapolis, where many of the troubled loans are concentrated in downtown buildings that are struggling to attract new customers. In March 2021, Target announced plans to vacate a large complex there, reducing its lease on nearly 1 million square feet, or about three-quarters of the space available in the entire building. The big retailer held on to other major Minneapolis leases and said the 3,500 company employees who worked at City Center would instead move to other major headquarters in the city.
The move is a major blow to downtown Minneapolis, said Brian Anderson, director of market analysis at the CoStar Group. The vacancy has aroused little interest among potential tenants. “The more these companies choose to embrace remote hybrid work, the more important it becomes. It will bring big changes,” he said.
Downtown Washington faces a different dilemma. In the district, office leasing activity hit an all-time low in the first quarter, with just 900,000 square feet of office leases signed. According to Trepp, that’s down from the five-year quarterly average of 2 million square feet.
The bottom line: Interest in office space is falling and there are few signs that the trend will reverse. Much depends on what happens to the more than $5 trillion in commercial real estate debt floating around in the economy and the $2.75 trillion in commercial mortgages scheduled to mature by 2027.
The tidal wave of looming deadlines could hit regional banks hardest, as they hold about two-thirds of the country’s total commercial real estate debt (not just office space) and are more vulnerable to events in individual cities. Economists have worried about regional lenders since the banking crisis earlier this year, when the demise of two medium-sized companies suddenly threatened the economy.
It’s also important what else is happening in the overall economy. The Federal Reserve is still trying to contain inflation and has promised to keep interest rates high for as long as necessary. The goal is to slow down the economy by cooling demand for credit and investment, which appears to be working. A July report said lenders are seeing reduced demand for commercial real estate loans while banks are tightening standards.
In doing so, Hendry said he fears the vicious cycle could stem from factors big and small. “If you have a mortgage with an interest rate of 3.5 percent and you want to refinance it at 7 percent, that’s inevitable, regardless of geography,” he said.
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