There are some dark clouds hovering over the office leasing industry that started with the pandemic and remote work. Industry veterans suggested for years that the trend would pass. However, 2 1/2 years into the pandemic, we can conclude that it is surely enduring with approximately 50% employee attendance around the country.
In order to adapt, landlords collectively spent hundreds of millions if not billions to attract tenants back to the office as a destination with environmental improvements, amenities, and reconfiguration of offices. However, this has only worked in the trophy buildings. Older and less attractive buildings are suffering. As leases come off the books, tenants are renewing at lower rents, for smaller spaces or not at all. Add in $17 billion of mortgage bonds backed by office buildings is coming due in 2023 as compared to 2022, and this is a recipe for trouble. For that reason, rumors of discounted sale prices and distressed loan sales abound.
That alone would be bad enough. However, those landlords looking for new financing or with adjustable-rate mortgages are now being hit with a double whammy. Due to the rapid rise in interest rates, their cost of borrowing has increased substantially. As a result, in many instances the cost of new debt now exceeds the capitalization rate (the ratio of net operating income from a property to its current value) that indicates the annual return on investment for landlords.
This development will inevitably lead to increased defaults and further lowering of property values, as reflected in the drop of the stock price of many of the major public real estate investment trusts. Compounding the problem, the cost of alternative uses for real estate such as conversion to apartments is very expensive and only works in spaces with smaller floor plates. Even flexspace giant WeWork, whose raison d’etre is as an alternative to traditional offices, continues to hemorrhage cash and is closing 40 locations across the US after losing $629 million in the third quarter of 2022 (which they tried to spin as an improvement over the prior year’s performance that was worse).
Obviously, higher interest rates impact all industries. When the tide goes out, many of the problems which have been masked by low rates that have allowed weak or zombie companies to survive become exposed. This is not a sudden rush of withdrawals and/or fraud as in FTX (we await the gory details) or an apparently calamitous error like the floundering Metaverse. Real estate markets are the complete 180 degree opposite of crypto at the extreme or even more traditional markets in stocks and bonds, as they move at a relatively glacial pace reflecting the complexity of sale transactions and absence of trading markets that provide easy liquidity.
The cruel reality is that unlike the examples above, landlords have done nothing wrong from a business or ethical standpoint. To the contrary, they have admirably attempted to adapt to the dramatic shifts in urban real estate. I have been saying for some time that Covid has been a great experiment in the world of work. Business as a whole passed the test and reacted phenomenally well by maintaining profitability and keeping people employed at record levels. However, the trend toward working at home accelerated exponentially nonetheless. It didn’t help matters that empty cities suffered increased crime rates and homelessness to the social dislocation and unemployment stemming from the pandemic.
With a drop in demand of historic proportions as availability rates for empty offices are close to 20% nationally and in NYC, the last thing that landlords needed was a substantial increase in interest rates forecast in the vicinity of 400 basis points. This of course is now combined with more restrictive lending criteria by banks and other lenders are understandably being more cautious in extending credit to property owners seeking new financing or refinancing of old loans. Vornado wouldn’t talk about it, but these are surely the reasons why it paused the new Penn Station development.
We are long-term bullish on New York, but make no mistake – danger lies ahead. A former president once said that we will not stand by when danger is gathering, but gathering it is. This time the danger is a slow motion ticking time bomb gradually gathering steam which is poised to spread through the real estate industry over the next few years. I fear that it may be very difficult to defuse until more employees return to the office, which they have refused to do thus far. Many major business leaders and pundits are predicting that a recession is anticipated in the next 6 to 9 months, so that will surely impact what comes next. As with the recent elections, expect the unexpected and you won’t be surprised.