Crisis Alert: The 'Urban Doom Loop' - The Next Economic Quagmire Looms over Midsize Cities Caused by Corporate Downsizing & Real Estate Armageddon
Today, let's lift the curtain on the increasingly ominous prospects of the 'urban doom loop,' posing the next significant economic quagmire.
Landmark moves by significant players are painting a grim picture for the commercial property landscape, particularly in midsize cities. Salesforce, the tech titan, is trimming its office footprint by a substantial 25% in the towering edifice of Indianapolis, straying away from a six-year tradition. A similar fissure has surfaced in Atlanta, as the financial magnate Starwood Capital stumbled on its $212 million mortgage for a towering office complex. Meanwhile, Baltimore's iconic building recently swapped hands for $24 million, marking a plummeting descent from its original price of $42 million back in 2015.
This kind of dramatic shift is ringing alarm bells nationwide. City centers, officetowns, and shopping precincts run the risk of becoming the epicenter of this impending economic calamity that we're terming the 'Urban Doom Loop'. The torrential fears are grounded in the premise of a potential armageddon in commercial real estate, which is positioned to ripple into the wider economy, plowing down local tax incomes and slogging the pace of commerce.
The spark for this bleak trajectory was the pandemic-spurred seismic shift to remote work. Metropolitan powerhouses like New York and San Francisco have grabbed headlines for their conspicuous vacuum in previously vibrant office towers. However, the dicey predicament has raised even more alarm for midsize cities that simply lack the resources to cushion the detrimental impact of significant companies downsizing office arenas, a dramatic fall in building sale prices or downtowns morphing into deserted shells.
The Blind Economist's perspective posits that this trend is more of a permanent shift in our global workspace paradigm than a fleeting issue. The pandemic has birthed a transformation in our reality, rewriting the rules of the professional setting. An exceedingly competitive labor market forces employers to vie fiercely for employee talents. Despite modest improvements in labor market conditions, the challenge for companies to amass the necessary workforce remains significant.
The prevalent sentiment reveals a workforce that is increasingly embracing the liberty and flexibility that comes with remote work — making hefty office spaces seem almost redundant. This dramatic shift isn't likely to revert fully. The question of where we work is the new conversation we need to have.? And as an economist, I predict our physical work spaces will continue to evolve, accommodating the shifting landscape of trends and demands.
As we delve deeper into this urgent matter, let's paint a picture of a potential worst-case scenario: Imagine Milwaukee or Memphis, where an increasing number of employees have transitioned to remote work. Businesses, consequently, are reassessing their need for physical office spaces, either breaking away from leases or not renewing them. This leads to surging vacancy rates, complicating the task for landlords to find new residents or make profitable sales of their properties.
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This new reality could place property owners under financial pressure, making it arduous to clear mortgage payments or other debts. Following this, business sectors could wither, reducing tax revenue generated from commercial properties or salaries. The once lively downtown zones could face a noticeable downturn, with the decline of people going to retail stores or restaurants. This would constrain commercial spending, potentially leading to layoffs in the hospitality and retail sectors.
Stijn Van Nieuwerburgh, a professor at Columbia University’s Graduate School of Business with expertise in real estate and finance, and co-author of a paper delineating the "urban doom loop," warns, “Once those office buildings are vacated, the chances of revival are slender, displaying limited after-hours activity.” He further points out, “mid-sized cities are faced with a greater hurdle compared to metropolises like New York City, due to their limited morphological ability.” He grimly concluded, “It's akin to a gradual, ongoing train wreck.”
However, there's a silver lining. Economists have suggested that this doomsday scenario is not inevitable; the spiral hasn't yet set into motion. A few factors may be cushioning the impact: cities sustain on historic levels of aid from the state and local stimulus from the 2021 American Rescue Plan, with funds likely to last another year or two. In addition, large portions of outstanding business and mortgage loans aren't due for a few more years. Plus, through the strength and resilience of the economy itself, the fear that extensive layoffs or dips in consumer spending could instigate this perilous loop is currently held in check.
Nonetheless, overlooked issues persist in the economic discussions. An imminent challenge, for instance, is the upcoming need to shift approximately one trillion dollars within the commercial real estate market into higher rates over the next 12 months.
In what appears to be an escalating risk to financial stability, the Federal Reserve has underscored the potential danger posed by the commercial real estate sector. The red flags are increasingly apparent, particularly in areas already grappling with economic vulnerabilities. It appears that mid-scale cities bear the brunt of the predicament with some of the highest portfolios in office delinquency - a scenario where loan payments on buildings fall into arrears - and the lowest in-office occupancy rates.
Data from Trepp, a leading real estate analytics firm, pegs the average delinquency rate within the top 50 metropolitan areas nationwide near the 5 percent mark. However, this figure soars to an alarming 30 percent in cities such as Charlotte, North Carolina, and Hartford, Connecticut, suggesting an uneven distribution of the crisis.
Similarly, while the average occupancy rate hovers around 87 percent, several cities have significantly lower figures, including Oklahoma City at 71 percent and Memphis and St. Louis both at 76 percent. This trend could potentially take a dire turn, especially when properties are due for refinancing. "What we're witnessing are the initial effects, but the heaviest rains, metaphorically, are yet to make their appearance in the upcoming 18 to 24 months,” warns Lonnie Hendry, Trepp’s senior Vice President. "We're still in the early phases of this cycle."
As someone recognized as The Blind Economist, my perspective is that this situation could manifest as a systemic challenge for the entire economy. Although the predominant 50 metropolitan cities report only a 5 percent vacancy rate in commercial office space, the national average skyrockets to 20 percent. This sharp uptick in vacancy rates, compounded by the upcoming shift into higher rates of debt service, could usher in significant difficulties for property owners and regional banking outlets alike.
As I've previously emphasized, the malaise affecting the commercial real estate marketplace may exert a disproportionately negative impact, especially on regional banks that majorly manage and issue these mortgages. If these dominoes begin to tip over—creating issues for the regional banks—it could potentially catalyze a full-blown economic recession.
Continuing our discussion in this newsletter, the 'doom loop' theory, pioneered by Van Nieuwerburgh, has garnered considerable attention. It sparked a media frenzy and earned Van Nieuwerburgh the unofficial title of “the prophet of urban doom.” However, it's crucial to understand that this downward spiral isn't a foregone conclusion for every city.
Tracy Hadden Loh, a specialist in commercial real estate and governance at the Brookings Institution, reminds us that responses to vacant commercial spaces will vary across cities. Not all cities are new to this challenge - some grappled with office vacancies pre-pandemic. How cities have been utilizing and when they will exhaust stimulus funds will also play a role in their resilience.
Critical tax regulations add another layer of complexity. For instance, cities like Chicago and Boston, with extensive office footprints, heavily depend on property tax revenue and may be more vulnerable in this respect. Alternatively, Philadelphia, reliant more on wage taxes from commuters than real estate, could face significant revenue shrinkage with declining office attendance. According to Loh, "The local tax structure matters tremendously in the United States. You can’t make a 100 percent true general statement about any class of cities because they each have their own bespoke revenue structure that has evolved over time.”
Speaking personally, the key takeaway in this newsletter is understanding the role of revenue diversification. Cities with a more varied tax revenue base are likely to be less vulnerable. However, this situation could widen the economic gap between larger metropolitan areas and medium-sized communities. It opens up discussions about demographic shifts - will population migrations towards larger metropolitan areas increase due to shrinking tax revenues in smaller locales? How quickly and effectively cities can recalibrate their tax dependencies will be fascinating to observe.
As we continue to navigate the evolving real estate landscape in the Blind Economist newsletter, it's evident that there's an increasing struggle to find sound solutions for the surging issue of mortgage defaults and distressed building sales happening daily. This is largely evident in metropolises and smaller towns alike. Notably, some innovative property owners have attempted to repurpose vacant offices into completely different uses such as residential apartments, food preparation spaces, or even wellness centers. However, these alternative solutions are not always economically viable, and their impact is yet to be felt on a significant scale.
Highlighting a case study, let's focus on Minneapolis, a city that's seen a concentration of distressed loans primarily in downtown buildings that are finding it challenging to secure new business. A significant occurrence was in March 2021 when Target decided to vacate a key location in the city, slashing its lease of almost 1 million square feet. This formed about three-fourths of the entire space within that particular building. It's important to note that Target retained other substantial leases in Minneapolis and indicated that the 3,500 corporate personnel who previously worked at City Center would be relocated to other major headquarters within the city.
Brian Anderson, Director of Market Analytics at CoStar Group, stated that the move was a considerable setback for Downtown Minneapolis. The vacuum left by Target hasn't been able to draw significant interest from potential tenants. “With more companies opting to adopt a remote-hybrid work model, we expect it to make a considerable difference. It's likely to trigger massive shifts," he highlighted.
Consequently, as the Blind Economist observes, it's becoming increasingly clear that city councils are likely to face heightened challenges when it comes to re-zoning commercial spaces. This is due in part to variations in tax levels associated with different property types.
In our focus on the evolving landscape of Downtown Washington, we note a concerning scenario unfolding. The District has seen office leasing activity plummet to an unprecedented low during the first quarter. Merely 900,000 square feet of office leases were signed during this period - a considerable drop from the five-year quarterly average of 2 million square feet, as reported by Trepp.
Our key insight from this inescapable trend is that enthusiasm for office space has significantly diminished. Current signals do not hint at a reversal of this trend anytime soon. A crucial element to watch out for is the fate of the massive $5 trillion worth of commercial real estate debt floating within our economy, in conjunction with the $2.75 trillion in commercial mortgages set for maturity by 2027.
This overhang of impending deadlines may disproportionately impact regional banks, as they account for two-thirds of the nation's total commercial real estate debt, encompassing more than just office space. These financial institutions' stability is particularly vulnerable to shifts in individual city economies. The abrupt downfall of two midsize firms during the earlier banking crisis this year already unnerved economists, raising concerns around the stability of regional lenders.
Gauging the trajectory of the broader economy is equally crucial. The Federal Reserve hasn't loosened its grip on the fight against inflation, committing to sustained high interest rates as required. The intent is to temper the economy's speed by reducing the appeal for loans and investment. Initial indicators suggest success in this approach. A July report shows that at the same time banks are setting their standards higher, loan demand for commercial real estate is on the decline. Experts will be keenly watching the knock-on effects these developments will have on regional and national economic health.
In the illuminating words of Hendry, the so-called 'doom loop' may not unfortunately be limited to just a few factors. He paints the stark picture, "If you have a mortgage with an interest rate in place at 3.5 percent, and you want to refinance at 7 percent, that is unavoidably a global predicament, not confined by geographical boundaries."
My closing words, as 'the Blind Economist', pivot on the belief that the entirety of the real estate sector is in the midst of a paradigm shift. This ripple of change echoes not just in the commercial office space sector, but reverberates across all spectrum of the real estate industry.
The aftershocks of the pandemic have permanently altered the landscape of our lives and by extension, the world we inhabit.
In light of this unprecedented metamorphosis that our global economy, and indeed our very world, are navigating, it is incumbent upon each of us to stay abreast of these tectonic shifts. It is a call to adapt, evolve and not be left adrift in the face of an ever-fluid reality.
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The Blind Economist,
Michael Anthony Francis,
CEO, Macroeconomic Solutions