WeWork’s Implosion; A Bellwether for the United Kingdom & Canada’s Real Estate Markets & Economies

Earlier this week, WeWork announced doubts regarding its going concern status, effectively marking the final chapter in a company that has been entangled in a series of controversies over the past couple of years [6]. However, while not downplaying the role of WeWork’s mismanagement and misappropriation scandals in its fall, WeWork’s collapse can be seen as a harbinger of things to come within the real estate sector.

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The real estate sector has taken a beating in recent times due to a combination of factors. This has affected both commercial holdings and residential property, signalling the biggest real estate crisis since the subprime crisis. This impending crisis is location agnostic and is impacting economies across the globe; particularly countries which are emerging from a zero or near-zero interest rate regime. Additionally, structural shifts and changes in the behavioural patterns of people since the pandemic have also affected the way property is used and, in turn, its valuation. A shift to hybrid and work-from-home patterns has severely affected the office space sub-sector as fewer people come in to work regularly. Companies have used this as an opportunity to trim overheads by not renewing their leases or reducing their office space and transitioning to a hot-desk working philosophy. Consequently, office property is facing its lowest occupancy rates in more than 30 years in Canada, Britain, and America, excluding the pandemic lockdown period. This decrease in occupancy rates has led to a fall in property valuation and related services catering to working from an office space, including transportation, dining, and fashion.

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In April 2023, Blackstone completed the sale of twin office towers it had on its books, located in Santa Ana, California, for $84 million [7]. These buildings were purchased for $129 million in 2014, suggesting a 36% loss. Factoring in inflation over this period, this loss expands to 49% in real terms. Gupta et al (2023) in their paper “Work From Home and the Office Real Estate Apocalypse,” estimate that $506 billion has been wiped away in the US office property market [9]. This drop in valuation, while not yet recognised on the books of asset managers, also applies to other developed markets.

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Office property in the United Kingdom is similarly impacted. However, the situation in the United Kingdom is slightly mitigated with more government intervention in the real estate markets, both directly and indirectly. Earlier this year, Schroders Capital disposed of its 2 Ruskin Square office building in Croydon. This building was supposed to be a lynchpin of its SCREF UK property fund. In a series of announcements, it stated it leased this building to a UK government department for 25 years (with the UK government now partly responsible for the fittings and finishings which would go into this building) [4], before announcing a sale of this building to Pension Insurance Capital [5]. This has effectively derisked the SCREF fund and removed the headache of having to source for long-term tenants in a falling market. Given the UK government’s much-publicised levelling up campaign, which aims to decentralise government from London as a means of developing other regions, it would seem logical to speculate that this lease was more to prop up the UK commercial market than to fulfil an actual need for working space. It is also worth noting that this was not a pre-build agreement, reinforcing the fact that this lease was an unofficial intervention by the UK government. Coincidentally, other property development projects have opted to transform office buildings in Croydon, Stratford, and other parts of London into residential and student accommodations [1, 17], signifying the fact that if this were merely a need for space, the UK government could have acquired this required space at a significantly lower cost by leasing any of these buildings before their conversion.

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The British government’s intervention in real estate isn’t solely confined to the office space sub-sector. England’s prominently promoted Help-to-Buy scheme asserts that it has aided in the acquisition of over 375,000 houses during its 10-year existence (ironically introduced in response to the subprime crisis) [12]. In the same period, the UK reported 1.99 million net residential additions, of which approximately 1.66 million were new residential constructions [26]. This suggests that Help-to-Buy might comprise around 20% of new mortgages/property acquisitions, potentially positioning it as the UK's largest mortgage provider/enabler. Considering this is just one of several property acquisition initiatives by the UK government in England and the rest of the United Kingdom, it provides insight into the property market's dynamics and the government's significant role.

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The Help-to-Buy scheme is a British government-funded programme, founded on the premise that many individuals are unable to afford mortgage payments to finance the purchase of homes. It aims to reduce the number of individuals unable to own homes, which is at its lowest level in decades. It proposes that individuals contribute 5% of the property's value as their collateral, while the UK government provides an upfront contribution of 20% to 40%, along with a 5-year payment moratorium. This scheme was introduced in an environment of nearly zero percent interest rates. However, bank rates currently stand at around 5.5%, with mortgage rates ranging from 7% to 9%. Given the steep increase in mortgages, particularly when the moratorium on these mortgages is set to expire, non-performing mortgages are poised to rise. In the private sector, this would undoubtedly spell disaster. Nevertheless, due to the UK government’s support of this scheme, and its status as a cornerstone of the Tory government’s housing policy and overall legacy, it is plausible that a more lenient approach towards defaulters on the British government’s share of mortgage payments would be adopted. This does not absolve defaulters from their obligation to pay for the increase in mortgage payments to the commercial partners of the mortgages they took out through the Help-to-Buy scheme. The government might choose to extend another moratorium, effectively deferring the issue. However, this is hindering the UK government’s ability to control inflation, as further moratoriums are akin to printing money to stimulate consumption, a primary cause of the current inflationary trend. Presently, it is estimated that residential prices have fallen by an average of ￡15,000 in the UK [3, 18], with average house prices being supported by new builds which are comparatively valued higher than existing stock.

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The UK’s residential market isn’t alone in this situation, as the Canadian and U.S. residential markets also face similar challenges. In fact, the situation in Canada is more severe than that in the other two countries. While British and American fixed-term mortgages are long-term arrangements, lasting between 20 to 30 years, Canada’s fixed-term mortgages are essentially 5-year fixed resetting mortgages. This means that after 5 years at a particular mortgage rate, these rates reset to a new mortgage rate, either floating or fixed, based on prevailing market rates at the reset time. Hence, individuals who secured fixed-rate mortgages at the beginning of the pandemic in Q4 2019/Q1 2020 would witness their 1% to 2% mortgage rates surge by roughly 400% to between 7.5% and 9%, as interest rates and mortgage rates continue to climb. Very few individuals can afford such a substantial increase, as most individuals secure the maximum possible mortgage to purchase the dream house they now can no longer afford. Canadian mortgages are currently not backed by a federal government, indicating a possible significant rise in bad and non-performing mortgages in the near future. In fact, the proportion of mortgages outstanding provisioned for in Canada from Q4 2019 to the present averaged 0.2190%, which represents over a 20% increase from the long-term 0.1810% provisioning for outstanding mortgage loans in Canada [22]. This shows the uptick in non-performing mortgages has already begun.

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Furthermore, as interest and mortgage rates rise, some mortgage owners have requested moratoriums on principal repayments, choosing to only cover the interest portion of their mortgages. However, due to the sharp rise in interest rates, even these payments aren't sufficient to cover the entirety of interest payments. Some financial institutions have opted to capitalise the unpaid portion of interests by their customers, effectively leading to an unusual case of negative amortisation. These increases and economic slowdowns have started to temper the demand for residential property. Property developers have turned to offering various bonuses to attract customers. A condominium complex in downtown Toronto offered 24 hours of free coffee and biscuits in the foyer, along with a year's free health insurance and the semi-standard 12 months of complimentary internet. Another advertised free electric vehicle charging kits alongside free internet. When factoring these discounts and bonuses into the average costs of a 2-bedroom apartment/condo in downtown Toronto, which rents for $3,500 on average per calendar month, it significantly impacts the Net Operating Income (NOI) of these properties, accounting for approximately 1.5 to 2 months of rentals. This is a huge impact on the earning potential of these properties and should represent a significant impairment on their valuations However, there hasn't been a corresponding reduction in the valuations of these properties by asset managers. Anecdotally, an acquaintance residing in a new property development scheme within the Greater Toronto Area was presented with an offer to purchase a 4-bedroom luxury detached house within this scheme for $1 million by the scheme developer. Notably, the listed price of this property currently stands at $1.45 million, implying a concealed discount of 45%.

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Given the shocks that both the office and residential sub-sectors are going through, with the situation most likely going to get worse, it can be argued that we are currently facing the most significant property crisis since the subprime crisis. The occurrences in the real estate sector and the increasing probability of these risks crystallising should be a significant concern for all participants in the real estate sector and the economy at large. This is because real estate is the largest store of capital for many people, comprising up to two-thirds of individual wealth globally [28]. The global real estate sector was estimated to be worth $327 trillion in 2020 [24]. A significant drop in valuations of real estate across the board could result in a substantial loss of resources for billions of people. Given that many people also fund their consumption, investments, and business activities through equity releases and mortgages, a collapse of the residential sub-sector of the real estate market could have a large knock-on effect on the global economy.

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Real estate serves as a leading economic indicator, particularly in terms of housing starts and construction activities. Real estate trends are closely tied to the state of the economy. Real estate transactions in Canada, the United Kingdom, and the United States have declined by 16%, 15%, and 18.9% [29, 25, 13] respectively over the past 12 months, indicating declining consumer confidence in future economic growth. Additionally, real estate contributes more than 5% of the GDP in the United Kingdom, Canada, and the United States. It contributes around 7% to both the Canadian and UK economies [21, 2], while contributing roughly 4.8% of the GDP in the United States [10, 14]. The real estate sector directly employs 1.2 million [2] and 1.3 million [20] people in the economies of the United Kingdom and Canada respectively, while approximately 3.95 million people are estimated to be employed in the commercial real estate sector of the United States of America [11]. These figures represent 3.9% [23], 6.4% [20], and 2.45% [26] of the labour force in these countries. The high levels of individuals employed in the real estate sector underline the risks these economies are facing. Of particular concern is Canada, where the real estate sector contributes to and serves as a store of value for 21% of Canada's national wealth [21].

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What does this portend for the economies of the United Kingdom and Canada? The total value of outstanding mortgages in Canada currently stands at $1.7 trillion [22], while in the United Kingdom, it is ￡1.68 trillion [8]. This statistic rises to $12.04 trillion in the United States of America, constituting over 70% of U.S. household debt [15]. These figures highlight the significant exposures these countries face if their real estate sectors were to crash, and the level of contagion that could potentially affect other sectors of their economies. It should be noted that a significant portion of the rise in mortgage value in the last 12 months can be attributed to increases in mortgage balances brought about by rising interest and mortgage rates. The most vulnerable sectors that will be affected were real estate markets to collapse are banks and mortgage providers which hold substantial mortgage debt on their books. They are confronted with the dual challenge of rising non-performing mortgages and the need to raise additional capital to address the increasing risks posed by their real estate exposure. Not all financial institutions would have the capacity to raise capital independently or effectively hedge the risks they face from real estate. Therefore, we could potentially be witnessing another round of bank failures, bailouts, and consolidations similar to what occurred at the peak of the subprime crisis, or even on a larger scale. Providing proper perspective, the total outstanding mortgages in the United States (both commercial and residential) amounted to $19.33 trillion at the end of 2022, 32% higher than the $14.62 trillion total outstanding mortgages in 2007 [19].

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So, what can investors and property owners do in light of this situation? To protect their asset base, asset managers may need to take proactive measures to safeguard their portfolios by reducing their exposure to real estate. However, given the relatively illiquid nature of real estate investments, asset managers might encounter challenges in expediently exiting these investments or avoiding substantial losses. Therefore, it would be prudent to consider hedging these exposures using financial derivatives such as index swaps or puts, particularly if their real estate investments are made through financial instruments. Alternatively, asset managers could try out dynamic and tactical allocation strategies to ride out the coming real estate slump using derivatives to change the composition of their portfolios in the near-term. Scaling down holdings in entities connected to real estate and reviewing engagements with counterparties holding significant real estate positions are also advisable.?In addition to this, asset management firms could reduce their leveraged positions to real estate, or else hedge these leveraged positions, if they employ leveraging on the real estate portion of their portfolio. Asset managers should also be encouraged to take the necessary haircuts and impairments to their real estate portfolio, especially if it can be determined that these impairments are permanent. This would enable properties and leases to become or remain attractive to potential buyers and lessees at a more realistic price point. For asset managers who want to take advantage of this situation, maintaining a dry powder reserve will come in handy when the eventual price slump happens, and choice property can then be picked up cheaply. Above all, continuous stress and scenario testing would help fund managers identify possible risks to their portfolios and would give them the opportunity to take effective strategies to protect their holdings.

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For individuals facing difficulties in servicing their mortgages, they might need to curtail other expenses, proactively renegotiate their mortgages for extended periods if future payments are unaffordable, explore options for sharing or leasing parts of their property, and as a last resort, downsize their mortgages by selling their current homes and transitioning to more affordable residences. Although property prices are currently slightly affected and selling might entail discounted prices in a declining market, the earlier this action is taken before the market fully shifts, the more advantageous the deal they can secure.

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Lastly, there is a pressing need for increased regulatory intervention and oversight within the real estate market. Despite significant progress made to introduce more regulations, reporting standards, and risk mitigation tools into the financial services sector since the 2007 subprime crisis, the same level of progress has not been achieved within the real estate sector [18]. To put this in perspective, while dedicated international bodies exist to regulate and guide the operations of financial institutions, such as the Bank for International Settlements (BIS) and the International Organisation of Securities Commissions (IOSCO), no equivalent international bodies for real estate fulfil this role. Considering its interconnectedness with financial services—where many real estate purchases are funded through bank-issued mortgages, forming a substantial portion of retail loans—real estate holds significant importance in all economies and can be considered a potential weak link in the face of a global economic crisis. Continuing its operation without comprehensive oversight poses an ongoing threat to global economies, especially in an environment of rapidly rising interest rates.

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