What Comes Next for Commercial Real Estate

A lot of professional organizations are coming to realize what we figured out many years ago: Working from home has a lot of challenges, but also a tremendous amount of benefits. One benefit we have long enjoyed is, by not requiring someone to move, we are able to recruit the best people to be part of our team. Another is not having to burden our nonprofit budget with paying monthly office rent. The sweetener is that we spend some of that savings getting together two or three times a year, always someplace enjoyable, usually accompanied by churros and thrill rides.

But we’re a small operation with a tiny budget. I know people working tech in downtown San Francisco, people whose employers have long insisted they come into the office daily, people who are now working productively from home. Those employers are watching their workforce maintain (or even increase) production levels while they simultaneously pay millions in rent on empty buildings.

More than a few people are speculating how this period of quarantine will change how we work. Few things are certain, but it’s difficult to imagine it increasing demand for office space.

That’s interesting because, heading into this pandemic, we already had a glut of commercial space. In 2017, there was an interesting piece from Greater Greater Washington on the glut of vacant office space in Washington DC. The article lamented why, in a city with explosively high housing prices, some of the 14 million square feet of vacant commercial space could not—or was not—being converted for residential use.

If half of it was converted to 1,200 square foot units, that would be around 5,000 new units. According to the same site, that is more units than were permitted to be built in DC in the prior year. This seemed an easy and obvious way to address the demand for more housing.

Some people on Facebook were rather dismissive of my take and the article in general. Come on, Chuck. The market will take care of this problem. Indeed, I think it will, but not in ways we’re all going to enjoy. The financing of commercial real estate has some strange incentives that, while difficult to grasp during good times, are going to become vividly apparent in short order.

The value of a commercial property is based on the rent that can be obtained. As rents go up, the building is worth more. As they go down, the building is worth less.

When obtaining commercial financing—when getting a loan—the value of the building will be appraised based on the rents that can be obtained. If you can collect a lot of rent, the bank will loan you a lot of money. If you can’t collect much rent, the bank is not going to loan you very much.

This is all pretty straightforward, right? Let’s back up six months in the commercial real estate market and understand what was happening.

The Economics of Commercial Financing

Let’s say a commercial property developer acquires a $1 million office building. First, they must put 20% down—$200,000. Likely half of that down payment comes from gap financing from a local bank(s) and the other half comes from investor cash. That means they will borrow $800,000 from a major bank—and that loan will be a financial instrument that will ultimately get sold onto a secondary market and securitized into different packages that are then sold in bundles around the world. It's a very top-down and efficient capital allocation model.

To get that $800,000 loan, the developer is going to need to show collective rents that value the building at $1 million. For ease of calculation, let’s say they have seven different units in the building and collect $10,000 per year from each unit. That is $70,000 of revenue annually. That’s enough money to make their annual debt service of $52,000 on a 5% loan, and have some money left over for other things (maintenance, taxes, investor return, etc…).

Building Value: $1 million

Loan Amount (80%): $800,000

Annual Debt Service (5% interest): $52,000

Annual Rent Revenue (7 units x $10,000 per unit): $70,000

Now the developer owns the building and everything is going great until—oops—market glut. We’ve just built too many units in the market and, as things turn over, we’re not able to fill all the units at the $10,000 per year rate. In fact, ponder a situation where only four of the seven units are rented. This was very common, even in the roaring days

The developer has some options at this point. Option 1: Lower the rent to a level that fills the vacancies. Option 2: Convert the office space to some other use. Option 3: Stay put and hope that the vacancies are a momentary blip in the market and that new tenants will soon be secured at pre-vacancy rates.

Let’s take a close look at how the "marketplace"—which is how we’ve come to define our top-down, centralized, corporate/government financial system—works these things out during the pre-coronavirus times. Doing that will help us understand what will happen next.

Option 1: Lower the rent

With a sound grasp of free market economics, the developer understands that supply and demand find a balance through price. If the units don’t fill at $10,000 per year, then the price has to be lower.

Image by Tiger Pixel

Let’s overlook the impact this has on the four existing tenants who are paying the higher rate—sure, they have leases, but contracts are malleable and fluctuating prices tend to destabilize agreements—and just focus on filling the three vacant units. Let’s say our developer drops their prices by 20% and so the market clearing lease rate is now $8,000 per year.

Now the developer is bringing in $64,000 per year instead of $70,000 per year. That’s okay. They're still making their payment to the bank. They're still keeping up with the maintenance.  Their investors aren't happy to take a haircut, but that’s part of the risk of investing. So, this is stable, right?

Not really. Commercial loans are generally financed over 3-, 5- and 7-year timeframes. That means every few years, the developer is going to have to roll over that loan. When they do, the value of the building is going to be based off the current market rent, which in our case, is now 20% less.

So instead of having a building that is worth $1 million, your building is now worth just $800,000. When you go to get your next loan, the bank is only going to lend you $640,000. And, in a falling market, they might be a little bit nervous about that.

Here’s the kicker: The developer has been making the loan payments every year and is completely current, but after five years, they still owe $735,000 on the initial $800,000 loan. Since they are only going to get a new loan at $640,000, they are going to have to come up with the difference—$95,000 in cash—before they can refinance.

Where is that money coming from? That’s a year and a half of rent! Are the outside investors going to kick that amount in? Not likely, since they are getting stiffed on their return already. Is another bank going to loan the developer that money? Possibly, but not likely, and certainly not at friendly terms.

The only real option is for the developer to take $95,000 out of their own pocket and put it into a declining building, something they are really not going to want to do. There is little to be gained at this point and nearly six figures to lose. You don’t last long in the development game doing things like that.

In summary, lowering rents to market price lowers the value of the building and makes the project insolvent. Game over.

Option 2: Convert from office space

Securities and Exchange Commission in Washington DC. Photo from SEC.

Remember that whole bundling and packaging thing with the original $800,000 loan? The people who made that happen—the banks, the agents, the brokers, the insurers, etc.,—they all deal with commercial office space. Their checklists and forms and paperwork are all dealing with a commercial office product. The stuff they report to the Securities and Exchange Commission (SEC), let alone their investors around the world, stipulate that they are investing in commercial office paper.

The developer, who is not the owner of the building—it is the owners of those securities that technically own the building—is not able to unilaterally change the arrangement and make that commercial office paper into residential mortgage paper. If the developer does, there is going to be a lot of paperwork of the unpleasant variety (the kind that involves lawyers and sometimes lawsuits).

The developer could opt to refinance the building with a different financial arrangement, but they would be subjected to a very different set of rules and standards that would impact the value of that property. This would, almost certainly (unless residential rents were really high and practically guaranteed) bring about the same insolvency situation as simply lowering the rent, albeit with more paperwork.

And, since the developer specializes in commercial office space—and they almost certainly do specialize because it’s more efficient that way—making the shift to residential is not something they even feel qualified to do. While they have downside in the current arrangement, it is limited. Switching business models would open them up to a lot more. This is not really an option, so game over.

Option 3: Ride it out

The developer keeps making their loan payment with three of seven units vacant. It’s not ideal, but it’s stable. Refinancing time comes and the developer can assert – and the bank can verify – that the market rate in that building is $10,000 per year.

Yes, there are three vacancies and they're making an effort to fill them, but they will be filled at the $10,000 rate like the four that are currently leased. Please, banker, continue to value the building at $1 million so we can roll this loan over and wait for the market to improve. In the business, this is called “extend and pretend.”

Here’s where the incentives for the bankers get interesting. If this is a local bank financing a local commercial product, the conversation probably gets rather personal. That local banker knows the local market and has a sense of what kinds of rents are possible. They are taking depositors' money—literally the money of their neighbors—and investing it in this commercial enterprise. Hard questions are asked and whatever is finally agreed upon, we can guarantee the developer has a disproportionate amount of skin in the game.

Unfortunately, that’s not how banking works today. If the local bank has any involvement at all, it is as a broker—getting paid to make the transaction happen and then selling that commercial loan onto a secondary market—and so their main concern is twofold: (1) Getting paid the fees associated with the transaction and (2) making sure the loan meets the underwriting criteria and therefore can’t come back to bite them if and when it goes bad.

So, if the banker can legitimately certify that leases are in place to justify a $1 million valuation, that vacancies are only temporary, and that there's a good faith effort underway to fill them at rates that justify the loan, then it’s all good. Extend and pretend.

This is why you’ll often see commercial space offered with free rent at the beginning of the contract. If the developer lowered the rent by 20%, then they become insolvent and are pushed into default (that was Option #1 explained above). If they give you 20% of the rent for free—say the first year free on a five year lease—and the rest of the time charge you the elevated price, then they can claim the free months were just an incentive and the real market price is the elevated one they need the bank to certify. It's the same dollar amount just expressed in two different ways.

Centralizing commercial real estate finance dulls the direct feedback loop a vacancy should create. It changes the incentives for all the players and makes “extend and pretend” the only viable option for them to avoid serious pain. This is why we witness aggressive commercial construction simultaneous with high commercial vacancy rates and insatiable demand for housing. It’s a paper marketplace, a financial construct, divorced from reality.

So what happens when reality intercedes? What happen when we can no longer pretend?

What Comes Next for Commercial Real Estate

We’ve centralized the finance of local real estate transactions and made our markets less responsive to local conditions because it was an efficient way to pump money into the system. It was an easy way to create jobs, growth, and economic development. It was an easy way to drive up real estate prices, which benefits nearly everyone involved. In short, our desperate pursuit of inflation as a proxy for a real economy created a bubble in commercial real estate.

The dramatic slowdown of life in response to the Covid-19 pandemic has popped that bubble. We’ve seen how many corporate tenants have already stopped paying their rent, threatening the entire finance model. Billions in bailout dollars were aimed at this part of the market. The Federal Reserve is buying commercial real estate and corporate bonds in a desperate attempt to keep their prices stable. This is all an attempt to buy time in the hopes that things turn around soon. The cries you hear about restarting the economy use small business and the poor as their rally, but this is all about keeping the tear in the many bubbles we’ve blown from expanding.

The longer this goes on, the more businesses that will opt to not pay their rent. That’s not a dumb move since it’s not like a landlord can go through the eviction process with the hopes of quickly securing another tenant. Many landlords will find themselves with no income on properties that have ongoing cash demands. These are the weakest players and it won’t take them long to be forced into liquidation. This will start to happen in months, not years, although the properties could sit empty for years as tangled and interwoven claims are worked out.

The greatest drama is playing out with those properties unfortunate enough to have their loan expire during the next twelve months. We will undoubtedly find some creative ways to “extend and pretend,” and it’s almost certain that the federal government will try to bail out this system by lowering rates, extending payback terms, and guaranteeing loans. Even so, there is going to be a reckoning based on the reality that market participants — the tenants in those buildings — will not be able to afford pre-crash rates of rent.

Remember, if the rent drops, the value of the property drops. Even with a long feedback loop, that’s the constraint that can’t be avoided. Lower rents destroys the commercial real estate market along with your pension fund (as I wrote a year ago) and a whole bunch of other supposedly safe investments that were chasing higher returns. This is going to be painful, and I suspect we’ll do everything we can to blow more bubbles and try to avoid this pain.

Yet, our small businesses need lower rents. Our commercial property owners need more flexibility in how they respond to local needs. This adjustment is acutely painful, no doubt, but let’s understand that it is fixing a chronic problem that has also grown deeply painful for a broad spectrum of society.

We desperately need to get off this roller coaster, to stop inflating and then reinflating a series of financial bubbles. The reckoning we sought to avoid has arrived. Our conversation needs to shift from preventing damage to setting ourselves up for the quickest recovery. How do we use our limited resources to seed the next generation of small businesses and entrepreneurs? How do we help them get back on their feet the quickest?

We can spend billions bailing out commercial real estate investments that have lost all touch with reality, or we can spend a small fraction of that keeping our local businesses on life support, allowing them to emerge after this financial disaster (of our own making) in position to thrive in a marketplace cleared of the unfair subsidies and advantages long given their corporate competition. That’s how we respond to local needs. That’s how we salvage something from this mess.

The urgent lead to localize is upon us. It’s only going to get crazier unless we shore up the foundation of our economy. We need to start building strong and resilient places. We need strong towns.

(Top image from MoneyBlogNewz.)

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