America's
big cities are facing major problems. From sky high interest rates
to the reluctance of employees to return. To their office. The impact of higher rates
and the banking stress is hurting smaller businesses across the country.
Many of which can be summed up by a controversial new phrase
the urban doom loop. The environment is certainly shifting on Main Street,
and it's weighing on optimism. Losses at the bank level, reducing
the losses to the investors level. And I think for the city's right,
they're going to have this potential, this urban doom loop. Columbia Business School Professor Stijn Van Nieuwerburgh coined the term. Here's how it all works. Early in the pandemic, a lot of office
sector workers started working from home. And here we are three years later. Many of them are still working from home,
at least some of the time. All of that has led to a large reduction
in the demand for office. We see a lot of companies downsizing. We see a lot of companies not renewing
their leases at all and consolidating. And with this demand decline for office
comes declines in the revenues for the owners of those offices
and value declines in these offices. Declines in property values, reduced
property tax revenues for the city. The cities have to balance their budget. They now need to cut spending. But that means less money for public safety,
for sanitation, for transportation, for education makes the city
a less attractive place to live. People migrate out. Property values fall more, less money,
more people moving out. And the city gets into an urban doom loop
where its fiscal health spirals down. At the height of the COVID
19 pandemic, remote work policies prompted many employees to leave their city
and move to new states. These population outflows
have long term implications for cities which rely on tax revenues for funding. Property tax revenue in New York
City is about half of all tax revenue. Commercial property tax revenue is about
10% of all tax revenue. So if the value of that falls by 40%,
we're talking about a 4% hole in the budget. So if New York City's budget is $100
billion per year, that's a $4 billion shortfall
that has to be made up somewhere else. Rich people pay a disproportionate
share of income taxes. In New York, for example, a few thousand
taxpayers are paying half of all taxes. Migration has become easier because you can leave the city
without leaving your job. So if a few rich people or families leave,
that could leave a large hole in the budget. Technology sector has been more permissive
to remote work, so those areas tend to be affected
the most. Think of places like San Francisco,
Seattle, West Coast City, sort of more generally. The urban doom loop isn't just a theory,
it's playing out in the real world, with landlords finding themselves financially underwater
and regional banks facing a credit crunch. So when on the landlords and want to buy a building,
typically I'm going to buy it with a combination of my own money,
my equity, and a piece of debt. Because real estate is such good
collateral. Banks are generally willing
to lend a lot of money. So typically there will be 60, 65,
sometimes even 75% debt and 25% equity. So that would be a typical financing structure
for a commercial real estate building. And then typically
the debt will be fixed rate. The only difference is I'm not paying off
any principal, which means that ten years later, when my loan comes,
do I need to refinance that loan? Normally that's not a problem because normally the value of my office
will have gone up these past ten years. But what if it hasn't? What if the value of my office has in fact
gone down? So now the bank will look at that office
all over again and reassess it. And to the extent it's even willing to give me a new loan, it's going to only
want to give me a smaller loan. So now, as a landlord,
I'm going to have to make a tough choice. Either I come out of pocket
and put more money into the deal because the loan that I'm getting now
is smaller than the one I need to repay ten years ago. So I put in more equity in the deal or I walk away
and I have the right to do that. I can send the keys to the lender
and just walk. A lot of the debt is non-recourse,
which means the bank has no recourse to my other assets. I can just simply take this one else's
building that I've borrowed against and just send the keys to the bank.
The bank now owns the building. So banks are facing this deterioration
in basically the credit quality of these commercial mortgages
that they have on their books. So these smaller regional banks
that have done a lot of local commercial real estate lending,
they're now tightening the screws on the credit for the local
non-real estate firms as well. That is sort of a traditional credit
crunch. Commercial
real estate is a very large asset class. There's about $5 trillion
of commercial real estate out there. And whether you know it or not, you know,
your pension fund might very well have an exposure to commercial real estate
directly or indirectly. There's also a part of the equity markets called the Rete market, which is
the publicly listed real estate space. And again,
a lot of folks have exposure to that through a mutual fund,
through an exchange traded fund. And those rates,
especially the office reads, have fallen on hard times
in the last several years. Their stocks are often down 56 and 70%,
sometimes occupancy of office getting to 30% below
pre-pandemic levels. The office sector certainly is going to experience more pain
than any other sector in the next 2 to 4. Years, with only a small. Percent of desks occupied around the world
five days a week and trillions of dollars of commercial and office debt about to come due
in the next couple of years. It really makes you wonder
how it's all going. To shake out. So are we really doomed? Or is there a way for cities
to pull themselves out of the loop? The fundamental problem
is that we have too much of the only solution in the long run
is to get rid of some of the excess office
we have and repurpose some of that space. The solution you hear about
the most is apartments. Turns out that
that's easier said than done because a lot of our large offices
are very big buildings. By my own calculations,
only about 10% of office buildings are physically suitable
for conversion to apartments. But that's just one of the options you can
think about more medical office space. You can think about more entertainment
spaces, more hotel space. There's a lot of creative things
we could do with the land. This is nothing new. Cities have always reinvented themselves
throughout the ages, and it's now basically our next challenge is to get rid
of some of that defunct office space.
