Even before artificial intelligence replaces millions of American office jobs, there are large US cities with office vacancy rates over 10%, even over 20%. The list includes San Francisco, New York, Austin, Houston, Boston, Seattle, Salt Lake City, Phoenix, Atlanta, etc., etc. Actually, most American towns and cities have vacancy rates well-north of 15%. According to a January report from the Commercial Edge, the national vacancy rate reached 18.3% at the end of December 2023. Want some quality alone time? Head on over to downtown San Francisco: Tech layoffs, hybrid work habits (or completely remote work), downsizing, rising interest rates, and tons of small businesses that catered to these now abandoned office workers. Retail businesses in and around Union Square are departing at high speed.
According to the Visual Capitalist, “At the national level, the supply of new office real estate has been dropping steadily since Q1’2022, down by a whopping 67% year-over-year.” In some decimated markets, office space is renting at 40% below recent, prepandemic times. And there are chills going down the backs of a whole lot of mortgage lenders, where cash flow is always the basis for setting mortgage rates. While the larger American banks can weather the storm, there many local banks whose core business is lending for commercial real estate. Uh oh.
The January 14th CBS 60 Minutes, headquartered in Manhattan, looked around the city, where the vacancy rates have risen 70% since 2019, and the story was anything but pleasant for local real estate developers, building owners and… lenders: “[It's] not just the real estate industry that is impacted. The effects of vacant office space could ripple through the economy because many buildings are financed through short-term loans from banks. If real estate firms are unable to make rent money from commercial tenants, they may default on their loans, increasing the risk for banks.
“That's what led real estate company RXR to default on a $240 million bank loan at 61 Broadway in New York City. With half his office tower sitting vacant, RXR chief executive Scott Rechler says it was ‘time to face reality.’… ‘This post-COVID world of higher interest rates, the changing nature of how people work and live, we're not going back to where we were,’ Rechler said. ‘And it's going to be turbulent.’…
“With remote and hybrid work hardening from trend to new normal, office occupancy rates are at an all time low. More than 95 million square feet of New York City office space is currently unoccupied –the equivalent of 30 Empire State Buildings.
“As tenants shrink their office footprint, office landlords are confronting the fact that some of their buildings have become obsolete, if not worthless. By some estimates the price of office buildings has tanked by as much as 40% since the pandemic. At Columbia Business School, real estate professor Stijn Van Nieuwerburgh has modeled out the impact of hybrid work on pricing. He calls it a ‘train wreck in slow motion.’
“‘And this is just the beginning. And the reason it's just the beginning is because there's a lot of office tenants that have not had to make an active space decision yet,’ Van Nieuwerburgh said. " 'Do I want to renew this space? Do I want to vacate? Maybe I sign a new lease for half as much space.' This is what tenants have been doing for the last three years.’
“Marc Holliday, CEO of SL Green Realty — New York's biggest office landlord, and 60 Minutes' landlord — considers work from home to be ‘one of the biggest societal problems we're facing right now.’… ‘I think that it's bad for business. It's bad for cities. It's bad for people,’ he said.” Combine this reality with staggering interest rates on residential mortgages with the fact the residential housing market is still holding its value vastly better than the commercial counterparts… and you get a bizarre pricing anomaly. Rents skyrocketed after the pandemic, and while they are settling down somewhat, housing affordability is one of the major stories in the coming election.
So, do we convert these office buildings with tons of empty space into residential units? Just think of the plumbing associated with bathrooms and kitchens, vastly more extensive than any office requirement, and you can begin to see how expensive an office-to-resident conversion might cost. It’s a bold and expensive move for many building owners, and many would prefer to walk away from their buildings, given that the outstanding debt on these structures is often higher than the true value of unrented space. They would rather take the loss rather than “throwing good money after bad” in a very uncertain marketplace. Others believe that the predicted “doom loop” will vaporize, and offices will recover their lost values.
The February 11th The Wall Street Journal found one investor looking to buy up some of these buildings, starting with very-vacant San Francisco. “Most investors are running away from San Francisco’s downtown real-estate market, but Ian Jacobs is heading in. Call it a family tradition… Jacobs is an heir of the Toronto-based Reichmann real-estate dynasty, which made a fortune buying properties in nearly bankrupt New York City during the 1970s. A bargain-seeking stock investor who once apprenticed himself to Warren Buffett, Jacobs has mostly avoided the family business—until now… San Francisco is the epicenter of a national commercial real-estate collapse…
“Jacobs has lined up commitments of $75 million for his first few deals, the people familiar with the matter said. Ultimately, he hopes to buy 3 million square feet of office space for prices about 70% below what it would cost to build the properties, according to marketing materials for the project viewed by The Wall Street Journal. Recent building sales in San Francisco averaged between $200 and $300 a square foot, implying total purchases of $600 million to $900 million.
“The plan is called ‘Project Uris,’ a nod to the Reichmann’s 1977 purchase of eight Manhattan buildings from Uris Buildings Corp. through their company Olympia & York Developments. Like San Francisco today, New York City was struggling with crime, corporate flight and political dysfunction. Five years later, a resurgent Wall Street lifted the local economy and the buildings were valued at 10 times what the Reichmanns had paid… Jacobs’s great uncles Paul and Albert Reichmann developed Canary Wharf in London and the World Financial .. Center in New York. The empire grew to $10 billion by 1991, collapsed when debts bankrupted Olympia & York, then slowly recovered to at least $880 million by 2005…
“The biggest short-term risk Jacobs has flagged to co-investors is that the window of opportunity slams shut before he can buy. Soaring interest rates chilled property sales by making mortgages costlier, but many think the Federal Reserve might cut rates this year. That could prompt fund managers and other institutional investors to return to San Francisco, they said… Even if rates remain high, Jacobs is an outsider in San Francisco competing against wealthy locals also looking to buy buildings on the cheap. He has bid on a few properties but hasn’t completed any deals, the people familiar with the matter said.”
So, will the revalued buildings generate new office rentals as much lower rates? How much of this vacant space can be converted into desperately needed residential real estate. Does Ian Jacobs know something that most owners of these buildings do not? Stay tuned.
I’m Peter Dekom, and for all those people who believe real estate is a risk-free investment, think again…
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