Commercial Real Estate Faces Perfect Storm: The Demise Of Downtown Office Buildings
A societal change is occurring where people are no longer wanting or needing to work in large downtown office buildings. This will cause problems financially.
In the middle of the 1970s, I was an economics and business student in a difficult time. My tuition and expenses were paid by working part-time and summer jobs that required physical labor, as well as student debt.
One day, I hoped to work on Canada's Wall Street. It was located in Toronto at King and Bay streets. When the Dominion Bond Rating Service employed me as a junior analyst in spring 1980, that dream became a reality. The corners of King and Bay were occupied by four of five of the five largest Canadian banks, with their impressive skyscrapers. The golden towers of Canada’s largest financial institution, Royal Bank of Canada, were just a block away. The 1982 book "The Book of the Year" was published.
Towers of Gold and Feet of Clay
"," refers to the fact that the RBC towers have a thin layer or gold.
Coating their windows
It was logical at the time to locate the brokers and banks so close together. It was not possible to use the internet, email, cellphones or video conferencing. At the beginning of 1980s, spreadsheets were not even available.
Bankers and brokers would meet in their boardrooms to discuss new bonds or equity issues. There were not many food courts back then. People like me would bring a sandwich and some fruits to work and eat lunch. My boss would take me to Ed's Warehouse every Friday. We would order the one item on the menu, which was roast beef with frozen peas. Pretentious restaurants and private men’s clubs were the preferred choice for big shot diners.
The entire area was shut down at 6 p.m., with the exception of a few investment bankers who worked tirelessly to close deals. More people moved to the Financial District as Toronto and Bay Street grew. There were many food courts, bars and pubs that opened. After work, people began to stay in the area for dinner and drinks. To accommodate those who couldn't commute or had children, condos were eventually built in the area.
Now, fast forward to 2023. Many offices are still half empty three years after the lockdowns began.
It is much smaller than the pre-2020 crowds that ate and shop in the underground below the towers. The underground was actually overcrowded before the lockdowns. It was an introvert's worst nightmare. The story of the Toronto Financial District is similar to that of many other downtown cores in major American cities, if it's not the industrialized one.
People working remotely are a trend that is set to continue.
It is costly to rent office space. We now have email and video conferencing. This is a far cry from the 1980s when we used to work in offices. My time was spent analyzing portfolios and investing in the economy. My time was wasted by coming into the office. I was ahead my time. One-way commutes in major cities such as New York, Los Angeles and Toronto take approximately one hour. Workers have significantly more time to live when they work from home. They are able to avoid getting stuck in traffic and being crushed by people who use public transport, many of whom haven't even washed since the financial crisis.
These are not enough reasons to avoid large office buildings.
The downtown has become dangerous and dirty.
A block from Scotiabank's Toronto head office earlier this year, a 89-year old woman was
Brutally pushed to the ground
By a thug, and killed right outside Starbucks. That is where I bought my morning coffee more than a thousand times. It was just before lunchtime, in broad daylight. You can find drugs nearby to restaurants that serve $200 meals, which are popular with wild-eyed junkies.
What does the decline of financial districts and their lamentations have to do about commercial real estate's prospects? I want to stress that
Commercial real estate is experiencing a storm like we have never seen at a systemic scale.
Some cities, such as Detroit, have been devastated and many Wall Street companies moved to Mid-town in the 1970s. However this is happening now in all cities.
It is a time of social change.
Due to current financial difficulties, this reality will be hard for many. This is not the past, but a secular change that coincides with a downturn in office real estate. A few key parameters are essential to making office real estate profitable. The landlord earns income after expenses. Rents rise, which increases the property's value and allows for more rent. You can sell the building at a substantial profit.
Interest costs are the biggest expense for landlords. This is due to debt.
A landlord might buy a building worth $100 million with $20 million equity and $80 millions in debt. This is just an example. For example, a 3 percent loan will be taken out by the owner for a few years. In this instance, interest would be $2.4 million. The landlord would make $2.6 million if the building is fully occupied. If rents are collected totaling $6 million and operating expenses are $1 million, he will earn $2.6 million. The landlord's return on his equity of $20 million is 13 percent (2.6 million divided by 20 million). This is only an example.
This is a great idea in theory, but it also works in practice. The building's value and rents will rise over time. The landlord is happy, tenants are happy if they have a good management, and bankers are happy as they earn $2.4 million on a property that has a collateral value over $100 million. The bank's shareholders and depositors eventually get the interest. Everyone wins. Capitalism isn't all bad!
We have experienced a long period of artificially low rates, which were lower than inflation. This era came to an abrupt halt in 2020, as inflation rose.
These historically low rates have made it possible for real estate companies to rely on them. The rates have risen dramatically in a very short time and are now a major problem for the commercial real estate industry, particularly in the office building sector. Tenants will decrease the square footage they rent as leases end. Thus, vacancy rates are likely to rise. To keep tenants, landlords will need to reduce rents. Cratering revenues will be caused by lower rents and higher vacancy rates.
As if this weren't bad enough, loans will become more expensive as they mature. Investments in real estate that were once cash cows are now bottomless money pits.
As the property's value falls, this vicious cycle continues. The value of the collateral will drop, and banks won't be able roll over the entire loan amount. The amount of the loan exceeds the property's value. This is the negative equity in our hypothetical building.
As the market for commercial real estate falls, banks will suffer. Wealth of anyone who is exposed to banks via their mutual funds or pension plans will decline.
Both public and private pension funds are major investors in real property. Pension plans could also be affected by this scenario if it gets worse than some believe.
A combination of artificially low rates and the decline of once-great cities has created a terrible situation that will impact us all.
We are at a moment of great reckoning.
It may seem odd, but our need for security and ease has made life more complicated and less secure. Retrospectively, it is clear that the homeless junkies who pestered you for change over the years were a sign of trouble.