This was not a fluke or even an isolated incident. With office workers staying away from their offices in droves, downtown office buildings have sold at fire-sale prices, with defaults on office loans reaching near-record levels.
To get a sense of how shaky the downtown office market remains, Governing spoke with Stijn Van Nieuwerburgh, a professor of finance and real estate at Columbia University who coined the term “urban doom loop” back in 2022.
Spoiler alert: He has not grown more optimistic over the past couple of years. What follows is an edited transcript of our interview.
Governing: How risky is an investment in downtown office space at this point?
Van Nieuwerburgh: To me, there's still an enormous amount of uncertainty about the future and the future of remote work. Depending on what data you look at, some statistics are suggesting the return to the office is continuing, at least a little bit. But you look at some other data that shows you that basically it's flat as a pancake.
That raises the question of how many office tenants are still serving out their long-term, pre-pandemic leases. When their leases come due, what are they going to do about their footprint? If the past four years are any guide, there will be continued reduction in office demand, just from the simple mathematical fact that more than half of the pre-pandemic leases are still outstanding today. So, in that sense, the knife is still falling.
Governing: Meaning vacancy rates aren’t showing the whole picture, since there are still lots of leased offices that aren’t occupied or are under-occupied.
Van Nieuwerburgh: Half of the tenants have not re-optimized. Once you sign a 10-year lease, that’s a hard legal obligation. So I expect to see continued weakness.
Then the other important factor is that there's still a lot of mortgage debt on these offices that is outstanding from before the pandemic. These are people that are still paying much lower interest rates than the current interest rates. When their mortgage is up for renewal, they have to refinance. And when the lenders look to underwrite that office building, they see lower cash flows, they see lower valuations, and they see interest rates that are still substantially higher than they were 10 years ago. Now they have a big problem. They can decide that it's not worth it and walk away, because their building is essentially underwater — the value of the building is lower than the value of the debt.
We have about $1 trillion of mortgage debt coming due this year, and then there'll be $600 or $700 billion more the next year and the year after. So that too is a very slow-moving problem, and not a problem that is going to disappear anytime soon.
Governing: With valuations still falling, what does that mean for tax collections on commercial properties?
Van Nieuwerburgh: That is also a very slow-moving story. Often the values of property taxes are set based on income from these buildings, but they’re always backward looking. So if an office building has had a lot of long-term tenants that were still paying their rent, the income may still look fine. But then as these tenants are slowly falling off, the income on that building is slowly falling and the property taxes are slowly falling.
A lot of the reduction in property tax revenue has not taken place yet. It's only beginning to take place, and that's going to take more years to play out, because that's the most backward, the most lagging part of this whole story. So, even though you're reading in the press that we've hit bottom and things are sort of turning up — in my mind, that's a very premature conclusion.
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Van Nieuwerburgh: In my research, I've calculated that the value of office buildings in the U.S. would be lower by roughly 40 to 50 percent. So that’s a $550 billion hit, a massive valuation shock. That has implications for the lenders, the banks and potentially even a little bit for financial stability.
It also has implications for all the local governments that are deriving substantial shares of revenue from these types of properties. It's a massive hit, and not just to office but to retail. If fewer people come into their office, there are also fewer lunches that they buy and other services that they consume, and that then also depresses the value of the retail real estate around it, and also the construction sector. There are a lot of macro implications from all of that.
The other point is, we've had a very strong economy in the last four years, so all of this has been playing out against a pretty favorable macroeconomic background. Imagine that we have a recession next year. There could be more negative shocks coming our way in the future that make this worse.
Governing: Do you see any hopeful counter-trends? People keep talking about residential conversions of office space. Are there cities finding new uses for all the vacant space?
Van Nieuwerburgh: I think it's an all-of-the-above approach. In my view, we have permanently lower demand for office stock that is built on valuable land, so something else is the highest and best use for that land. The only option is to repurpose those buildings or that land.
Residential conversion comes to mind very naturally because there’s a shortage of housing everywhere, but it’s complicated for many reasons. My conclusion is that only about 15 percent or so of the office buildings are even physically able to be converted to residential. Then, among those, there’s only a small number for which it's financially viable. It's hard to make the numbers pencil out and earn a reasonable return, because these are very complex development projects. It's really hard to make it work, even with the sort of high market rents that places like New York City can get for apartments.
That's why we have seen so little of this activity so far. And that's why governments are trying to subsidize it left and right, just to sort of improve the economics, improve the numbers for the developers, which I think is necessary if we want to do this right.
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