Why the CRE Urban Doom Loop May Still Be Coming

24:07Definitely one of these things that sounds good. It seems expensive. It seems slow. I can never really tell even if everyone got their ducks in an order, whether it would move the dial enough to meaningfully, A, ease some of the housing strains, or B, sort of fill in some of this empty space. What is your work saying right now? Is this happening on any scale or is this just a thing people tweet and write papers about? So we did write a paper on this and have tweeted about it as well. So we've contributed the last few components, at least. What we find in our work is, again, joint with Stainwood Norberg and another co-author, Candy Martinez, is that there is a prospect for physically converting about 10 to 15 percent of the nation's office stock.

24:49And that would produce something like 400 ,000 apartments, where our annual average apartment production is something like 260 ,000 a year. So it's a reasonably large prospect relative to the size of annual production, but it's still a pretty small overall part of the entire office ecosystem. Across cities, we do see some cities that are exploring it more aggressively than others. Cleveland actually is a city that seems to be engaging in these office to raise the conversions a little bit more. So when you say explore, this is what I'm trying to get. Is there like in New York or maybe even Cleveland, like is this actually happening?

25:22Yeah, it seems like these conversions are happening. Here in the financial district, we converted somewhere in the order of tens of thousands of apartment units out of former office buildings. So that's something that happened particularly after 9-11. And it is happening now, it seems like, at an increasing rate across a lot of cities. So you mentioned timelines earlier and the idea that this dynamic is really operating on a lag. And so it might not seem that the doom loop is upon us right now, but a lot of those rents or leases have yet to be renegotiated. And so it might just take longer than a lot of people anticipated.

25:57Maybe we could reframe the question as like, when would you expect this to play out? Like, what is the approximate timeline that you're sort of envisioning at this stage? So I think there are two important things to keep in mind with this urban doom loop concept. First is that it's sort of a cycle, not necessarily a prediction of something that will happen, right? So we kind of talked about how aspects of these dynamics have happened in the past. And I think it's an open question whether we're going to see this element of urban downward spiral happen in the future. If it were to happen, I would sort of expect it to really materialize as you see this federal stimulus dry up and the impact of these property losses start to accumulate for cities.

26:38So as one benchmark, New York City had a relatively severe recession in the early 90s. We had a big problem in commercial real estate back then. We had a lot of failures of banks with the S &L crisis, big losses for commercial real estate back then. And it actually took a really long time until the late 90s for New York City to see the losses from those commercial real estate property tax losses materialize, at which point the city had already experienced a growth cycle because of the dot-com bubble. So the forecast, I think, is in the next few years, you're going to potentially see the impact of these property tax losses combined with the drying up of co-ed funds.

27:13And that's going to be the moment of greatest stress for cities. I think the other thing to keep in mind is that in parallel with the urban doom loop, you have the suburban boom loop, which is the phenomenon going on in suburban areas. As more people move to these areas, you're seeing more amenities pop up and these make them more desirable locations, enabling a positive flywheel of economic activity. So remote work in aggregate is probably a good thing for the economy. It just has these concentrated pattern of winners and losers. Can I just say, Tracy, the suburbs are getting so good. No, I really believe this.

27:44I may have mentioned it recently on an episode, but I was halfway between Austin and San Antonio recently, which is now basically just one giant contiguous suburb. And the sheer number of new different kinds of restaurants that are opening up out there and different concepts and stuff, it's so wild. It's so good. There's so much good stuff out there. So New York City is already seeing budget strains, right? Yeah. So there was a big back and forth about some cuts to things like libraries. And then I think the controller has estimated that in the coming years, we're going to see out budget gaps, you know, something like eight, 9 % of the city's budget in future years.

28:21So I think it hasn't really yet materialized for the city because revenues, I think, ultimately came in higher than expected, enabling us to avoid some of those cuts to things like libraries. There is the prospect of future cuts on the horizon, as we're forced with the prospect of increasing expenditures down the road, and thinking about what will be the revenue sources to pay for it. Joe mentioned how good the suburbs are getting, to which all I can say is you're dooming, Joe, and I'm booming. But actually, this brings me to another thing that I wanted to ask you about, and this comes up, again, a lot in these conversations, but the idea of perhaps making it easier to build, deregulating or rezoning or whatever you want to call it.

29:01And there is an argument that one of the reasons you've seen a lot of people, a lot of businesses move to places in the Sunbelt is because it's easier to build there. There's more room. It's cheaper in many ways, or at least it used to be relatively cheap, versus places like New York. Could you talk about that sort of regulatory aspect of all of this? Are there levers that the city could pull to make New York an easier city in which to construct new buildings or repurpose old buildings? Absolutely. So the lowest hanging fruit, I think, is the FAR cap here in the city. So we have a limit for multifamily buildings, they can only have an FAR of 12.

29:40So that basically means for every... What's the FAR stand for? So it's the ratio of all the usable space in a building divided by the plot size. So if I have a one square foot, I can create 12 more square feet of livable space on top of that, but no more. Whereas in fact, that ratio is higher for office buildings. And this is actually a big barrier for conversions. Because if I take a large office building and convert that into apartments, I may only be able to use a portion of that building for residential use and have to leave the other floors empty. There's also why those giant super tall buildings kind of south of Central Park are so skinny, they're sort of trying to meet these regulatory requirements on density.

30:15So that I think is the easiest fix. And policymakers are looking at that one right now. More broadly, we have a lot of restrictions on the ability to build in the city. And even here in New York, we have some neighborhoods that are still zoned for essentially single family homes, you're not allowed to build a multifamily building. Or if you are. They're really strong density requirements. So I think there are a host of regulatory shifts that cities can do to make it easier to build, which will then narrow that cost of living advantage between urban cities and the Sun Belt. I hadn't realized that about the sort of regulatory rationale for the skinny building.

30:50So the smaller the plot on the ground, the more you're allowed to go up. It's more that you're taking a certain plot of land. And if you want to sort of have a better view, you kind of have to make the building a little bit skinnier. And sometimes you have to leave some of those floors in the middle unoccupied in order to really take advantage of the high benefits. On San Francisco, as you mentioned, under a reasonable, normal assumption about new office leasing, I think you said 37 years would take to fill that hole or something like that? I think at an average rate, I think it's more than 15.

31:24What happens to a city with that big of a deficit? Like, is this like a serious, like, you know, there's a lot of excitement because basically every smart AI person in the world pretty much lives in San Francisco, is my understanding. Like, in your view, is this a sort of deep structural impediment to like the viability of the city and the city's budget going forward? I think it's certainly a big problem. So the city's own estimates, I think, suggest that they've lost something like a half a billion dollars due to remote work. And in the future, they're looking at a lot of property tax reassessments.

31:56So basically, a lot of people that own office buildings are appealing their property taxes, arguing that their building is worth a lot less now that you have all these vacancies. And so it's definitely a source of stress, I think, for the city's budget. I think this is really amplified by some San Francisco, California specific issues, right? So you have Proposition 13, which means that you're not able to raise taxes as much on residential real estate. So that puts more of the burden on other sources of taxation. They also have these things like business gross receipts and things like that, which are additional taxes levied on businesses in the area.

32:28So firms hate that and don't like having to pay these additional costs. And then in addition, I think you have the kind of spatial development of the city. So going back to the 70s and 80s, there was basically this deal whereby the city agreed to a downselling of most of the residential neighborhoods in exchange for a very concentrated building of commercial right in the downtown area. and this allowed the residents of San Francisco to kind of live in these small, nice, quaint little homes preserving their neighborhood character. They're nice. Oh, these are the ones with the like Victorian woodwork and stuff.

32:58Right, right, exactly. Which people hated at the time but grew to sort of love and see as kind of historic parts of their character. I visited a friend a few years ago who lives in like not one of the nice like Victorian homes but just like a sort of like little nice neighborhood with a bunch of single family housing and he's like a big Yimby guy and I was like, oh, I love your neighborhood. It's so nice. And he's like, Joe, you can't say that. I hate it. You said the wrong thing. But anyway, keep going. Absolutely. So the trade-off was you're going to have this downzoning of the rest of the city in exchange for this very concentrated development happening in downtown.

33:29And the problem is that that left the city really unprepared when the pandemic hit because you had all these people commuting from really long distances to try to get to that downtown core because they really couldn't find or afford any housing nearby. And that's one of the reasons why people were so excited by remote work because it allowed them to take advantage of the ability to move to Austin or wherever else and get a lower cost of living in order to continue working in the same place they were before. So you have this massive mismatch between the jobs and the people. And so that has to be corrected one way or the other.

33:59Either you move the jobs now to where the people are, so move the jobs over to Austin or wherever they are now, or you find ways of bringing more people back into San Francisco. And that'll actually fill back up the transit system, fill back up those downtown office course.

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35:39That's unlimited data for unlimited business. There we go. Get the internet you need at the price you want. Verizon Business. Starting price for LTE Business Internet, 25 megabits per second unlimited data plan with select Verizon Business smartphone plan savings. Terms apply. so people don't just want to live in cities because there's work there although clearly that's one aspect of it you know at least in recent decades going to a place like new york that's where all the jobs are and so that's where you need to be in order to make a certain type of living but there are people who will move to a city just because they want to be part of a city they want that vibrant experience they want to be close to other human beings they want to have options for restaurants and going out and experience everything that a city like New York has to offer.

36:30Is there a world where maybe cities get divorced from or slightly more separated from the economic opportunities? I think so. That would be essentially a world in which cities are really defined by those consumption opportunities, right? By their dating markets rather than their labor markets, right? And people... Oh, we're doomed. Sorry. I haven't heard anything good about them. And people, you know, what we see in the data is a lot of people are working remotely, even in Manhattan, right? So clearly a lot of people, when given the choice, will still choose to live in these large cities. I think the challenge is establishing the quality of life and cost of housing to enable people to do that.

37:11So, for example, the Citizens Budget Commission has been serving people over time. And they find that in New York, far fewer people rate their quality of life as being high compared to what they were rating it before the pandemic. So there are important concerns about the quality of life people are experiencing in urban areas. Now, they also found that people actually liked their neighborhood more than the city, kind of the same way that people rate their personal financial situation a lot better than the national one. So there's maybe some issue of negative urban vibes that are kind of impacting people's decision making here.

37:40But I think definitely something around trying to make sure that cities can remain these vibrant, exciting places is really great way to make sure that they continue to live there, even when they have options and can choose to live elsewhere. It's such an interesting phenomenon about like everyone's own situation is not as bad as they perceive everyone else's. Like, I think you see the same thing and like people talk about their representatives, too. Like it's like, oh, my senator, my rep is all right. But isn't it like Congress is terrible? It's like the Dunning-Kruger effect. Right. Like everyone just assumes they're doing better than everyone else.

38:10I like my neighborhood. But yeah, I guess maybe maybe maybe everyone likes their neighborhood, too. But, you know, on this point. So it's like there is this dimension that is not just about numbers and it sort of gets to the quality of life effect. And, you know, recently, for example, there was the headline about Governor Hochul deploying the National Guard to the subway. And obviously there's a lot of anxiety about safety on the subways these days. And like, you know, in my neighborhood, which I like, there are certainly many public vices that one sees as I walk or take my kids to the park or take them to school, etc.

38:48And some of these things aren't really just money things that can be solved with spending or taxes. There's a certain amount of political will or political consensus about the degree to which we crack down on illegal weed shops and stuff like that. How much is the future of some of these cities going to be determined by the ability to get political consensus for some things that aren't just sort of dollars and cents questions? I think that's really important because I think the pandemic was this whole desocialization period in which we were just not near each other as much. And that sort of broke down a lot of social norms.

39:22Right. And if you think about how new people are entering the city, they're sort of seeing people behave as they currently are and just assuming, OK, well, these are the social norms in the city. So it's really important, I think, to maintain sort of pro-social behavior. So just to take one example that you raised, the subways. So I think overall crime in the subway is down slightly compared to before the pandemic. But if you look at felony assaults, so people actually experiencing and being victims of crime in subways, that's actually up pretty substantially from what it was before the pandemic.

39:50And again, back in that CBC survey, they found that people basically rate the safety of the subway during the daytime, the same as they rated the safety of the subway at nighttime before the pandemic. So there's been a huge shift in the perception of crime and safety on subways. And I think part of that is driven by remote work, because you have fewer people taking the subway, so that's fewer eyes on the street, less sociable, you know, kind of enforcement coming from other people. And that sort of drives more antisocial behavior in ways that can compound on themselves, unless it's addressed by, you know, for example, putting more police officers in the subway, or sort of changing the social norms in other ways.

40:27So you're obviously at NYU. I'm curious if you're able to talk about it. Do city officials ever ask you for advice or ask for additional information on your research? We've, I think, talked to a number of city officials from across the country, particularly on the office problem, you know, thinking about conversions and things like that. I would say that this whole research has definitely resonated far more than any research I've done previously or probably will do in the future. But I'm hopeful that it's a sort of wake up call for city and local governments to think about what do they need to do after the pandemic in order to really continue to make sure that their cities are really exciting and vibrant places to be.

41:03Out of curiosity, just because you mentioned more, what has been the general gist of your work prior to this? So I do a lot of work related to the financial crisis. So thinking about all those subprime mortgages and defaults and things like that. I also do research now thinking about housing regulations and costs, right, and how we can use AI to better extract information from these zoning codes and better figure out ways of making housing cheaper. Real quickly, on that AI thing, I think you did a recent research paper using AI to do something about regulations and codes. What is your experience?

41:35We've got to get in an AI question on that. So I think it's a great use case, actually, because we have, you know, across the country, every municipality has a very long, complicated document, hundreds of pages long, that outlines all of their regulations, you know, these density requirements, lot size restrictions, so on and so forth. And people really haven't dug through and read all of these documents to really categorize and figure out what is inside them. And so that turns out to be a great application where we can basically get ChatGPT to do it and thereby create a data set of housing regulations across the country.

42:03So I think that's something we can really ramp up kind of across municipal government regulations to better understand where the rules out there. We should charge servers rent. That's the solution. Like charge the bots rent and property taxes. And this will solve the issue. I mean, data center CRE is like the hottest area in the world. Yeah, I know. So higher taxes. There we go. Office to data center conversions, I think, is the move. Rather than office to resi, office to AI conversions. I like that idea. Arpad Gupta, Associate Professor of Finance at NYU. Thank you so much for coming on. Great to finally chat with you.

42:40Thanks so much for having me.

42:51Tracy, so I guess my takeaway is maybe it's still coming. Like, I don't know. Maybe like the coast is not totally clear yet. Well, I take the point that in all of commercial real estate, it feels like it is operating on this incredibly lengthy lag time and it takes a long time for leases to get renegotiated. A lot of property owners don't want to have lower rents for the reason that Arbit discussed. But the other thing I would say is like coming away from that conversation, I kind of feel like there's two possible pathways, like two extreme pathways. One is the doom loop scenario that Arbit described.

43:28And the other one is the sort of like redevelopment of the urban environment where offices do get turned into new residential units. And maybe as rents are lower, there are new types of businesses that come in. It's that consumption economy rather than this is the place that you go to work idea. If everything went perfectly, if policymakers like pursued that path, that could be a relatively amazing outcome. I do not always have 100 % confidence that policymakers are going to be sort of visionaries when it comes to redefining huge urban cities. But it's kind of a nice lot. Totally. There are three things there that struck me.

44:11So first of all, disinclination to lower rent is like one of these great examples of accounting affecting the real world, right? So it's like something that exists on a spreadsheet somewhere creates a reason to not find that market clearing price for rent. And maybe the moment will come when the new businesses that like the cheaper rent can come in. And I think that's something interesting to watch. Two, I liked the way Arpit put it in response to your question about, you know, people, maybe people come to the cities for the dating markets instead of the labor markets. And that's sort of grim, but I think like, it's interesting if you think like about things like Tinder or DoorDash or some of these apps and like how much better they probably are on the cities rather than out in the sticks where you swipe and see the same three restaurants or the same, you know, six people.

44:55Same three people. And that these technologies that we think of as potentially diffusing could actually encourage physical concentration. And then third, you know, one thing I think about, and we talked recently about the megacity that the UAE might build in Northern Egypt is like this idea of like cities divorced from production generally. And I sort of think that's like the thesis of some of these mega cities in the Middle East is like the main thing they're selling is not some industry that exists in the city. It's the main thing is they're selling a nice quality of life, a quality of life and lower taxes and low taxes and low crime, et cetera.

45:33And then like the idea that the production has to happen there is like sort of not particularly necessary. That's a really good way of putting it. The one other thing I'd say is so obviously the big cities could develop themselves into like consumerist or human connection capitals of the world, I guess. But you could also see smaller cities, smaller towns, suburban areas start to build up their own like nightlife and restaurant options, sort of what you were talking about earlier. Like, and we have seen some places outside of New York, I think there was a really good Bloomberg article on a small town in Connecticut.

46:10Am I? I'm talking my own book now. But there was a there was a nice story about, you know, a relatively small town in Connecticut that had seen a lot of people move away from New York. They don't want to do the commute into the city anymore. And so their downtown area is booming. Now, that's that's relative for a smaller town, but they have new restaurants opening up. They have new shops. They have offices being built there. So you could see these sort of like smaller versions, I guess, of cities kind of develop across America where it is, to your point about the mega cities in the UAE and the Middle East, where it is much more about that quality of life.

46:48Tracy, I have a favor to ask. Can you go to town planning meetings and be ultra nimby so that people can't move out of the city? And, you know, like this is how we could exploit our natural hedge together, which is you fight to preserve your quality of life out in the middle of nowhere so that people have to stay in New York and keep rents and foot traffic up here. I think that would be a very dangerous thing for me to do personally. All right. I respect that. But we can talk about it, Jim. All right. Sounds good. Shall we leave it there? Let's leave it there. All right. This has been another episode of the Odd Lots podcast.

47:18I'm Tracy Allaway. You can follow me at Tracy Allaway. And I'm Joe Weisenthal. You can follow me at The Stalwart. Follow our guest, Arpit Gupta. He's at Arpitrage. Follow our producers, Carmen Rodriguez at Carmen Armin, Dashiell Bennett at Dashbot, Kale Brooks at Kale Brooks. Thank you to our producer, Moses Andam. For more Odd Lots content, go to Bloomberg.com slash Odd Lots, where we have transcripts, a blog and a newsletter. and you can chat about all of these things 24-7 in the Discord, discord.gg slash oddlots. And if you enjoy Oddlots, if you like it when we do deep dives into commercial real estate, then please leave us a positive review on your favorite podcast platform.

47:56And remember, if you are a Bloomberg subscriber, you can listen to all of our episodes absolutely ad-free. All you need to do is connect your Bloomberg account with Apple Podcasts. Thanks for listening.

48:17Thank you.

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