The 'Urban Doom Loop' for Commercial Real Estate w/ Stijn Van Nieuwerburgh

25:03And so the market is telling us that the distress in the office is much larger because It's an average of all of those asset classes. Right. This is such an important point. When people talk about CRE as the academic commercial real estate, they're talking about all of these asset classes or sub-asset classes, one of which the largest, I believe, is multifamily housing. So essentially, you have these CMBS securities that represent a spread across that asset class. And it almost sounds like what you're suggesting, San, is that you have the buoying of those assets by things like residential multifamily housing against the office space.

25:41And it sort of suggests that maybe that subclass is actually doing worse than the price action in those mortgage-backed securities would suggest. Right. I mean, one way of trying to get at that, which we do a little bit in our research, is to compare different vintages of these CMBS deals. It so happens that deals that were issued a few years ago have less office in them than the more recent deals. And so when you're looking at the relative price declines of the more recent deals with more office in it, and you compare it to the price declines of CMDS of earlier deals with less office in it, from that difference, you can distill sort of how the market views the office distress.

26:19And sure enough, these later deals that have more office in it have gone down more in price than the earlier deals that have less office in it. And so from that, again, the bond markets are sending us sort of a distress signal about distress in office specifically. I'm sure some of our viewers and listeners have gotten chills down their spine because it sounds reminiscent of a conversation we were having around the 2007-2008 period about RMBS, residential mortgage-backed securities. I remember doing research when I was a reporter at CNBC at the time about precisely those questions about different loan vintages and trying to assess and figure out the underwriting standards and how they declined.

26:58One of the things that strikes me from the 2007-2008 crisis period was really just how much we didn't know in terms of things like the way that these assets had been securitized. Some folks out there will remember acronyms like CDOs and CDO squared. There was an absence of diversification in some of those assets that were thought to be there. And then also, as always, when we have talks of crisis, the word leverage rears its ugly head. Talk a little bit about the structure of some of these securities, what you see in terms of diversification risk, leverage risk, and other risks that you see in these securitized assets.

27:40So this is an important discussion. So what we sort of coming out of the financial crisis, right, there was a sort of a strong regulatory response, a lot of it in the Dodd-Frank Act. And a lot of this was trying to shore up confidence in these mortgage-backed securities, whether they be residential or commercial mortgage-backed securities. Coming out of the financial crisis, having been burned by the financial crisis, underwriters became a lot more conservative in their credit standards. So credit standards were very tight, call it in 2010, 11, 12. And then gradually credit standards started to loosen back up.

28:15People have short memories. And so, again, sort of leading up between 2012 and 2020, we saw a gradual erosion of credit standards, albeit not nearly to the same extent as what happened in the 2004 to 2007 period. So I think credit standards aren't really the problem. They're sort of missing the point a little bit. What's more interesting and more to your point of diversification is another development in the CMBS market, which is the increase in prominence of so-called SASB deals. So SASB is an acronym. It stands for single asset, single borrower. So normally, a CMBS pool would be a pool of, call it 80 to 100 commercial mortgages.

28:56It's a well-diversified pool across locations, across asset types. A SASB deal is very different. It has typically a single mortgage in the pool. So there is no diversification. I'm buying a large$1 billion office asset. I'm getting an$800 or$700 million mortgage. I'm putting that$1$700 million mortgage in a SASB deal, and then I'm issuing securities against that. There's only one mortgage in that deal. If that one mortgage goes in default, my entire deal goes into default. So it turns out these SASB deals actually became prominent and they became larger than these pools of mortgages that we're used to thinking about in CMBS.

29:35and some of them are office assets. So these are sort of a pure play office loan investment. And naturally, now that office is under stress, these SASB deals are under stress because they don't benefit from this diversification of having some multifamily and some industrial loans in the pool as well because there's only one loan. It's a SASB deal. SASB became maybe 30, 40, even in some years, 50 % of all the CMBS issuance was these SASB deals. So that's an interesting development and then sort of not one that gives us sort of a lot of comfort. Stan, to the best of your knowledge, is there anyone out there taking opportunities here to short some of this stuff?

30:14I imagine that our subscribers, viewers, listeners who work for hedge funds are thinking about that. Again, I think most people have probably seen the big short. We know that when there are these mispricing opportunities that folks do step in and take the other side of those trades. Have you seen any of that in your research or any evidence that that type of trade is on right now? Absolutely. So we looked at this a while ago, and there's two ways of looking at it. One way is to look at the equity market, again, at the REIT market, and to look at the short positions against some of these REIT shares.

30:44And they were very, very large and rising rapidly. It's generally expensive to short REITs because you have to pay the dividend, and REITs pay a lot of dividend. So the cost of holding these short positions is larger than for other stocks. But clearly, there was a large rise in the shorts outstanding against REITs. The other way you can take advantage of a decline in office values is to go through the CMBS market, specifically to go through the CMBX market. This is essentially a pool of the largest CMBS. And so if you have, let's say, the 25 largest CMBS deals of a particular vintage, those get repooled into, let's say, the BBB trenches from all 25 of these deals get repooled.

31:28And now you can buy essentially a weighted average of these 25 BBB pieces. And if that CMBX deal has a lot of office in it, you could potentially go short in the CMBX market as well. And that, too, has been happening in the last few months and even years. I think now that trade is sort of starting to pay dividends as you see the prices of these triple V tranches slide. So you mentioned that you look at a whole series of different data points in your research. What else do you look at that we haven't yet talked about? Right. So, you know, we spoke about debt investors, the CMBS market. We spoke about equity markets, the REIT market.

32:11You know, we spent quite a bit of time looking at bank data, which we touched upon, but there's a lot of individual bank level data out there. And one thing we've done is we've looked at, you know, how much exposure do banks have to commercial real estate lending and how does that exposure vary by the size of these banks? And if you want to think about so the overall commercial real estate debt market is about five and a half trillion, about 60 percent sits on banks balance sheets. And then if you look across bank sizes, it turns out that the very largest banks are the ones above 250 billion, whatever the 10 largest banks in the United States.

32:48They have about a third of all the commercial real estate exposure. But as a share of their assets, it's only about 5%. So they're actually not terribly exposed to commercial real estate, which is a good thing because these are all systemically risky banks. They're all too big to fail. the next tier of banks any sort of between 250 billion and let's call it maybe 10 billion they tend to have a lot more commercial real estate exposure these are all the regional banks that have been in the news in the last few months and there's there is a range but they have you know anywhere between 15 all the way to 40 30 40 commercial real estate exposure and so there's some banks in there as i mentioned earlier that have essentially more commercial real estate exposure than their entire tier one capital.

33:32So again, a severe shock or a severe loss scenario on those commercial real estate loans could actually impair these banks' equity substantially. And then you have a lot of small banks out there. And typically, there's sort of a matching process. The small banks will make loans to small commercial real estate investors in their locality, right? And so as some, and they too have, as a share of their small, but as a share of their assets, commercial real estate lending is big. It's bread and butter local banking. And so as we see sort of distress in those places pop up as well, that also impairs these smaller banks.

34:10And that's not just important for commercial real estate. It's important for the broader economy. This goes back to your earlier question about the broader economic ramifications. These same small banks are making loans to small businesses in their communities. And so now that they have to take losses on their commercial real estate portfolio, they'll be less likely to make that small business loan or they'll charge a lot more for that small business loan. So credit standards tighten, best case scenario. And so that's bad, obviously, for all these small businesses in those communities, right? And that's sort of the macroeconomic spillover from some of that commercial real estate distress as well.

34:46What's the worst case for the banking sector and what's the probability in your view that we get there? I have not done a lot of research on this. Some of of my colleagues at Columbia Business School have sort of calculated that, you know, banks, you know, are severely sort of undercapitalized if you mark to market their assets. So I do think a lot of this has to do with policy responses and to the extent to which investors feel like their money is safe in banks. I mean, I think there is sort of a possibility of a banking panic, whether that be justified or not. At the end of the day, if depositors decide to run on the banks, it's very difficult to stop, especially in this day and age where we can all message each other on Slack and five minutes later, there's a big banking run.

35:30And even if it's unjustified or based on a rumor, you know, it's a self-fulfilling prophecy. So I do think sort of the worst case scenario is a pretty bad event. I don't think it's particularly likely. You know, I do think the most likely scenario is one of slow burn, the train wreck in slow motion where banks will have to provision for years, for several years, they will have to take losses for several years. But most of the banks survive this. There'll be some consolidation among some of the weaker banks. Some of them might need to get resolved by the FDIC, but hopefully not large banks. So I do think we sort of muddled through.

36:06This is sort of my best case scenario. We muddled through this over the next several years. It's not going to be supportive for the economy. We will have a modest credit crunch. That's sort of as a best case scenario. and but you know eventually the economy will turn maybe we'll have a recession we'll get through that as well you know but I think they're sort of that's a best case scenario in my mind it's so interesting I just had a conversation this morning with Caitlin Long who's someone who's very prominent in the digital asset crypto bitcoin space and we were talking about what it means to have essentially capital flight from banks at the speed of cell phone transactions The minute that you hear that a bank that you have a deposit in that's over the FDIC insurance limit might be experiencing trouble, everyone just jumps on their phone and they start moving funds.

36:54I mean, the point that she was making is that we're in a new era in terms of banking and what it means to experience risk, something that we frankly did not even see in place. And I'm not trying to be gloom and doom here about this, but it is kind of a new regime with the speed of digital capital flight than we saw even during the 2007-2008 era. For sure. And I think our banking regulation has to adjust to this. Our banking supervision needs to adjust to this. And maybe we need to sort of start, you know, putting time limits on how much, you know, how much money one individual can withdraw in a certain amount of time, right?

37:29Just to sort of deal with this and slow down, slow down these crashes. You know, give people, just like we have circuit breakers in the equity market, maybe we need something like that for depositors as well. Give everybody some pause, not to panic. Think about it. Let policymakers do their job. But I do think supervision will have to think about this carefully. Well, capital controls from demand deposit withdrawals is something that probably is freaking people out just hearing those phrases. But like you said, we are living in a new digital age. If I can message the entire Silicon Valley venture capital community and five minutes later, we are all collectively pulling our money out of Silicon Valley Bank, then within five minutes, this bank is bankrupt.

38:08And if we don't have, if we don't adopt, and there's no amount of supervision that can stop that, you know, until we are aware of this and potentially put some guardrails in place that sort of prevent this outcome in the first place. Yeah. And, you know, when banks are carrying seven to 10 percent of their capital in a way that can be withdrawn and you do have. And by the way, for people listening, they probably know this already. That's not a hypothetical. The case that you sketched out, maybe not five minutes, but over a period of days, it certainly did happen in the most recent. The three bank failures we saw this year.

38:42Yeah, absolutely. And, you know, a lot of these banks have commercial real estate loans, which are very illiquid. You know, good luck trying to sell those in a short amount of time. especially in this environment. This is a bit the case of Signature Bank. They had a large exposure to commercial real estate, a lot of it in New York City. So it's very difficult to raise capital for banks with those type of portfolios in a short amount of time. Yeah. Let's switch gears here a little bit and talk about the macro backdrop. Again, I'm not trying to be gloomy, but I just want to talk a little bit about the context in which we find ourselves.

39:15Obviously, a period of sharply rising rates. Federal funds rate now at 500 to 525 basis points. Part of this broader hiking cycle, we've got about$8 trillion on the balance sheet at the Fed, less eliminations from consolidation. We have a period where we're looking at here where the 2-10 spread is upside down about 100 points. I mean, this is 100 basis points. This is an unusual moment in history to be uncovering some of these risks that are, in many ways, a consequence of COVID and some other broader factors. It almost feels as though it's a potential perfect storm type situation here. Yeah. So a lot of things to unpack there.

39:53So one point that I often make to my students is, you know, we've been in this environment where interest rates have been gradually going down for the better part of 40 years. And we all got used to rates falling and then falling some more to levels that were really, you know, historically low. We never seen low in hundreds of years. You could go back to the 1700s and we did not see sort of such low interest rates, right? And so we got really used to that. And all the assets, including real estate, but many other assets were pricing sort of off an assumption that long-term interest rates were going to stay low for forever after.

40:27And we all of a sudden find ourselves in a very different environment where long rates, not just short rates, but also long rates have gone up meaningfully, 250 basis points. The 10-year has gone up 250 basis points, which is a massive shock. We have to go back to the 80s to find a 250 basis point increase in long-term treasuries. Treasuries have also become, even long-term treasuries have also become very volatile. It's very unusual to get these 20, 30, 40 basis point spreads in a matter of days in the 10 year. So that's sort of another part of the capital markets that we are not used to. And so what you could do is you could do this very simple calculation, right?

41:03Take a building, which is a long-term asset. It's generate cash flows. Let's imagine these cash flows are unaffected by the interest rate environment. And I'll reprice this given set of cash flows with a treasury curve that has moved up 250 basis points, right? So let's say we went from 200 basis points, 10-year treasury to 450 basis points, 10-year treasury, which by the way is where the forward curve is trading 10 years from now. At the 10-year, 10 years from now, the forward curve tells us it's going to be 450 basis points. So just reprice that same stream of real estate cash at these higher treasury rates, that reduces the value of your asset by more than 35%.

41:42And there are no cash flow problems in this asset, just from the rise in interest rates. And the reason is because real estate is a long-lived asset. And a large increase in interest rates is particularly painful when that change in interest rates comes from a very low level of interest rates, right? So we had very low levels of interest rates. In real estate, we would say we had very low cap rates. and now the cap rate has gone up a lot, that's convexity. People in fixed income call this convexity. It's not linear. It's nonlinear. If you started from very low rates and rates go up, the decline in value is massive.

42:17And that's because the percent change is very high when you're moving 25 basis points from 25 basis points. Yeah, exactly. It's sort of math, but at the same time, it's real. That's like a 35 % revaluation of an otherwise perfectly healthy cash flowing asset. Now add on top of that, all the cash flow trouble that we've been talking about from remote work, especially in the office market, maybe also e-commerce in the mall market. So add that on top. And now you're down to 50 % decline in value. In office, we can also talk about climate regulation that's going to shave off a few more percent of value.

42:52I've done these calculations. You can have a perfectly healthy class B office building in New York City be worth$100 million in 2019. Now you let this asset experienced this triple, I call it the triple headwind, the triple headwind of higher rates, cash flow trouble from remote work, and climate regulation. And this asset is worth$38 million. Okay, it lost 62 % in value. And again, I don't think this is hypothetical. This is the revaluation of that asset. You know, this$100 million plus B office building is now worth$38 million, which means somebody needs to take a massive loss. The equity is wiped out, the debt takes a big loss.

43:32Yeah, this is something that you've talked about in your work, which is this idea of the heterogeneity in the space. You've got obviously different classes of buildings, different classes of properties. Talk a little bit about how that might be a problem. Yes. So there is a flight to quality going on in office, which means that the very best, very youngest buildings are doing reasonably well. And I'm talking office buildings. So think about a brand new building, one vendor builds, a brand new office building. it gets rents that are substantially above even regular class a properties but they you know think of hudson yards like brand new office buildings anything built after 2010 in our data we show has gotten about 30 increases in net effective rents so 30 increase in rents in this environment is obviously a great thing right but that's a small fraction of properties maybe it's a larger fraction of the cash flows and a larger fraction of the values because these buildings are very valuable But nevertheless, it's sort of the exception to the rule.

44:30So we sort of define A plus in our research to be all the office buildings that are in the top 10 % of rents in a given sub market in a given year, right? If you can charge a rent that's in the 90th percentile, I'm going to call you A plus. And so when we separately do our valuation for the A plus universe versus everything else, instead of finding an overall 45 % decline, we're finding an only 20 % decline for the A plus space. and we're finding a 60 to 70 % decline for everything else, right? So a huge bifurcation in the market happening. It's not that, so flight to quality suggests that the A plus is gaining in value.

45:08It's not, okay? This is an aggregate shock. Remote work is an aggregate shock. It doesn't help even the class A plus. And interest rates is an aggregate shock. It lowers values of A plus also. But the value decline is a lot less than it is for the class B, C, A minus space. And there it's absolutely catastrophic. Take an old building, class B, it could easily lose 60 % in value. And so why is that? Well, it's older product. It's not been maintained as well, potentially. It is potentially large capital expenditure risk. you know it's hard to charge you know high enough rents and then a lot of a lot of it is smaller companies small think of your class you know your second tier law firm your second tier accounting firm they are the ones occupying these second tier office buildings on third avenue these are not deep pocketed tenants these are not tenants they can say you know what i would really love a child care center or a pet the pet care center downstairs in my building and have some balconies in my office building, they cannot afford that.

46:11And so, you know, they are there, you know, a lot of them went remote and they said, you know what, this remote work thing works great for our company. We were productive. We were able to build more hours than before remote work. Why would we go back and sort of pay top dollar rents? They cannot afford it and they don't want it. And so a lot of small tenants, you know, are in these small properties and these small properties are getting devastated right now because they cannot pay these$130,$140,$150 per square foot that some of these trophy buildings are charging. So we see a bifurcation of the market.

46:46I wouldn't want to be in any of the office, including the A +, but the A-plus is clearly less severely affected than the Class B, Class C. One of the other attributes of this heterogeneity distributional effect question that comes out of the COVID pandemic and the work from home period that came up after it is this idea of tax revenue inequality and what happens when the wrong people leave. You could have several people. Let's talk a little bit about what happens when you see folks maybe who worked at hedge funds here in New York City who say, hey, you know what? Why can't I do this from Palm Beach?

47:23And there are a lot of those people and it doesn't take many. Yeah, no, that's absolutely true, right? So this is sort of back to our urban doom loop story. You know, tax revenues are very concentrated. That's not just true for property tax, it's definitely true for income tax, right? So here's a useful statistic. New York City gets about half of its income tax revenue from the top 0.4 % of taxpayers. So that's literally a few thousand rich individuals. And if a substantial fraction of those leave, that creates a real hole in the budget of even a large city like New York City. And like you said, this is happening.

48:01We see this in the data. There are a whole bunch of millionaires that have left New York City in the last year, especially in 2022. We see this very strongly in the data. And it's potentially a risk factor going forward, because if property taxes go up, if other taxes go up in New York, by virtue of the doom loop that we talked about, this process will only accelerate. And it's these high income people that are very mobile. They have a higher out migration sensitivity to the tax rate than average people. Average people may say, you know what, my taxes go up a little bit. I'm stuck. Too bad for me.

48:35I'm just going to have to pay up. But that group of people, you know, can potentially keep their job in New York, buy a house in Palm Beach, work from there, you know, Be a tax resident in Florida, still spend a substantial fraction of the year in New York, keep the same job. Right. So we're living in a new world where because of remote work, we are able to separate our location of residence from our location of work in ways that we were not able to do before. And in ways that sort of promote this type of let's call it tax arbitrage. Right. And so people are taking advantage of it. And it's to the detriment of higher tax locations like New York, California.

49:13and it's to the benefit of low-tax locations like Florida, Texas, and so forth. Yeah, and these obviously have broader social, cultural, political, and economic ramifications that you can obviously begin to piece together, particularly because people can spend a substantial minority of their time here in New York City and maybe avoid the worst of the heat and hurricane season down in Miami. We've got some really great questions coming in for our audience. Our first one is from Charge Collier. Charles has clearly been following the thread through. He asks, Stan, who will be the ultimate holder?

49:46Borrower stops paying. Building goes to the bank. Bank lets it go. It goes to the municipality. What happens to the city? Yeah, so I think neither the bank nor the city wants to own this office building and eventually will need to sell it. I think sort of the Resolution Trust Corporation experience from the 1980s is potentially a guide here. Back in those days, we actually, that experience actually saw the birth of the CMBS market. It saw the birth of modern real estate private equity. and so something similar could happen. We have to set up pools. We have to set up pools of these defaulted properties and those pools then get auctioned off.

50:25Potentially distressed real estate, private equity money gets raised to buy these pools. Maybe we securitize some of these loans after modification. So models like that are possible here as well but it's clear that the banks have sort of no comparative advantage holding and running these properties. That's the last thing they want to be doing. Yeah. Here's a question from Kim Hembree. Do you have an opinion on industrial-focused REITs? So industrial has been the star of the show over the last two or three years. You know, it's sort of benefited secularly from the rise in e-commerce. There's also some more local factors like the widening of the Panama Canal that has been very supportive for industrial on the eastern seaboard of the United States.

51:09I expect e-commerce got sort of, you know, accelerated during COVID quite dramatically. That's sort of slowing down a little bit now. If you look at the share of sales that are e-commerce, it's actually growing, but at a much slower rate than in past years. I also think that, you know, a lot of real estate became very expensive, you know, on the back of very strong rental growth. I don't think these rental growth rates are necessarily sustainable for the next few years. So we're certainly going to see a slowdown. Because industrial real estate was so profitable, a lot of supply has come in, right?

51:45So development has roughly doubled. New industrial development has roughly doubled. So that's also not good for fundamentals. And then on top of it, interest rates affect all property types. And they actually disproportionately affect industrial because industrial tends to have very long-term leases. So I like to think of industrial as a long-duration bond. And as we just like higher interest rates, you know, reduce the value of long duration treasuries by more, higher interest rates also reduce the value of industrial real estate by more. So I'm not very bullish on industrial sort of on the back of all of those observations.

52:23Here's a question that comes to us from Alfredo Rumia. When is peak commercial refinancing due and would that represent the bottom? Sophisticated question. So people have looked at this. they talk about the wall of maturities. You can look at it in terms of overall commercial real estate debt that comes due. Actually, the peak is 2023 and it's very similarly in 2024. So there is about a trillion and a half of commercial debt that needs to be refinanced between those until by the end of 2024. And it goes down after that. So the peak is coming soon. I do think that those refinancing events will be catalysts.

53:03There will be places where we get to rediscover. We look at the price formation, basically. We see what happens to those deals. I do expect, in many cases, that refinancing will fail and these assets will go through distress. But we'll get a lot of data from this. If you look at CMBS, the peak is in 2023. So a lot of the debt that's coming due this year is in CMBS. For banks, it comes a little bit later. In 2026, 2027 is the peak of bank debts that needs to be refinanced. But it's a very good question because I think these refinancing events are going to be the catalyst. And we're going to see a lot of that debt.

53:38You know, the typical mortgage in commercial real estate is a 10-year mortgage. So a lot of that debt was issued in 2013, 2014. Typical interest rates in 2013 and 2014 on commercial loans were 4.5%. Today, CMBS loans are 7%. So if you need to refinance, and banks are not open for business. So if you need to refinance that 4.5 % mortgage into a 7 % mortgage, it means you're going to have to contribute a substantial amount of equity. Or you throw in the towel and sort of give up on the property. So it'll be very interesting to see what happens. And I do agree with you that we're going to learn a lot in the next year, year and a half from those refinancing events.

54:19Boy, that's a great question. Stan, that's one hell of a number,$1.5 trillion. Back of the envelope, that's about one-sixth of U.S. GDP. Yeah, it's a big number. I agree. Yeah. So we've been talking, obviously, a lot about the potential risks here, but I don't want it to be all gloom and doom. Let's talk about some of the opportunities that come as a consequence of the future of work, remote work, digitization. What do you do? Is there a silver lining in this? What are some of the places where people might hide or even find opportunities? Yeah, so the first thing I want to say is just sort of as an individual, not necessarily as a researcher is I do think remote work has created a lot of benefits for a lot of people.

55:00Let's not forget that, right? There are especially sort of mid-career folks have small children at home. Now they can have dinner together. You know, there's a lot of benefit that has come from this. Let's not ignore this. That's sort of the first observation. You know, the second observation is cities have always gone through transition. I like to think of this period as sort of similar to the period where we had deindustrialization in cities. You know, if you walked in Manhattan 100 years ago, you would have seen a lot of pollution, steamboats, manufacturing, warehouses, none of that stuff exists anymore, right?

55:35We've cleaned up the waterfront, it's now, people go running there now, there's no more ships docking with grain and with coal and whatever else. So we have gone through like a 20, 30 year deindustrialization in New York City. Ironically, it was the office buildings and the service sector that was our bailout back then. Today, the office properties are the problem, not the solution. But similarly, we need to reimagine the future of our large cities. And in a nutshell, we have a misallocation of our real estate stock. We have too much office and we have too little, mostly housing, right? Maybe also too little of some other things like childcare space and maybe educational space.

56:15And so we need to repurpose some of our real estate stocks, simply put. And maybe more broadly, I like to think of the city of the future as being less of a production, a place of production, and more a place of consumption. So our cities, places like New York, have tons of amenities. They have lots of things going for them. Young people want to be here. If you have kids that are in college and you ask your kids and their friends, where do they want to live for their first job? They're going to answer, I want to be in New York City, right? And so why is that? Well, because we have all these amenities.

56:48These are amazing places where you can meet other people. We have thick labor markets. We have thick marriage markets. You know, they're amazing, amazing places to be. And we need to embrace that. And we need to turn some of that real estate around, repurpose it, create more housing, create more healthcare space, childcare space, life science space, mixed use. There is a lot of ideas out there. You know, I'm a big believer in selected instances. I should be careful. In selected instances, I'm a believer that office can be converted to apartments, and we could talk about that if you like. Yeah.

57:19What is the percentage? There are all kinds of zoning requirements, all types of physical usage issues around it. What's the percentage? Because it's not just a let's flip it all type of situation. Absolutely. Right. So I wrote a new paper on this that just came out a week or so ago where we studied this question. And I like to think of it as there are sort of three challenges. The first challenge is, is the building physically suitable for conversion? The second challenge is regulatory, like what you talk about, zoning. And the third challenge is an economic one. Even if I am allowed to convert the building and even if the building is physically suitable, does it make economic sense to convert?

57:55So the answer to the first question, the short answer to the first question is about 10 percent of the office stock in the United States is, in our view, physically suitable for a conversion. In New York City, that number is closer to 30 percent. So there we look at things like floor space, floor plate, the size of the floor plate cannot be too deep. The distance from the core of the building to the window cannot be too large. Otherwise, the layouts are clumsy for apartment living. You can look at high density areas. Buildings are built before 1990. There's a whole series of criteria we go through to sort of filter the stock of offices all the way down to what we think are potentially convertible buildings.

58:32And in New York City, we get to 30 percent nationwide, more like 10 percent. Then you have the zoning piece, which is complex. But here I feel like the policymakers have woken up. And for example, in New York City, there's 100 different pieces of the zoning code and the building code that are currently being revised in order to make these conversions more feasible, right? So simple things like, you know, I have a 15-floor building. I want to convert it to an apartment. But oops, I can only build 12 floors by the zoning code because this lot has a floor area ratio of 12. but the existing office has 15 floors.

59:07Please let me convert this 15-floor office building into a 15-floor apartment building. So simple fixes like this, stroke of a pen, it's not hard to change. It makes a lot of sense to change. And so the policymakers are sort of thinking actively in that direction. The third piece is sort of the most subtle piece, which is, does the economics work? Even if I can do it, and even if it's sort of from a layout, from an architectural perspective makes sense, can I actually make money doing this conversion? And the answer is sort of a cautious yes. It's a yes, but. And the but is, first of all, I need to be able to buy the old office property at a really low value.

59:43My basis has to be low enough. Essentially, somebody needs to recognize the inherent value destruction that has already taken place in this office. And remember my example of my$100 million building that's now worth$38 million? I have to be able to buy this building, this old office building, this Class B brown office building. I have to be able to buy it for$38 million. If I can buy it for$38 million, now I'm going to have to spend maybe$100 million actually renovating it. It's going to be very expensive, give or take$400 ,000 per apartment. I'm going to make it green, so that's going to cost some extra money.

1:00:19And now I'm going to turn it into market rate rentals. And I've worked through the math, and you can earn just about enough return to justify the risk of this investment. I'm going to call it an IRR of 16%, 17%. and a positive MPV. So it's feasible, but sort of not a whole lot can go wrong. And the key parameters are what's my cost of debt? What's my basis? And how much do I have to pay for the building? How much does it actually cost to convert this office building? And that's going to depend a lot on the layout. Do I need to drill a core in the middle of this big building? So this is going to work a lot better for smaller floor plates, for older buildings, which by the way are cheaper because they're class B, they're beaten down.

1:01:01So that should work well for conversion, also because they're typically a little bit more charming than these 1960s to 1980s glass and steel office buildings. So the economics can work as a market rate rental. But now the politicians want affordable housing. They don't want market rate luxury housing, or at least not exclusively. So if we put an affordability mandate on this conversion project, now very quickly the economics get ruined. And now very quickly we get into negative MPV territory. So it's no longer feasible to convert, economically feasible to convert, unless we have additional subsidy, right?

1:01:37And so sort of I go through how much subsidy would we need to throw at this problem to have, let's say, 20 percent of the units be affordable. Yeah. And these are collective decisions. These are public policy choices, political choices, cultural and social choices. It almost makes me wonder how far away we are from asking questions about outright demolition of some of these buildings. And maybe I know it's controversial, but 1970s style urban renewal type projects in cities. I mean, some buildings for sure have the long have sort of the wrong physical layout to be to be convertible in a practical way.

1:02:09And I think for some of these properties, demolition will be the right answer. If you could replace a large glass and steel 1960s in a large floor plate office building with a large multifamily property where the apartment units have the right layout for the modern consumer, that could be a very valuable project. By the way, not only for the developer, but also for the city, right? Because you're gonna be replacing a declining tax revenue stream with a much larger and rising tax revenue stream, right? So even from a fiscal public policy perspective, this could be the right decision. The one thing I don't like about these demolitions is sort of the climate angle because renovations are much more climate friendly than demolition, right?

1:02:53demolition, you know, yes, we could be demolishing a brown office building and building a beautiful green new apartment building in its place. But the actual construction creates a lot of greenhouse gas emission, the cement, the concrete, the steel, and so forth, right? So that's where conversion is a more climate-friendly alternative. But again, conversion doesn't always work. So we need to be open-minded and we need to think about sort of the economics as well as the climate piece. Stan, this has been an extraordinary conversation. I think at times a sobering one, but incredible amount of information.

1:03:25You are going to be an incredibly important voice in this conversation in the future going forward. I'm sure we're going to be seeing and hearing a great deal more from you as we come to the conclusion of this conversation. Final thoughts, key takeaways that you'd like to leave our viewers and listeners with. Yeah, I think we're facing an important challenge to not just, you know, the urban environment in the aftermath of remote work. I think remote work is a fundamental change, a secular change in society. For the first time in history, we've been able to divorce our place of work from our place of residence.

1:03:56And that's a very powerful idea. And it's going to take decades for us to really fully come to grip with this change. And this change is going to have winners and losers. There will be a lot of value destruction, but there will also potentially be a lot of value creation as we sort of reimagine what the city of the future looks like. Stan, when you're the lead off guest on 60 Minutes, I hope you'll come back and still remember us. Thank you so much, Ash. I'm not holding my breath. Stan, thanks for joining us. Really incredible conversation. Thanks for watching, everybody. Thanks for joining us, everyone.

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