Will empty offices hurt the US economy?

0:05Pushkin. It's Thursday. So at the FT's office in Lower Manhattan, it's about two-thirds full here. But you come here tomorrow on Friday. And man, it will be an absolute ghost town. If you are a commercial office owner, that is a big problem for you. And in fact, if you're somebody that participates in the U.S. economy, it might be a problem for you too. This is Unhedged, the new markets and finance show from the Financial Times and Pushkin. I am reporter Ethan Wu, joined in the New York studio today by my boss, Rob Armstrong, a grizzled financial crisis and downturn veteran. Hi, Ethan. Well, Rob - Grizzled.

0:47I don't know if I like grizzled. Veteran? Yes. Is veteran an insult or a compliment? Wise. Sagacious. Yes, not grizzled. Yes, not grizzled. Well, Rob, today we're talking commercial property. And, you know, just to set the scene here, right? There's work from home. Everyone knows about that. Office attendance is way down. But there's two other problems for commercial property too. And one is this blistering increase in interest rates that we've seen in the US, 5 % higher than it was a year and a half ago. And because offices are bought on debt, because you can't just pay in cash that you have in your wallet or on your balance sheet, you need to borrow money.

1:23An increase in interest rates makes that harder, more expensive to do. On top of that, there's also tech and finance, which pay for a lot of office space, they're undergoing contractions right now. Everyone's heard about layoffs in these industries. It's not a great time to necessarily work at a bank or work at a major tech company. And that's having pressure on offices too. The problem is though, it's hard to know where we are in that cycle, how much damage is work from home doing, how much damage are higher interest rates doing. Because transaction volume in the commercial property sector, it's down like 70 to 80%.

1:57And what that means is how much an office building is worth becomes kind of like a theoretical abstract question that you can't really answer with up to the minute data. You have to piece it together. And even if the market was liquid and there was lots of transactions, you'd also want information about what occupancy rates are in buildings in midtown Manhattan and downtowns all across the country. You'd want to know which buildings were making their loans and which were falling behind with their banks. You would want to know how rent renegotiations were going. And we know this only in bits and pieces.

2:35But there were these two transactions in the office market that we wrote about recently. Both of these are New York examples, but I think there's a broader point in these two deals, which is that they represent something of a divergence between the high end of the commercial office market and the rest of it. One of these transactions, Ethan was near and dear to my heart because it was 1336 Avenue, which was the FT's office. Is that right? Yeah. I think we were on the, were we on the eighth floor anyway? This is why we have the grizzled veterans on. This is, so listeners will remember this building because it had the big pink FT sign.

3:11It's on 6th Avenue up near the Museum of Modern Art. And it was a good enough looking building. It's a beautifully located building in the heart of Midtown near Central Park. However, the inside was a wretched cubicle warren with low ceilings and the desks were close together. And I remember it not smelling that great, although maybe I'm making that up. And that building recently sold for a third less. Am I getting that right? I think it's a third less than its 2006 price. And that's nominal terms, not inflation adjusted. Yeah. So this, you know, that building has gotten a lot less valuable. And that is kind of shocking.

3:53Even just looking at where it is, you would think that wouldn't have happened. Whatever the inside looks like. The contrast case is 245 Park, which is a very glossy new building. And that recently sold at a tiny little markdown from its price of a few years ago. And the news of that sale to a group of Japanese investors, I think, was greeted with euphoria in the industry because it was like, oh, we get to live. Yeah. Right? People will still pay a lot for these assets. Yeah. The markdown was from$2.2 billion to$2 billion, which, I mean, given how panicked everyone is about commercial real estate, it's not bad at all.

4:34No, no. That tells you a lot about the state of commercial office real estate in America right now. Yeah. That when an asset only sells at a small loss, everybody is leaping up from their desks and cheering. Yeah. So these two examples demonstrate a broader point about the office market across the country, which is that there's a flight to quality. These lower end, highly commoditized buildings with not a lot of amenities that smell like cheese or whatever, smell like cabbage. No one's going to pay for that, especially when people are coming into work three days a week instead of five. But then the higher end of the office market, there's, you know, three days a week is not zero days a week.

5:09There's still demand for it. And people want a nice place to work. And companies want less but better is what you hear from analysts in this space. That is true. But, Ethan, we must remember the stock market is looking into the future. and the stock market is telling us there is going to be trouble at the high end too. That's right. So the stock market doesn't have the luxury of sitting on its hands at negative 80 % transaction volume and saying, oh, well, we'll deal with it when it comes. They got to trade this every day on the best information available. And you look at real estate investment trusts, which are like these publicly traded pools of commercial property, office real estate investment trusts, they're a little more panicked about this than the kind on the ground data would suggest right now?

5:50Well, the organizations we're talking about are people like Boston Properties, SL Green, Vornado. All these companies own high-end buildings in major American cities, New York, Boston, Chicago, San Francisco, et cetera. And just to give you a sense of how big a deal the sale of this one building was, SL Green, which sold the building, was - The 245 Park Building. At 245 Park Building. Its shares went from 23 to 28. Oh, wow. Just on news of that one transaction. That said, in February 2020, this was$100 stock. So now it has come roaring back down only 70-odd percent from its pre-pandemic high. And if you look across the office REITs, they are all down by at least half.

6:43And so what the great discounting mechanism known as the stock market is telling you, is we may see the problems in commercial real estate contained to low-end buildings now, but there is a big risk it is not going to stay that way. Yes. And in the piece that we wrote on this recently, you put your finger on one interacting complexity that is scaring stock market investors. So think about the two biggest risk factors here. One of them is work from home and occupancy, and the other one is interest rates. Imagine yourself as the owner of the building we're sitting in right now. On the one hand, you drop by on a Friday and there's nobody here.

7:25So you know that when the FT comes to renegotiate this lease, maybe they're going to want less office, maybe they're going to want to pay less. At the same time as that is happening on the revenue side, you've got a lease coming up on the building, let's say. I have no idea who owns this building, but it's lease. I'm sorry if you're listening, madam, who owns this thing. Don't evict us. Don't evict us, please. But on the other side of the ledger, say you've got to renegotiate with your lender. Your loan term is coming up. You took out your loan on this building, let's say broadly, at 3%. It's going to be 8%.

7:58Yeah. Right? Yeah. And in this business, that's enough to make your profit margin disappear, even if it wasn't for the threat to rents and occupancy. So depending on the timing of when your lease renegotiations are and when your loan renegotiations are, you're having some hard thoughts. Both of those two things are great unknowns, right? So even if we had – if the real estate market was perfectly liquid and we had perfect visibility into occupancy, leverage levels, rent payments, et cetera, et cetera, we would still have these two monstrous unknowns. where does work from home land on the one hand and where do interest rates land on the other hand?

8:42And if you knew the answer to either of those, this wouldn't be an issue. But there's like two interacting forms of uncertainty here that not only do we not know. It's scary. Nobody knows. No one knows. So, Rob, we should ask the question that all the grizzled veterans in the listenership will be wondering, which is, is this going to be something like a 2008 redux? Ethan, I said before, not grizzled. Wise. sagacious. Sagacious. Let's start with some good news. Office real estate as an asset class is a fraction of the size of residential real estate 2008. Every family in America thinks about its net worth.

9:23Every, I should say middle class family, middle and upper class family in America thinks of their net worth in the context of the value of their house. That is not analogous to the situation we're seeing now. Second thing is this is, you know, houses are a faster moving asset class than buildings. The transactions are fewer, they're bigger, the lease terms are quite long, there's more room to negotiate. So there'll be some natural buffers in this situation that were probably absent when people were just putting the keys in the mailbox and walking away on houses in Las Vegas or whatever. Now let us turn to the bad news.

10:02Hit me with it. The bad news is that this is an industry that is perfectly set up for financial contagion. We have a very highly levered asset class where the asset values are falling. We have a fairly concentrated group of lenders who are lending to all these people. Problems in individual buildings or neighborhoods will transmit to lenders. that will help the problem spread. There is going to be a 2008-like transmission of this problem. And it's going to get worse if we get the recession that the yield curve is currently telling us we're going to get. Federal Reserve hiking cycles, especially ones that are fast and sharp, tend to end in recession.

10:48What we're seeing now is against the backdrop of quite a strong economy. That's why the problem has been so contained to the lower end of the market. Doesn't have to stay that way. Yep. So I guess where we land at the end of the day is there is a lot of scope for things to go bad here, but maybe not quite 2008. Ugly, but smaller. It's the worst. It's the worst way to describe your second child.

11:19Ugly, but smaller. At least he doesn't eat much. We'll be back in a moment with Long Short.

11:34Welcome back. This is Long Short, that part of the show where we go long and short, one stock, company, child. All right, Rob, I am Long, Joe Biden's student loan forgiveness program. Now, I do have student loans, so this is very much a biased call. But the Supreme Court is hearing a challenge to the legality of the program. They're supposed to rule today or sometime soon. And I think they just might shoot down the challenge to Biden on standing grounds. If there's anything these conservative justices like, it's some standing technicalities. And I think they may wriggle a way out to let it stand.

12:14At least I hope. So I'm long. Ethan, I am confidently short whatever mope of a bank lend you money for your student loans. You mean the Department of Education? I know. I know what they pay you here at the FT, and nobody's ever going to see that money again. Oh, God. That's a sore spot. But I suppose that's what I deserve for emphasizing your grizzled veteran status. Don't poke the bear, Ethan. All right, Rob. Thanks for being here. And listeners, we will not be back on Tuesday as it is July 4th in the US. but we'll be back a week from now next Thursday in your feed. Catch you then.

13:15Just go to ft.com slash unhedged offer. I'm Ethan Wu. Thanks for listening.