To be clear from the outset, I’m not now, and have never been, a professional real estate investor. I spent 28 years as a professional equity investor, much of that time heavily involved in Asian stock markets, where commercial real estate companies were a key–sometimes dominant–sector. So I know a little bit. Anyway…

the academic finance take

In business school and for many years later, I read academic articles extolling the semi-magical properties of real estate as an investment. According to “research” analyzing records of transactions, real estate had both the highest return of any asset class and the lowest volatility of return (the preferred academic measure of risk)–meaning that, when compared with either stocks or bonds, real estate had the highest return and the lowest risk. The theoretical iron law that higher return must entail higher risk simply didn’t hold.

What the scholarly works ignored, however, is what every homeowner knows–real estate is very hard to sell in times of high interest rates or in economic downturns. So no one does it. If, for example, my wife and I had been forced to sell in 1982 the house we bought in 1981, we would have been lucky to get 2/3 of what we paid a year before–not enough to pay off the mortgage, either. It wasn’t until 1984 that For Sale signs began to pop up again in our neighborhood.

Academics working with publicly recorded transactions as their source for pricing happily (although very incorrectly) concluded not only that my house was worth the same in 1982 as in 1981 but that real estate of all types was as well. And that compared favorably with stocks and bonds, both of which decline in periods of higher rates (because transactions continue to happen).

All this would have been simply laughable had large US investment companies not taken this academic nonsense to heart and bought tons of real estate, whose illiquidity they only began to work out when they tried to sell in the late 1990s.

boom and bust

Commercial real estate projects, especially urban ones, tend to be large and to take years between initial planning/permitting and the end of construction. That’s even if a project is executed in phases. Also, the same economic signals that lead real estate company A to greenlight a major expansion also send their message to B and C …and maybe D. Also, office space, which has been regarded as the most dependable investment, tends to come in large chunks. Take Hudson Yards just west of Penn Station in Manhattan as an example. So there has tended to be at least a mild shortage/excess capacity character to office, hotel and retailing real estate expansion.

where we are now

Starting with what we know:

–if we count worker days as one worker being in the office for one weekday, total worker days in urban office complexes are running at around 47% of the level just before the pandemic

–if all workers are in the office only Tuesday – Thursday, then office occupancy is 78% of the pre-pandemic level during those three days

–if so, companies have 20% more office capacity than they need. If workers could be spread evenly over Mon-Fri, the overcapacity is 50%.

–the amount of office space on offer by current tenants for sublease is double the amount just before the pandemic

–office space is typically rented on multi-year leases. So tenants are on the hook for a while for space they probably will never need. During the 2008-09 financial crisis, the bottom for commercial real estate came around 2011. That would suggest 2023-24 for a new bottoming–the first time we’ll know which landlords will be able to make their mortgage payments

–experience suggests that tenants will gravitate away from the oldest buildings toward the newest and most technologically up-to-date, and may well end up with lower rents, to boot

externalities

–for landlords, since they’re renting space, there’s probably a big difference between having tenants who need a smaller amount of space that’s used five days a week and ones needing more space that’s going to be used only three

–for supporting services–restaurants, hotels, retail–the more critical variable is likely that worker-days may only be half the prior norm

–for municipalities, I’d imagine the big issue is the falloff in taxes–income, sales, property (?), even though the demand for public services may not be that much lower.

The financial press has been reporting recently that large institutional real estate funds have been experiencing enough redemption requests that they’re invoking clauses in their contracts that allow them to limit redemptions. I have no idea why, but the possibilities that occur to me are: sophisticated clients are trying to lessen their exposure to a potential crunch a couple of years down the road; clients are rebalancing into areas (IT?) that have been crushed in the downturn; clients need cash and are selling in areas that have held up relatively well.