Discover more from Diane Francis
March 30, 2023
The next challenge for the world’s banking system is the reality that city skyscrapers are emptying due to the popularity of remote work. This is a trend that will hurt mid-sized banks with sizeable debt exposure to office and retail properties. But another knock-on effect will be reductions in tax revenues for municipal governments. This massive urban transformation was the result of the pandemic. Remote work was required and many workers have refused to return to their offices. This is slowly turning high-density urban centers into ghost towns and upending finance, urban planning, and development. Landlords now scramble to repurpose their skyscrapers into residences or walk away. Cities prepare for lower incomes. Property values dive, causing more defaults and resulting in sleepless nights for mayors and bankers alike. This is the early stages of what’s been dubbed as the “Office Armageddon”.
Americans are leaving their cities. New U.S. census data for the period July 1, 2020 to July 1, 2021, “shows a huge spike in movement out of the big metro areas during the pandemic, an absolute decline in the aggregate size of the nation’s 56 major metropolitan areas (those with populations exceeding 1 million),” according to a piece written by William Frey for the Brookings Institution in Washington D.C. The same urban flight will take place in other countries wherever workers are packed tightly into forests of office towers and can opt to do their jobs at home.
This urban flight is a sea-change and the first time since 1990 that America’s major cities have lost, not gained, population. As this movement accelerates, municipalities with bonds and debts and obligations will face revenue crises — because most of those moving to the suburbs to work at home are among the country’s highest-paid workers. Under-utilized offices, and at-home shopping, is also cratering the value of retail properties. Most cityscapes are littered with shuttered shops and malls. Already, office and retail landlord defaults rise and forced some to give tenants rent-free space for long periods to entice them to renew leases, thus devaluing the properties even more. And in many cases, free rent doesn’t always retain tenants.
As of January 2023, 41 percent of Americans worked from home for some or all of their workweek. Most have abandoned downtown commutes and now vacant office canyons are populated by fewer workers and fewer commuters spending money on parking, transportation, meals, cocktails, or clothes. Half of Manhattan white-collar workers have not come back to the office. A recent analysis in Manhattan stated that the shift to home work was already costing the borough more than $12 billion a year in lost revenues and taxation.
The obvious fix is to convert office towers into residential condos or rental buildings. But this is easier said than done. Some have experimented with this but a wholesale switch won’t occur. This is because experts say there must be a further collapse in real estate values to enable residential developers to buy office building and pay for the high cost of conversion. Besides, city councils must be willing to change zoning laws to accommodate conversions or even to subsidize them in certain cases. In addition, these downtown neighborhoods must build new infrastructure and facilities to attract and accommodate full-time living by families or singles. Currently, they lack schools, health care facilities, and recreation, cultural, entertainment, and social venues. This requires large-scale urban renewal and those municipalities that pull this off could ignite an urban boom.
For most right now, however, the future looks bleak. Defaults by office owners are increasing, including those with impeccable track records. For instance, Canadian giant Brookfield Asset Management recently defaulted on more than $750-million in debt involving two 52-story towers in Los Angeles, according to The Wall Street Journal. Another firm, RXR, is negotiating a debt restructuring deal involving a gigantic tower in the heart of New York’s financial district. Another restructuring talk involves a new $150 million warehouse-to-office conversion project which has been unable to lease enough space to make it viable.
Some cities have already suffered high vacancies in their downtown cores -- like Calgary Alberta — due to the boom-and-bust nature of the oil business. In recent years, Calgary had office vacancy rates as high as 30 percent, and had to create new planning, zoning, and government financial schemes to re-invent its city center. Some residential conversions were subsidized and new zoning rules were established to allow pop-up or temporary leasing in vacant buildings. The city also waived business license fees and complicated permits in order to entice new tenants into dormant buildings.
The Office Armageddon will continue to hit the financial world. Investors, mortgagers, lease companies, commercial-mortgage-backed securities, municipal government bonds, and local government treasuries are already negatively impacted. Real estate professionals describe what’s going on as a commercial real-estate “recession” that may last years. One consultant forecasted that by the end of the decade in the United States there will be twice as much commercial vacant space as was vacant in 2019. Such predictions, needless to say, will result in more defaults, more foreclosures, and more stress on banks.
The disruptive role of technology in this metamorphosis cannot be under-estimated. Silicon Valley’s San Francisco already has office vacancy rates of 40 percent because it’s populated by tech workers who now demand remote work options. In Manhattan — where half the workers have disappeared into the suburbs — some developers rise to the challenge. For instance, a trophy tower -- One Wall Street – is the largest office-to-residence conversion to date, involving 1.25 million square feet of living space, amenities, and a gigantic Whole Foods on the ground level.
On the other hand, Washington, D.C. — with its relatively low-rise downtown — should be a hotbed of conversion activity but isn’t. As one developer said one in 20 of its office buildings could become housing easily but not until acquisition costs plummet. This is because current conversion costs of $400-$500 per square foot are too high unless a building can be bought at a fire sale price and zoning restrictions lifted.
Office space values will continue to take a dive which will speed up this change, but governments can fill the gap in the meantime by subsidizing the conversion of hotels or offices into residential or social housing. For instance, New York City is providing financial assistance to convert hotels into housing for its growing population of homeless persons. One of the first was the conversion of a 30-storey hotel in a wealthy section of Brooklyn called Dumbo. Such projects are a priority for newly-elected Mayor Eric Adams, who estimates that 25,000 hotel rooms could be turned into social housing. The Brooklyn building, for example, has 500 units plus amenities such as a gym, workrooms, and on-site mental health and social support services.
The transformation of our cities is unstoppable. The transition will be messy because the next urban renewal era won’t happen until values are destroyed. And this will happen. There’s simply no way workers are going to leave the comfort of their pyjamas and dens to work in the big city unless there are vibrant and livable options available where the big towers used to be.