Wednesday, March 8, 2023

Commercial Real Estate Meltdown?

Like dominoes, once a building goes bust, it takes down another.

I wrote before, how in law school, I took a course in real estate law, thinking it might come in handy some day if I wanted to do real estate closings.  The course turned out to be something different - taught by an attorney who represented a commercial office builder in the DC area.  He made money putting together "deals" in the 1980's and then made money taking them apart in the 1990's as the market for office space collapsed.

As I noted in an earlier posting, the problem was overbuilding, and once that happened, a domino effect occurred, which caused many building owners to go bankrupt:

In the late 1980's, this happened in many cities, and created a domino effect. In Washington DC, a new office building would go belly up, and the new owners, paying pennies on the dollar for the place, would offer it for rent at bargain prices. Tenants from adjacent buildings would then jump ship, leaving that building vacant, driving another landlord or builder bankrupt. Like giant dominoes, each building would in turn, topple another, with devastating effect.

I lived through this, as at the time, I was working for a good law firm with fairly inexpensive offices near Thomas Circle - a sort of sketchy area known at the time for prostitution and where Mayor Marion Barry was arrested for smoking crack.  The partners said they would "never move" as they had a low cost lease.  But then the real estate boom turned to bust, and their lease was up for renewal and they realized they could rent some high-class real estate in a brand-new building right above Metro Center for less money, so they moved.  The landlord at Thomas Circle was no doubt pissed-off that we left, as he had a mortgage to pay.

As my "professor" explained it, in the early 1980's, it was morning in Reagan's America and massive amounts of money were being thrown at military spending.  Every defense contractor and lobbyist needed new office space - government always gets bigger, even if government gets smaller.  Bill Clinton, for example, claimed to make government "the smallest it has been since the Kennedy administration" but accomplished this by firing government employees and contracting out their services.  That required yet more office space.  The game never ends.

So in the early 1980's, you could propose a new office building and have every square inch rented before you even broke ground.  It was like shooting fish in a barrel, so everyone jumped in - capitalism at its best, and worst.  By the mid-1980's, you might have half the place rented before breaking ground, and the rest by the time the building was finished.  By the end of the decade, "see-through" buildings were going up with no tenants at all, even months after completion - which is how the partners at my firm scored a deal on prime office space for cheap.

But that meant tenants fleeing older buildings, which in turn went bankrupt, and were then sold for pennies-on-the-dollar, bankrupting the builder and the bank that financed it.  The new owners, with a low cost basis, could then poach tenants from other, high-rent buildings, and the process repeats, each building toppling over (figuratively speaking) like a row of ugly dominoes walking across downtown DC.

Eventually, the carnage stopped.  The lenders realized that if they didn't accommodate the building owners somehow, they would get slaughtered as well.  So the work-out was created, which created lots of billable hours for lawyers.  Some folks call it a "cram-down" and old Donald Trump was king of this - foisting off his problems onto his lenders, who should have know better to lend money to him in the first place.  Same shit, different year - casinos in Atlantic City were overbuilt.

It's like the old saying, "If you owe the bank $100,000, you've got a problem.  If you owe the bank $100,000,000, the bank has a problem!"  And banks don't like to have problems.

In a typical work-out, the lender assumes at least partial ownership of the building, and the building owner (who may be the developer) becomes the building operator, renting out the place, collecting lease money, doing routine maintenance, and taking a little off the top.  The lender has an asset on their books, so they no longer appear to be insolvent, and they have a nice income stream from it as well - that they don't have to manage.  Over time - a decade or so - the market eventually recovered and the lenders cashed out (perhaps selling back to the builder) and everyone was happy.

In a way, these workouts are not dissimilar from bankruptcy of a corporation - the lenders become shareholders and then take over the business.  Maybe management hangs on, but the shareholders are pretty much wiped out.

Maybe Elon Musk sees the writing on the wall, and by not paying the rent on his various Twitter office buildings, he can "cram down" the building owners, or even trigger their bankruptcy, before being evicted himself.  And even if evicted, no doubt some other low-cost real estate will become available or he could move the whole thing to the middle of Iowa.  The world of business is a pretty cruel world - but that's just business.

We may see this history repeating, albeit not in the same way.  In the 1980's interest rates were falling and demand for office space was increasing.  The problem then was overbuilding - too much space for too few tenants.

Today, interest rates are going up and most commercial real estate is mortgaged on variable-rate callable notes.  And with the pandemic, more and more people are working from home, at least part-time, and sharing office space one or two days a week, if that.  We were doing that at the Patent Office well over a decade ago!   Some building owners are already in default on their mortgages.  And others are cutting back on building plans, including Amazon with its ambitious plans for a "Second Headquarters" in Crystal City.

Some building owners are looking into converting undesirable office space into highly coveting residential space.  At least for the time being, the demand for residential space is high - although prices are dropping dramatically there as well.  The problem with converting office space to residential is that most office buildings are not properly zoned, configured, or located for residential use.  Think about your office - drop ceilings, cheap cardboard walls or even just half-height cubicle dividers - do you want to live there?  I mean, unless you work for Twitter, that is.

Not only that, but most office buildings don't have the proper plumbing to accommodate all those toilets, showers, kitchen sinks, laundry machines, and whatnot. They would have to be stripped to the bones and rebuilt, which costs as much - if not more - that building a new building.  Where do you vent the range hood above your stove in a 30-story building?  Just asking.  And if you can solve all those problems, you still have to fight with the zoning board, unless you own a unicorn known as residential/commercial, as I did once.

Then there is location - the three biggest elements in real estate: location, location, location.  Are there good schools near your office building?  Any schools near your office building?  What about other amenities like parks and green space and recreational opportunities, as well as places to shop and the like.  The sandwich shop at street level and the convenience store aren't going to cut it for a residential community.  Most office buildings are located in food deserts - so they are not readily convertible to residential space.

Converting to residential might save some buildings, but I suspect it will be a small percentage - maybe 10% would be located and amenable to such conversion, but at great cost, and at a time when the residential housing market is cooling off.

Is this an exact replica of the commercial real estate meltdown of 1989?  No, it is far worse.  Far worse because interest rates are climbing, not sagging, and far worse as "work from home" is killing the demand for office space.  This isn't a matter of the market over-building office space by 10% or so, but the market decreasing demand by 50% or so - and permanently, too.  Despite all the hoopla about "back to office" I suspect that "work from home" is here to stay.

Like I said, the Patent Office has been doing this for well over a decade - perhaps two - and shows no signs of going "back to office" simply because there is no advantage to doing so, only increased costs. They literally would have to buy new office buildings to accommodate all the Examiners.  And since the area they moved to is now "built out" with the Federal Courthouse and residential spaces, they would have to move the whole kit and kaboodle somewhere else.  I doubt that would happen.

No, people are not going to start magically going back to the office and drive up demand for office space.  This could be a commercial real estate debacle that makes 1989 look tame in comparison.