Zombie Office Towers
Zombie Office Towers
The rise of remote work has decimated commercial real estate, threatening the economy
After WW2, there was a scramble to build enough homes for the veterans returning from overseas. Levittown was a planned community built in Long Island, New York far enough to be free of the hustle of Manhattan but close enough to commute there for work. The community featured rows of identical homes that were built sequentially, like on an assembly line. Over the next few decades, the Levittown model went national and America suburbanized. Populations shifted from the cities to the suburbs, the Interstate Highway System connected this suburban sprawl to city centers, and middle-class suburbanites became a vast new political constituency.
Today, a similar transformation is occurring. The COVID-19 pandemic and the Internet ushered in the rise of remote work, lessening the importance of the physical office. As a result, vacancy rates in commercial real estate have skyrocketed and rents have plummeted as firms shed unneeded office space. This is terrible news for the owners of commercial real estate (CRE), which includes offices but also retail, hotels, and a variety of other commercial spaces, and the banks that have provided CRE loans. As these loans expire or go delinquent, the solvency of the banks that made them is under threat. A potential wave of bank failures threatens the US economy.
How We Got Here
This unfortunate series of events began with the COVID-19 pandemic and the response to it, which caused the highest inflation in 40 years. Ad Astra covered this extensively. In response, the Federal Reserve raised interest rates at the fastest pace in history, destabilizing the financial system. The banks that survived had weakened balance sheets, making them more susceptible to further shocks.
Rise of Remote Work
During the pandemic lockdowns, many white-collar workers were able to log in to their jobs remotely. When the lockdowns ended, workers, aided by extra bargaining power from a national labor shortage, successfully negotiated to permanently defer a return to the office. While exclusively remote work has declined from its peak in 2020, the majority (53%) of workers remain “hybrid”, meaning they combine on-site and remote work. This is causing employers to shed office space to cut costs. Half of multinational corporations plan to cut office space in next three years[i], according to a recent survey.
Figure 1: The changing nature of work[ii]
Commercial Real Estate Vacancies
The results of the office space reductions can already be seen in office vacancy rates, which have spiked nationwide since 2019. But office space isn’t the only casualty as the second order effects of fewer office workers hurt retail, restaurant, and other city center tenants. Reduced cell phone traffic in urban cores confirms this trend. This is a nationwide problem but the severity of the harm is unevenly distributed:
the pain would be concentrated in certain regions of the US, including large urban centres such as San Francisco and New York, as well as in second-class office buildings that are in need of repair.[iii]
Figure 2: Office vacancy rates by city
Impact on the Financial System
The decline in value or widespread defaults in CRE loans could further destabilize banks. According to a stress test by CBRE Group, a global commercial real estate services and investment firm:
the real estate advisory firm analyzed Federal Deposit Insurance Corp. data on the balance sheets of 4,800 insured banks to identify the banking sector's total exposure to commercial real estate. It then applied a hypothetical stress scenario in which property values and net operating incomes fell enough to result in a total loss.
Under this extreme — and unlikely — scenario, Barkham said 311 banks would fail, with the vast majority being community banks, along with about 20 regional banks and one large bank. He did not identify which banks are most exposed to this risk. Barkham said the assets of the failed banks in the scenario totaled about $600 billion, roughly three times the size of Silicon Valley Bank, which failed in March.[iv]
This scenario echoes the Global Financial Crisis in 2008, which was caused by the systemic decline in residential real estate values. Luckily, the scale of CRE is roughly $4 trillion versus the $43 trillion residential real estate market[v]. One can never be certain but there is reason for optimism that a 2008-style crisis is unlikely. Bad CRE loans could nevertheless be very harmful for the broader economy. Banks tightening credit due to CRE losses could slow economic activity and throw the US into recession.
Turn Office Buildings Into Housing
So what should be done with these zombie office buildings? There is a housing supply shortage in the US which has kept home prices high. This has prevented lower-income and younger people (Gen Z and Millennials) from owning homes, the traditional route to the American Dream. Homes have been underbuilt in America since the 2008 housing crash and the US is short roughly 6.5 million homes[vi].
Figure 3: US housing shortage over the last decade
Building high-density affordable housing has been subject to Not In My Back Yard (NIMBY) fights and no progress in most major cities. The CRE downturn offers the opportunity to alleviate the housing shortage by turning vacant office space into affordable housing.
There will be costs converting office space into homes but versus the alternative (bank failure, financial instability) they will be manageable. Moving people downtown will also revitalize these areas, with restaurants, retail, nightlife, etc. benefitting from co-located customers. A homeowner downtown will have easy access to amenities, reduced driving time (and emissions), and vibrant community life.
By resurrecting these zombie office towers as homes, we can avert bank system instability and restore the American Dream for millions.
[ii] Gallup
[iii] https://www.ft.com/content/a77695ac-a516-4654-8e0f-5aeb4f4fff71
[iv] https://www.americanbanker.com/news/big-commercial-real-estate-downturn-could-sink-300-banks-report
[v] https://www.americanbanker.com/news/big-commercial-real-estate-downturn-could-sink-300-banks-report
[vi] https://www.cnn.com/2023/03/08/homes/housing-shortage/index.html