Charlie Munger, believed by some to be the real “brains” behind Berkshire-Hathaway, the multinational investment behemoth helmed by Warren Buffet, recently told The Financial Times, “We have a lot of troubled office buildings, a lot of troubled shopping centres, a lot of troubled other properties. There’s a lot of agony out there” in real estate.
His comments are well-founded.
Crain’s New York Business reports that there is 94 million square feet of available office space in the borough of Manhattan alone. The business periodical reported that the amount of available office space is up nearly 75 percent since March 2020, when COVID-19 first forced business shutdowns.
Alignable, a B2B networking and referral site for small and medium sized businesses nationwide, reports that a poll of 4,205 randomly selected small businesses showed that 40 percent of them could not pay April rent, including nearly half of the restaurants it surveyed. That breaks the previous record, also from 2023.
Gone and Not Coming Back
It was assumed that, after the pandemic, commercial occupancy would resume as usual but that is proving not to be the case. There seems to be a number of causes.
First, workers got settled into a work from home (WFH) motif, which had been trending forward for years, well before the pandemic. Workers like not having to spend the time and money commuting, to say nothing of the 5 to 7 percent of take-home pay one spends to keep up a professional wardrobe.
Second, crime in major cities has increased decidedly since the pandemic. While New York City has a relatively low per capita crime rate relative to other major cities, the stochastic nature of some of the crimes there earn easy headlines among the two major tabloids, four local TV network affiliates, the headquarters of all three major broadcast networks, and Fox News channel which is headquartered there. Violent crimes that happen in purportedly “safe” neighborhoods like Wall Street and Times Square tend to terrify the workers who formerly commuted in.
In New York City, much of the high level of office vacancy is attributable to overly optimistic building plans adopted prior to the pandemic. While the attack on the World Trade Center destroyed 10 million square feet of commercial office space, about a quarter of it was replaced with the new Freedom Tower at One World Trade Center.
And building continues apace, notwithstanding that the assessed value of office properties have declined by “$28.6 billion citywide on the FY 2022 final assessment roll, the first decline in total office property market values since at least FY 2000,” according to the New York State Comptroller.
The Federal Reserve’s near zero interest rate since the 2008 Financial Crisis has flooded the sector with new office space. Even as rates began to normalize, the trade group New York Building Congress estimates that 17 million sq. ft. of office space was or will be built from 2021 to 2024, much of it based on the economics that existed in the post-crisis low-rate environment.
Where This Could End Up
My mother used to say “people grow too soon old and too late smart.”
Warren Buffet himself has written that it was Charlie Munger, now 99 years old, who changed his investment strategy from buying “fair companies at wonderful prices to buying wonderful companies at fair prices.” In that respect, Munger seems to have grown both old and smart, but smarter faster than most of us.
But what can we intuit from his recent warning on real estate?
Well, we’ve just seen a First Quarter 2023 in which four regional banks collapsed, largely as a consequence of mismanaged interest rate risk; specifically, matching customers’ demand deposits against bank reserves of long-term Treasurys. Banks knew, or should have at least considered the possibility, that the ultra-low interest rates of the last several years were likely to explode, even as the Biden administration dismissed rising prices as “transitory inflation” in 2021. But clearly, several of the regional banks did not and did not brace for the rising interest rate shocks. They missed it. And so did the regulators.
So, what’s to say either the bankers were any better stewards of their commercial real estate loan portfolio? Or the regulators?
Most likely, they were not.
Real estate is heavily leveraged, meaning that nominal “owners”—usually spread among several partners and partnerships, but not always—tend to finance most of a building’s purchase price (or building costs) with bank loans. Those loans tend to be sanguine; not much (if any) of the repayments are devoted to paying down the principal amount of the borrowed funds, but tend more toward servicing interest payments, usually for a decade or more. Investors are mostly looking for after-tax cash flows.
For the most part, office landlords are able to meet debt service payments because their pre-pandemic tenants are still paying their rents. But as those leases expire, they are less likely to be renewed, or—if they are—rents received will likely be less than the pre-pandemic rents. It is then when banks will be put under pressure and the refinancing of the mortgage debt associated with the property will become a considerable challenge. Real Estate Investment Trusts (REITs), again, here in New York, have suffered considerable downside shocks to their stock price and a few have suspended their dividends to preserve cash.
The Japan Precedent
Toward the end of the 1980’s, Japan’s banks engaged in what bankers call “extend and pretend” loans; that is, rolling over real estate debt that could not be repaid even as the value of the mortgaged property had declined. Banks did not take the write-downs of their bad loans, which would have adversely affected bank earnings.
As the 1990’s commenced, though, the Bank of Japan, Japan’s central bank, intervened to raise interest rates to slow what it viewed as an “overheated” economy. That, in turn, tended to “turbocharge” the decline in property values and put Japan into what has now come to be known as “Japan’s Lost Decade,” a period of slow growth and price deflation. Nearly 30 years later, it still vexes Japanese fiscal and monetary policy makers.
What to Do Now
Ronald Reagan once said, “The most dangerous words in the English language are, ‘We’re from the government and we’re here to help.’” We should study Japan’s failures during their real estate crisis and avoid what Japanese policymakers did.
It’s critically important that U.S. policymakers simply allow the marketplace to simply work. That will include letting losses shake out when, where, and as they occur, without fear or favor (something that was not done, we believe, with the decision to rescue Silicon Valley Bank and which we believe made the circumstances worse than if the Fed and the FDIC has simply acted as we suggested as the crisis unravelled).
People will suffer financial losses; jobs will be lost. The “millionaires and billionaires” so often targeted for financial punishment by activist progressives will incur some; even maybe be bankrupted. And while government can and should try to ameliorate the suffering that results from bad decisions, it should not attempt to inoculate the economy from them. That means assistance with government safety nets like unemployment insurance, not billions of dollars in bail-outs.
Accepting the losses—when, as, and to the extent they come, and managing them as they occur—will be a critical element in avoiding something akin to Japan’s “Lost Decade.” Failing to do so, and stepping in with big bail-outs, will give the illusion of financial stability for a while, like a Potemkin Village of financial stability, but doing so will blow up the deficit and Federal Reserve balance sheet (as it did for Japan), and usher in a lengthy period of stagnation and malaise. It will spread the misery.
Creative destruction is as necessary to the maintenance of a healthy economy as much as the shedding of a snake’s skin is necessary for its growth. But to achieve that, we need to let the chips fall where they may, when they may, and as they may.
J.G. Collins
