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Musings Report 2023-48 11-25-23 The Sun Sets on Commercial Real Estate (CRE)
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The Sun Sets on Commercial Real Estate (CRE)
Several readers asked for more commentary on Commercial Real Estate (CRE), and so I am obliging this request.
I view CRE in contexts larger than the real estate market alone, for the answers to the key question, what drives supply and demand for CRE?, originate in the national and global economies.
Let's start with cities, which are the economic engines that power both supply and demand for Commercial Real Estate.
What is the primary economic engine of cities today?
As I've discussed in previous posts, correspondent Tom D. proposed a progression of the core value-added propositions of urban centers, from their original functions as A) depots for raw materials and the manufacture and distribution of finished goods, and B) the nexus of political elites to manage the state's affairs and collect taxes, to centers of finance--processing transactions, managing wealth generated elsewhere and managing loans, insurance and regulations--to the present-day function as centers of entertainment / tourism.
Cities retain some of their original functions as distribution depots and political centers, but the FIRE sectors--finance, insurance and real estate--are what filled the office towers with employees.
The digitization of the economy created demand for office space from tech companies, but it also changed the nature of the office-based work performed in the FIRE sectors--the work that traditionally demanded large offices to house thousands of workers processing files and transactions.
The digitization of the economy has reduced the need for physical proximity to perform thee tasks. This reality was catalyzed by the pandemic lockdown, which pushed remote work from the fringes to the mainstream.
There are limits on how much real-world tasks in warehouses, bakeries, etc. can be digitized. Someone has to actually be present, even if some of the work has been automated. Purely financial / transactional tasks can all be done somewhere else, scattered across thousands of workers and managers.
At the same time, the primary engine of economic expansion for the past 40 years, financialization--the commoditization of everything into collateral for debt and leverage which could be packaged, sold and traded--has reached the top of the S-Curve and is in the decline phase.
Every drop has already been squeezed from financialization, and we see the decline globally, the deflation of China's real estate bubble being one example. There is only so much financialization to be done before the edifice collapses under its own weight.
Financialization greatly expanded Commercial Real Estate, as low-cost credit and the churning of assets into income streams that could be commoditized and sold incentivized the over-building of CRE, from strip malls to office towers to retail. The square footage of CRE per capita in the US is many times higher than the totals in other developed nations.
Financialization drove over-building, and so CRE that was constructed to be financialized, not because there was high demand for the space, has generated a massive overhang / surplus at the same time that demand for office space has crashed due to the remote-work catalyst of the pandemic.
A key driver in urbanization is cost: as historian Fernand Braudel observed, cities have always had a higher cost of living but this was more than offset by the value added, which generated profits and higher wages.
As urban rents and other costs have soared globally, this advantage is no longer absolute: wages are not keeping up with soaring costs, and the value added by being in a city may no longer be enough to offset soaring expenses for enterprises.
As Peter Drucker observed, enterprises don't have profits, they only have expenses, and offices, warehouses, workshops, transport and employees are all expenses. If enterprises have pricing power, they can raise prices to cover any increases in expenses. But if the ability to pass along higher costs falters, the only way to maintain profits is to cut expenses. Whatever is not absolutely essential to creating value must be jettisoned, and enterprises are awakening to the reality that office space is no longer essential to value creation.
Consider remote work and the debate about declining productivity when employees no longer commute to the office daily. Few analysts consider the hours and energy squandered on commuting long distances to the office; hours wasted in stop-and-go traffic or sitting on subways or buses impair productivity, too.
If employees are happier working from home and devoting the time they wasted on two-hour daily commutes to the rest of their busy lives, doesn't this positively impact productivity?
The point here is requiring employees to spend exorbitant quantities of time and money to transport their physical selves to centralized offices makes no sense unless their physical presence is absolutely required to create value. As the value-added proposition moved from warehouses, factories and marketplaces to transactions, physical presence is no longer essential in digitized realms.
Offices, warehouses and factories are all expenses that cost more in cities, and so we've witnessed an exodus of these facilities to lower-cost regions.
Simply put, enterprises cannot justify renting expensive space in cities unless the locale is absolutely essential to their value-added proposition. Few tasks meet this standard in the digitized realms.
As the digitized sectors migrate to lower-cost arrangements, cities are left with government, entertainment and tourism.
The problem with depending on entertainment and tourism as the value-added proposition is these ultimately rely on workers having ample discretionary income to spend on entertainment and tourism, income and spending which generates taxes for government to collect and spend.
As the costs of essentials rise due to depletion / scarcity / national security, there will be less discretionary income to spend on entertainment and tourism. As discretionary income dries up, the bottom 80% will not be able to afford the absurdly high costs of entertainment and tourism.
As noted, cities are inherently expensive, and so every enterprise only has so much wiggle room to trim expenses before they must either move to a lower-cost locale or close up shop.
American urban planning exacerbates this by strictly segregating residential and business. The city dweller must typically rent or buy a horrendously costly residence and then rent or buy a hideously expensive place to do business.
In contrast, elsewhere in the world (Asia, for example), cities are filled with small shops and workshops that front the living space, or occupy the lower floor with living quarters above. What Americans regulate as "cottage industries" are the norm elsewhere. People fix motorcycles on the first floor of their space or set up a small shop outside their residence without being fined for violating zoning laws.
I don't think it is an exaggeration to say that cities that encourage cottage industries on a mass scale will thrive and those that restrict them due to zoning codes designed to limit "unfair competition" to large high-cost businesses will wither as expenses increase and discretionary income declines.
If enterprises have to lower expenses, the value added by being in a high-cost city no longer offsets the higher costs.
If we add all this up, we can imagine a permanent decline in demand for office space and other CRE in urban centers. By moving from physical-world value creation to digitized tasks and experiences (i.e. entertainment and tourism), cities are now exposed to the hollowing out of their digitized sectors and the decline of high-cost experiential sectors as the global economy contracts as financialization declines due to its excesses of leverage and debt.
Since the buildings are all valued on high demand keeping rents and occupancy high, their valuations will collapse.
As for rents, buildings are costly to maintain and the taxes are substantial. The rents enterprises are willing to pay may be lower than the costs of operating the building. If no one is willing to pay enough rent to cover the bare-bones cost of operation, the building is a White Elephant, an asset that bleeds the owner with losses.
The value of the building drops to zero, as who will pay for an asset that generates a net loss?
Much is being written about the question, "who will absorb the losses?" Clearly, owners and lenders will absorb the devaluation of CRE to much lower levels. Lenders with high exposure to CRE may well be pushed into insolvency.
More important is the question, "who will pay the higher social costs and borrowing costs of government and the private sector going forward?" Entitlement costs are soaring, with no end in sight, wages are barely keeping up with inflation, and most enterprises are struggling to maintain profits. Who will pay the higher costs that are already baked into the coming decades?
Put another way, who will sacrifice discretionary income to pay higher costs and taxes? And as discretionary income is siphoned off to fund higher social and borrowing costs, what happens to sectors that depend solely on free-spending consumers such as entertainment and tourism?
Capital--the owners of assets and debt--have benefited from changes in regulations and the economy over the past 45 years, to the detriment of labor. We can anticipate a reversal of this trend to restore some balance, and that means capital / business will have to pay more going forward, not less.
What will become of high-cost cities that are dependent on government, entertainment and tourism as costs rise and discretionary income shrinks? Every increase in taxes further reduces the income left to spend on entertainment and tourism.
What is the value-added proposition of entertainment and tourism in a digital age? Is it enough to fund high-cost urban centers? How many workers will be able to pay the high costs of entertainment and tourism often enough to fund these labor-intensive sectors?
Workers are drawn to cities if the wages are higher than the expenses of living in the city. If costs are sticky and don't decline while the purchasing power of wages declines, workers will not be able to enjoy the entertainment in the city because they're barely scraping by. This is already the reality for many households.
In effect, cities are counting on the top 20% of households to continue to have surplus income to spend freely on high-cost entertainment and tourism. Is this enough to support the immense costs of operating a city?
Many with zero construction experience have concluded the solution is to convert office towers into residences. This turns out to be a complex, costly process that often exceeds the value of the building; it may be cheaper to tear it down and start from scratch.
Turning Empty Offices Into Apartments Is Getting Even Harder.
The process has always been fraught with difficulty and few office buildings are natural candidates. Conversions are easiest in older, lower-quality and mostly empty buildings with small floors. But less than 1% of office space in the biggest U.S. cities ticks those boxes, according to Avison Young.
Without large government subsidies, some housing analysts have doubted office conversions would ever become large enough to help address the U.S. housing shortage.
In other words, without enormous giveaways paid by taxpayers, conversions are not cost-effective, and those buildings that are converted to residences will be expensive to buy or rent.
This raises the question, "who will want to live in converted office towers if the city center has been hollowed out by high costs and the decline of value-adding enterprises?"
Enterprises don't have profits, they only have expenses. The same is true of workers. If the costs of city living exceed the value being generated, then people will migrate elsewhere. Should this happen, demand for CRE and residences will decline and that will lead to lower valuations for property--potentially far lower than anyone thinks possible.
Recessions cause migrations from high-cost locales. When the dot-com bubble burst in 2000, 100,000 people moved from the San Francisco area over the next few years as they could no longer afford to live there.
Costs have soared and wages have stagnated for most workers over the past 40 years, which happens to be the length of time that's passed since the world experienced what I call a "real recession" in which profits, employment and tax revenues all drop sharply, inflation and the costs of borrowing money rise, restricting central banks and governments' ability to flood the economy with "free money."
The costs of operating cities have risen sharply, along with debt loads on households, governments and enterprises. These higher costs and debt loads create risks that did not exist 40 years ago when costs and debt loads were much lower.
A recession will be a powerful catalyst, much like the pandemic lockdown was a catalyst.
Economies and societies are dynamic; there is no natural law that requires stability or eternal expansion. Locales and systems decay, decline and vanish. As far back as the early 1990s, Peter Drucker foresaw the potential for institutions we consider permanent (universities and healthcare, for example) to lose their value-added propositions.
The future of Commercial Real Estate is very much in flux. It is unlikely to be restored to its previous valuations by attempts to return to a world that no longer exists; how it may be used or re-used is an open question. If there is no value-added proposition, it will simply be abandoned.
Cities will have to re-invent themselves as value-adding systems, and CRE may or may not be integral to that re-invention. The previous era of urban decay (the 1970s) was reversed by reining in costs and inefficiencies and the rise of financialization in the 1980s. That force is now spent.
What can replace financialization is an open question that may well have no easy answer.
Highlights of the Blog
Black Flag Friday: Could Black Friday Be a Harbinger of a Tapped-Out Consumer? 11/24/23
Thanksgiving: When Gratitude Is In Short Supply 11/22/23
This Holiday Season, Give the Wonderful Gift of Nothing 11/20/23
Best Thing That Happened To Me This Week
Harvested our first avocado from the tree we planted 6+ years ago. The eggplant harvest continues to be fruitful.
From Left Field
NOTE TO NEW READERS: This list is not comprised of articles I agree with or that I judge to be correct or of the highest quality. It is representative of the content I find interesting as reflections of the current zeitgeist. The list is intended to be perused with an open, critical, occasionally amused mind.
Many links are behind paywalls. Most paywalled sites allow a few free articles per month if you register. It's the New Normal.
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Millions of UK households forced to unplug fridge or freezer amid rising bills--Families resorting to ‘desperate measures’ and struggling with ‘frightening’ level of hardship amid cost of living crisis.
We're Going To Have To Cut Down A Lot Of Big Trees To Upgrade The Electric Grid For EVs. Grid updates mean utility pole demand has exploded.-- we could use concrete utility poles like Asian countries....
Facing Financial Ruin as Costs Soar for Elder Care. -- this will start to matter....
How the Demographics Are Shaping the Housing Market
Billionaires are out of touch and much too powerful. The planet is in trouble
Census Bureau Releases New Estimates on America’s Families and Living Arrangements
In the Gut’s ‘Second Brain,’ Key Agents of Health Emerge (via Cheryl A.)
The enshittification of garage-door openers reveals a vast and deadly rot. Firms undisciplined by competition, regulation, or self-help measures. -- set aside his crude language, he's making essential points...
The wealthiest 20% of Americans have more money now than before the pandemic. Everyone is else is poorer.
"No amount of anxiety makes any difference to anything that is going to happen." Alan Watts
Thanks for reading--
charles |
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