A question that has been rattling around in my head for a while crystallized for me this morning when I read that a famous Nordstrom had closed in the heart of San Francisco. Then the Washington Post hammered the point home by leading the paper with this headline:
"How the ‘urban doom loop’ could pose the next economic threat."
My question has been about the long-term effects of the pandemic on work in offices. If enough people stay home to work, then businesses don't need as much office space. Restaurants, bars, coffee shops and other retail establishments see less traffic, and many close. As they close, downtowns become less attractive as places to live and work. Retail traffic declines further, fewer people come downtown, businesses need less office space. And down and down and down we could spiral,... meaning owners of commercial real estate could lose so many tenants that they default on loans.
That's where this could really become an issue for the insurance industry, because life insurers are the second-biggest holders of commercial real estate debt, behind only banks. Any long-term realignment of work and other activity in cities would also affect many other lines, notably workers' comp but also commercial property/casualty and others.
No big change will happen soon. If cities are headed toward major problems, they will unfold over at least the next couple of years as a slow-motion track wreck. But it's always better to be prepared.
So let's have a look.
The Washington Post article opens with this grim picture:
"In Indianapolis, the technology giant Salesforce is paring back a quarter of its office space in the tallest building in Indiana, where it has been a key tenant for the past six years. In Atlanta, the private investment giant Starwood Capital defaulted on a $212 million mortgage on a 29-story office tower. And in Baltimore, a landmark building sold for $24 million last month, roughly $42 million less than it fetched in 2015."
If that isn't enough for you, The Commercial Observer wrote in June: "The shifting of the tide and subsequent distress has been plain to see: Brookfield defaulted on $784 million in loans tied to two Los Angeles skyscrapers in February; Blackstone sent a $270 million CMBS [commercial mortgage-backed security] loan on a Manhattan multifamily portfolio to special servicing in February; GFP Real Estate defaulted on a $130 million mortgage-backed securities loan for 515 Madison Avenue in December; and just last month RXR defaulted on a $260 million loan on 61 Broadway."
The Post says: "All across the country, downtowns, office spaces and shopping centers are at risk of becoming ground zero for a new economic hazard: the urban doom loop."
It adds that, while problems facing New York, San Francisco and some other major cities are getting most of the attention, "many economists are even more worried about midsize cities that have fewer ways to offset the blow when a major company slashes office space, the sale price of a building craters, or a downtown turns into a ghost town."
Some $1.5 trillion in commercial real estate debt is coming due by the end of 2025, and refinancing much of it could be tough. Banks' appetite for lending has diminished, especially for anything that feels risky, following the recent failures of three major banks. In addition, while inflation has declined significantly over the past year, markets seem to now be betting that the Fed will keep interest rates high for some time, to try to head off a resurgence -- and a building that can carry a loan at 3% may have a much harder time making ends meet with a loan at 7%.
In other words, less financing will be available, and what is available will cost a lot more. Those would be serious problems even if you could set aside the fact that building owners are facing what looks to be a fundamental decline in the need for office space -- and you can't set that issue aside.
In the quarterly podcast I do with Dr. Michel Leonard, the chief economist at the Insurance Information Institute, he said lenders have been cushioned thus far from the full effects of the shift to remote work because of "something fairly unusual. We're not seeing cuts in rents."
He adds, though, that "once there is less uncertainty around [the number of people returning to offices], the bankruptcy process will start." And he adds his voice to those saying that they don't expect big changes from here, that we've probably found our new normal.
"We did a survey of our members, and about 80% of them,... for three days a week, are not in the office," he said. "Almost all of them have at least one day out of the office. And that has stabilized. The insurance industry was willing to go virtual, but [people] really resisted coming back to the office."
The Post notes that the surprising strength in job creation has softened the blow to building owners and their lenders -- just imagine what a recession would have done to office occupancy rates -- and that many cities still have reserve funds from the unprecedented aid that states and the federal government offered during the pandemic.
So far, ratings agencies aren't raising any alarms about life insurance companies, despite their heavy exposure to commercial real estate debt. The reason: The companies generally have high-quality debt. They typically are at or near the front of the line to get repaid in the event of a default, and the buildings they've lent to are generally performing well.
But I've learned to be cautious. Not only did ratings agencies grossly underestimate the dangers lurking in home mortgages in the leadup to the Great Recession of 2007-09, but I was running the Wall Street Journal bureau in Mexico City in 1994, when the country went from being a paragon of economic reform to being a basket case almost overnight. We had seen and reported on some warning signs as the country's foreign currency resources dwindled over the course of the year, but nobody was predicting a devaluation -- until it happened in December, and the bottom fell out of the country's whole economic program.
In any case, insurers will have to continue to adapt as cities do. For now, workers' comp carriers are prospering as fewer people are going into office settings and injuries are declining. In theory, the reduction in commuting should reduce vehicle accidents -- but theory isn't reality, and people seem to be slow to drop the bad habits, especially excessive speeding and distracted driving, that they developed while streets were empty during the pandemic. Commercial lines carriers will have to adapt as traffic at restaurants, bars, coffee shops, retailers, etc. morphs, and as establishments perhaps migrate to suburbs and exurbs, where the people are. And so on.
There will, of course, be wildcards, too, that will affect how cities develop. Dr. Leonard spoke of what he called "theme park-ification" -- the development of open spaces, including parks -- as a trend that is making cities more attractive. The spread of electric vehicles will reduce noise and pollution. In time, autonomous vehicles could allow for fundamental redesign because of all the space currently devoted to parking that will be freed for other uses. Cities could also benefit from the broad efforts to reduce climate change -- it's much more efficient to heat or cool an apartment building than it is to heat or cool 150 individual homes, because, instead of leaking to the outside, one person's heat or cool air helps those on either side and above and below heat or cool their apartments. On the flip side, crime tends to rise in cities if they empty out,
The wildcards are mostly long-term issues, though. What I'll really be watching is what happens over the next couple of years with commercial real estate, and to their lenders.
Cheers,
Paul