Office markets are the real estate crash we need to worry about

While everyone is sweating the housing and labor markets, the office market is heading for a hard landing.

The Federal Reserve’s new hawkish stance pushed stocks lower and heightened concerns about the direction of the US economy in the year ahead. Anxiety centered on work and housing accidents, but investors, city mayors and economic developers held out hope for an improvement in the office market. It is better to abandon this wishful thinking.

I can offer two reasons why office market watchers aren’t as pessimistic about the future of the sector as they should be – and not pessimistic enough about all the negativity about housing and jobs . First, they still view office activity as a pandemic-related behavior change that is still normalizing. Reality: Office properties are interest rate and economically sensitive assets with deteriorating fundamentals despite still booming job growth.

Second, a lack of imagination. We know what it’s like when unemployment hits 10%, house prices fall and there are millions of foreclosed homes. But we – especially us in the media whose working life is so concentrated in cities and offices – have a hard time imagining what happens in business districts.

The situation is already grim and not only do we need to be able to see it, but we need to start thinking about how to respond when things get worse. The stock price of Vornado Realty Trust, the Manhattan-centric office and retail REIT, is already below its March 2020 lows and, incredibly, is threatening its March 2009 lows. offices, including Boston Properties, Cousins ​​Properties and SL Green Realty, are nearing their March 2020 lows.

There should be no big surprise as to why. Daily office traffic, while continuing to slowly recover, remains well below pre-pandemic levels. Vacancy rates are rising, especially in older buildings, as leases come to an end. Higher interest rates are headwinds for both real estate values ​​and market valuations.

And now the Fed is signaling a “higher for longer” interest rate policy that will keep valuations low and make debt rollovers more difficult. To the extent that the Federal Reserve’s unemployment rate forecast of 4.4% for 2023 turns out to be accurate, that would mean a million more unemployed people than today – and the unemployed don’t need offices .

That’s not even factoring in the belt-tightening employers will do over the next year to cut costs as they feel pressured by a slower-growing economy. Office space is an obvious lever to pull at a time when remote and hybrid working has proven effective – if not always ideal from an employer perspective. Even large tech companies, which had been a bright spot for office owners during the pandemic recovery, might decide to rethink their office footprint when looking at their costs.

A bigger issue for the office sector is that it is unclear how well it would recover from a Fed-induced recession. If such a recession eventually led to lower interest rates, housing would likely rebound quickly. The labor market continues to be the strongest part of the US economy, so it could be the last to feel a recession and the first to recover. But once a 1970s office building empties, it’s not clear that demand would precipitously return in the ensuing recovery. Maybe some office buildings could be converted into housing, but not all buildings are easily converted.

Now consider that even empty or lightly occupied office buildings cost money to operate: electricity, heating and cooling, cleaning, maintenance, security, taxes. And these costs have greatly increased with inflation. Offering tenants cheap rent might fuel demand, but might also not provide a return to building owners. Cities could end up holding the bag on dilapidated buildings that are slowly deteriorating and no longer generating tax revenue.

It was a plausible scenario for many office buildings even before the Federal Reserve turned hawkish, but it now seems likely that the problem will be bigger and happen sooner. There’s still reason to think that other parts of the U.S. economy will come through this period of supply and demand rebalancing in relatively good shape, but when it comes to office buildings and downtown business, we have to prepare for the worst.

More other writers at Bloomberg Opinion:

Why is an apartment in New York always so hard to find? : Justin Fox

Markets need a less rosy view of inflation news: John Authers

Your Guide to the Permanent Pandemic Economy: Allison Schrager

This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.

Conor Sen is a Bloomberg Opinion columnist. He is the founder of Peachtree Creek Investments and may have an interest in the areas he writes about.

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