This article first appeared in The Edge Malaysia Weekly on May 1, 2023 - May 7, 2023

ON a recent trip to New York, I wandered around the Midtown and Lower Manhattan office districts. The first thing that struck me was just how few people were on the street and in the subways. In mid-February, I walked around the City of London, the commercial real estate capital of Europe, where I had just the opposite feeling. The city’s underground trains seemed fairly crowded. This week, I am in Frankfurt, where office tower occupancies are more like London and less like Midtown Manhattan.

What’s going on with downtown office space in global cities? Well, for one thing, in the aftermath of the Covid-19 lockdowns and the subsequent reopenings, the way people work has dramatically changed. Until now, the transformation of global downtowns was just my gut feel from visiting a few large city centres. Now, however, there is data and concrete evidence about the changes of business districts from New York to San Francisco where hybrid work models are now well established, to London to Frankfurt where work from home models are less popular.

More than a year after America began opening up following the end of rolling pandemic lockdowns, 10 largest US business districts still have average occupancies at around just 48%, according to property technology platform, Kastle Systems. Average daily occupancy levels in New York last week were at 43% of the capacity while in San Jose, in the heart of the Silicon Valley, average occupancies were running at just over 37% of what they were before the start of the pandemic. Average recent downtown office occupancies were running at around 43% in Washington DC, 49% in Chicago and 42% in Philadelphia. “Is 50% the new permanent level in most US metropolitan areas for return to office?”, private equity giant Apollo Global Management chief economist Torsten Slok wondered aloud in a note last week.

Empty downtown offices are just one data point. Cellphone activity, another key indicator of activity, is still at 31% of pre-pandemic levels in San Francisco. In New York, cellphone activity has returned to 74% of where it was at the start of 2020, in Chicago it is now at 50% and in Boston, it is at 54%. Low cellphone use in large US cities is evidence that it isn’t just downtown offices that are hurting but also restaurants and a whole range of retail outlets in areas that were humming with activity before lockdowns began three years ago.

Yet, it is the offices that attract people downtown while restaurants and retail help keep them there after office hours and lure them on weekends. While some companies still allow many of their back office workers to work entirely from home, most US companies with offices in large US downtowns now require staffers to work at least three or four days a week from their offices. As you might imagine, Mondays and Fridays are the days when downtowns have the fewest people. Whether you work three or four days a week in the office, you would rather take Monday or Friday, or both, off. Kastle doesn’t publish data for London or Frankfurt but figures from other sources for European commercial capitals are much higher, closer to 90% rather than under 50% for top US cities.

All that is bad for office real estate, a key segment of the vast US$20 trillion US commercial real estate market that, aside from downtown offices, also includes warehouses, data centres, logistics centres and retail outlets. In Manhattan, office vacancies are now around 19% while in San Francisco they are around 29%. With less than 50% of the workers back in their offices as re- mote work trends remain intact, the betting is that office real estate woes are about to go from bad to worse. 

If you want to get an idea of just how bad things are for Manhattan’s commercial real estate due to the remote work phenomenon, look no further than the owners of the choicest office real estate in the Big Apple. Shares of SL Green Realty, the largest owner of Manhattan A-grade real estate, are down 72% since June 2021 and 84% from their peak in 2015. The firm owns buildings like One Vanderbilt, a 62-storey skyscraper near Manhattan’s Grand Central Terminal, which opened in late 2020. The REIT currently offers a dividend yield of 13%. Late last year, SL Green slashed its dividend in half and many analysts are expecting another cut imminently. Empire State Realty Trust, a REIT that owns, among other things, New York’s iconic Empire State Building with its observatory deck, has seen its stock plummet 53% since June 2021. The REIT’s shares are down 73% from their 2017 peak. Vornado Realty Trust, the Manhattan real estate arm of billionaire Steve Roth, has seen its shares plunge 86% from their peak in 2015 and 70% since June 2021. And WeWork, the controversial global flexible office space provider, has seen its shares plummet 97% from the peak since its merger with a blank cheque special purpose acquisition corporation in October 2021. The firm had drastically downsized its struggling business just to stay afloat. WeWork’s market capitalisation last week fell below US$350 million, or a fraction of the US$47 billion valuation in the private markets in 2019 or between US$60 billion and US$75 billion that investment banks like Goldman Sachs and JP Morgan were touting before its 2019 initial public offering was abruptly yanked just days before it was ready to list.

The problem with commercial real estate in the US and elsewhere is that almost always, it is highly leveraged. The big four US banks — JP Morgan Chase, Bank of America, Citigroup and Wells Fargo — provide only a very small portion of total loans to the office property sector or gleaming new tower blocks like One Vanderbilt or the Hudson Yards development, which was completed in 2021. Smaller banks in the US play a disproportionately large role in commercial real estate (CRE) lending. Tighter lending standards were weighing on the CRE sector even before the advent of the recent banking crisis in March, which saw the collapse of three US banks, including Silicon Valley Bank and Signature Bank. The CRE sector was also seeing weakening of demand as the US Federal Reserve raised interest rates from near-zero in March last year to a range of 4.75% to 5% currently.

JP Morgan in a recent report noted that the top 25 large US banks had about US$13 trillion of assets on their balance sheets, including about US$6.5 trillion of loans. Smaller banks, or all the rest of the banks in the US, meanwhile, had a total of about US$6.8 trillion of assets, with around US$4.5 trillion of loans. While smaller US banks account for only about 40% of total loans, they make up for 70% of total CRE loans. Put it another way, the smaller banks lent US$2 trillion to commercial real estate while the biggest US banks lent just US$0.8 trillion. The small banks’ share of lending for all other major types of loans was much lower. Small banks, for example, make up 38% of total loans to the US residential real estate sector while the top 25 banks in America have a 62% market share.

In the aftermath of the Silicon Valley Bank collapse, deposits flew out of smaller banks into the biggest US banks like JP Morgan and Bank of America. In some cases, they were literally yanked out of small banks, moved to big ones and, in other cases, panicked depositors who were getting on average about 0.37% per annum for their deposits despite fed funds rates having risen from zero to 5% decided they would rather be in money market funds. At a click of the button on your smartphone’s bank app or the bank’s website on your laptop, you can move money these days from accounts that pay almost nothing to 5.1%. Even Apple, the iPhone maker which has branched into online banking, now offers 4.15% interest on deposits.

First Republic Bank, a mid-sized regional bank in the US, saw deposits drop 40% in the January-March quarter. Deposits would have plunged 50% or over US$100 billion had it not been for the biggest US banks transferring US$30 billion of their deposits to First Republic to help prop it up. Charles Schwab, which runs America’s biggest stock brokerage as well as a bank, saw its deposits decrease 11% in the first three months of the year. First Republic’s shares, which plunged 49% on April 25, are down 94% over the past two months while Schwab’s are down 36%. 

It’s been a perfect storm for commercial real estate — rising interest rates, falling occupancies and financing markets shutting down because many smaller banks have lost up to half of their deposits and are just no longer able to lend even to their best customers. Oh, did I mention that the Fed is expected raise interest rates again on May 3 by another 25 basis points? Whether the US central bank signals a pause or not, commercial real estate borrowers are unlikely to get any reprieve anytime soon.

Banks have lent US$5 trillion to the US commercial real estate sector. About US$1 trillion of those loans are coming due over the next 12 to 18 months. Here is the problem: highly leveraged Manhattan landlords with 19% vacancies in their buildings (which are rising as the US economy slows down and is expected to slip into recession) or landlords in San Francisco, where tech companies are continuing to lay off staffers or send them home to work, are more likely than not to default on a big chunk of those loans unless lenders agree to restructure their loans and in the process take a haircut on them. Typically, office landlords borrow for two to three years at floating interest rates. Most downtown landlords had refinanced their debts in late 2020 or 2021 when the Fed cut rates to the barest minimum. Now, they will have to refinance it when rates are over 5% and collateral is far less valuable.

Ironically, office real estate in New York’s Manhattan or downtown San Francisco was considered some of the safest real assets on earth. Now, office rents are falling, vacancies are rising and you can’t borrow money from banks or raise equity. Office landlords in large US cities have seen higher interest rates before. But in every other rate hiking cycle, they have been able to raise rents. Now, rents are falling as interest expense soar. In previous recessions, the US Fed had moved swiftly to slash interest rates to zero but it is clear even if the US economy plunges into a recession in this quarter, the Fed is unlikely to cut rates drastically, let alone take them down to zero. And vacancy rates will continue to rise and rents are likely to continue falling. Manhattan office rents are down 18% and San Francisco down 33% since 2019.

Another issue: Office vacancies in downtown US real estate are mostly in older buildings which need to be refurbished before they are put on the market again. That requires more capital. The irony is that New York and San Francisco are also facing an acute housing shortage. Why not just convert office buildings into apartments and kill two birds with one stone? Unfortunately, repositioning old office blocks as apartments won’t be cheap. Moreover, it would also require city legislators to drastically change rules, a herculean task. 

It is not clear whether CRE is the next shoe to drop in the unfolding US economic crisis. What is certain is that downtowns across America will be transformed over the next decade with more housing and fewer offices. There will also be a growing group of people for whom home will always be their office.

Assif Shameen is a technology writer based in North America 

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