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Weekly Market Report - April 11, 2023

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Only two months ago, the head of New York’s biggest commercial landlord firm told Wall Street analysts that traffic to the company’s buildings was picking up, and more than 1 million square feet of space was either recently leased or in negotiations. Then Silicon Valley Bank failed, and Wall Street panicked. Shares of developers, and the banks that lend to them, dropped sharply, and bank shares have stayed low. Analysts raised concerns that developers might default on a big chunk of $3.1 trillion of U.S. commercial real estate loans Goldman Sachs says are outstanding. Almost a quarter of mortgages on office buildings must be refinanced in 2023, according to Mortgage Bankers’ Association data, with higher interest rates than the 3 percent paper that stuffs banks’ portfolios now. Other analysts wondered how landlords could find new tenants as old leases expire this year, with office vacancy rates at record highs.


There are reasons to think the road ahead will be rocky for the real estate industry and banks that depend on it. And the stakes, according to Goldman, are high, especially if there is a recession: a credit squeeze equal to as much as half a percentage point of growth in the overall economy. But credit in commercial real estate has performed well until now, and it’s far from clear that U.S. credit issues spreading outward from real estate is likely. The vacancy rate for office buildings rose to a record high 18.2% by late 2022, topping 20 percent in key markets like Manhattan, Silicon Valley and even Atlanta. But this year’s refinancing cliff is the real rub. Loans that come due will have to be financed at higher interest rates, which will mean higher payments even as vacancy rates rise or remain high. Higher vacancies mean some buildings are worth less, so banks are less willing to touch them without tougher terms. That’s especially true for older, so-called Class B buildings that are losing out to newer buildings as tenants renew leases, he said. And the shortage of recent sales makes it hard for banks to decide how much more cash collateral to demand.


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The ongoing debate over working remotely or going into the office overlooks one major factor that could be disastrous for large cities, such as New York, Chicago and San Francisco. The commercial real estate market may be in serious trouble. Empty office space is a money pit for landlords and companies that invested millions in purchasing, leasing and retrofitting office buildings to accommodate and attract workers. Rising interest rates, oversupply and declining demand are contributing to the potential downturn. The report also notes that the impact of the pandemic on the commercial real estate market has been significant, with many businesses struggling to stay afloat and many people choosing to work from home. If workers don't return to the office, it could have a significant impact on businesses in big cities.


According to a report from the Wall Street Journal, concerns about safety, including on public transportation, have contributed to a reluctance to go back to the office. According to a report from the New York Times, San Francisco’s office vacancy rate increased to a record high of 29.4% in the first quarter, around eight times the pre-pandemic level. New York has a 43% declining in leasing in the fourth quarter of 2022 compared to the same period in 2021, according to Commercial Observer. With fewer people commuting into cities, they stand to lose their luster and reputation, as being the local epicenters of commerce, finance, media, entertainment, tourism and a vibrant social scene. If workers continue to work remotely, it will further disrupt the ecosystem of restaurants, bars, clubs, gyms, nail salons, haircutting establishments, retail-shopping stores and an array of other businesses in urban areas. Without the steady flow of people into the city, mom-and-pop shops and an array of businesses close shop, as they don’t have enough customers to keep them afloat.


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Last December, a panel of New York City and State advisors led by Governor Kathy Hochul and Mayor Eric Adams published the “New” New York Panel for New York City: Making New York Work for Everyone. In what they deemed a new era of collaboration between city and state, the ambitious proposal sets forth three major goals, which are comprised of 40 detailed initiatives: (1) Reimagine New York’s Business Districts as Vibrant 24/7 Destinations; (2) Make it Easier for New Yorkers to Get to Work; and (3) Generate Inclusive, Future-Focused Growth. This roadmap for the City’s future addresses a variety of concerns, ranging from the need for more flexible zoning in business districts, the ever-looming housing crisis, the affordability of childcare, and overall city safety and cleanliness. While this is undoubtably a pivot in the right direction, the real challenge lies in bringing these aspirations to life.


In the three years since the pandemic began, New York City has largely reopened and continues to recover to near pre-COVID levels. According to data, office visitor volume in Manhattan continues towards stronger in-person visitation, reaching just over half of 2019 levels and surpassing Q3 2022 (51%). In some submarkets such as Midtown Core, Chelsea, and Times Square, the numbers are even more positive at 67.4%, 68.2%, and 69%, respectively. However, through this process, the rigidness of the existing zoning governance has been underscored. Many Class B/C offices sit partially or entirely vacant and current zoning laws make it challenging to convert to a residential use, particularly in and around Midtown Manhattan. The code states that any office in a zoning district that allows residential use can convert if it complies with bulk regulations. Given the architectural differences between office and residential buildings, this is often physically and/or financially infeasible. There are, however, a set of more flexible standards (light, air, yards) for conversion that a building may use if it meets certain criteria: (1) Located in a district that allows residential use, Located south of 59th Street, parts of inner Brooklyn and Queens, Downtown Jamaica, St.; (2) George or Coney Island special districts or in a special mixed-use district Building built before 1961, before January 1977 in Financial District (FiDi), Jamaica; (3) Coney Island or St. George or before January 1997 in special MX districts.


The 1961 cutoff has severely hampered office to residential conversions in Midtown which is why the majority of office-to-residential conversions have occurred in lower Manhattan where the cutoff of 1977 is more lenient. One of the initiatives brought forth in the Plan proposes extending this threshold to December 1990, a change that would unlock approximately 120 million-square-feet (sf) of potential office space conversions in Manhattan. There is also discussion around re-evaluating high-density Midtown zones that do not allow new residential use such as areas between West 23rd Street and West 41st Street that are currently zoned as manufacturing districts. While these proposals are great in theory, some form of tax relief should be introduced in order to make conversion projects pencil. High construction costs, coupled with the increased tax rate associated with residential and the inability to pass-through real estate taxes to tenants, puts a great deal of burden on a landlord, not to mention the fact that there will likely not be affordable requirements attached to any zoning changes. Additionally, the New York City Council and Planning Departments are severely understaffed, impacting the timeline for any zoning text updated. Environmental reviews are also required to make amendments, and these processes are also long and costly.

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