I worked for a commercial property company before, and yes this is exactly how it works, and yes it's just as stupid as it sounds.
Margin Call nailed it perfectly:
"It's just money. It's made up. Pieces of papers with pictures on it so we don't have to kill each other just to get something to eat".
The question is, why would they actually do that? The premise is that the landlord has to take out a new mortgage every few years and then the bank won't give them a new one if they're underwater. But that's only true if it's a different bank.
Let's take the same example. Building was expected to be worth $20M, landlord pays $4M down and takes a $16M interest-only mortgage. The only thing the bank ever expected from this was to collect interest on the $16M until it's paid back, which could be never and that's fine as long as they get to keep collecting interest.
Then we find out the building is maybe really only worth $14M. But the landlord is still making the interest payments on the $16M, and over time it will likely become worth more than $16M again due to inflation if nothing else, so why does the bank need to foreclose? The risk that they could "lose $2M" is by that point a sunk cost. It's the thing that happens if they do foreclose (or fail to renew the loan). They'd be calling in the note against an LLC that owns nothing but a building which is now estimated to be worth less than the loan principal. So the obvious thing would be to keep renewing it as long as the landlord continues to make the interest payments.
This feels like some kind of regulatory inefficiency or accounting scam where the bank is listing the mortgage lien as an asset and would have to take a write off if they valued it accurately and therefore transfer their perverse incentive to the landlord to prevent that from happening.
Notice however that doing that also hurts the bank. The landlord is collecting $500k/year at half occupancy, then paying the bank $640k and losing $140k/year to try to avoid the total loss of their $4M initial investment. Maybe they can do that for a year or three but the longer it continues the higher the probability that they run out of money. Whereas if they were collecting the $700k/year from renting out the entire building at lower rents then they could keep paying the bank its $640k/year forever, regardless of whether they're technically underwater. And if the landlord runs out of money then the bank has to take the $2M write off because they get a $14M building instead of collecting interest on a $16M loan. So the bank is really shooting itself in the foot.
The average inflation over the last 10 years has been just north of 3%. If you have tenants today that are paying $500k/year, in 10 years they should be paying almost $700k/year with 50% occupancy. If you can string the bank along for another loan then your valuation is $28M instead of $20M. As the owner you can effectively take money out in this scenario.
If the bank won't refinance at that rate, then you could lower your rents by a bit in the last year. If you lowered your rates back down to $500k/year then you invite a bunch of new tenants, and now you can show high occupancy again.
Also foreclosure generally isn't the only option: the borrower could, for example, agree to repay part of the loan early, or give extra collateral, both of which would increase the LTV (and this would be better for the bank).
I'm not saying the explanation is wrong, but I don't blame people for finding it difficult to understand. Other factors contributing to this are probably borrower relationships/negotiating strength and the high costs associated with foreclosing.
They care about the regulatory requirements in so far as you either meet it, or you don’t at the time of writing a loan. And maybe you get a yearly review.
Also people are looking at this in a very isolated view. Just because a building is vacant doesn’t mean the owner has no other option than just lower the rent. Typically owners of commercial property own multiple properties and various other types of assets. Vacancy rates are also built into calculations.
Commercial leases are often for say 5+5 years, so once you lock it in, you know for sure what the property revenue is going to be for the next so many years. Your uncertainty equation has collapsed.
I think the main insight here is that commercial real estate is an entirely different animal than the residences that you may be used to.
You can apply this same reasoning to the "back to the office" pushes done on behalf of the institutional investors who have exposure to large commercial properties in inner cities. That too is a financial house of cards built on assumptions and vibes.
Well done. Way to encourage people to not do things.
and Spirit Halloween.
I suggest that like the dotcom/2008/AI bubbles, people will just keep dancing and making money until reality catches up and the music stops.
Keeping it vacant only impact current income, lowering rent impacts future forecasts.
Does it though? Suppose you can't find a tenant right now because the market is soft but is predicted to improve in a few years. If you leave the unit vacant, you lose money right now. If you rent it out with e.g. a 3-year lease, you make more for the next 3 years than you would with a vacancy, and if the market price has increased by then you can increase the rent on the unit and either get it from the current occupant or the one you get to replace them in the high demand market when the higher rent causes the low-paying tenant to not renew the lease.
So taking a tenant now only improves prospects (you fill a current vacancy) with no negative impact on future returns. The only thing it does is imply that current rents are lower than before and future rents might be too, but a vacancy implies that even more strongly.
Simply stated, if you rent a new unit for 25% lower, then the value of the building just dropped 25%. If you don't rent to a new tenant, your value must be the same, that's what the existing tenants are paying (not that I agree with this, it's just how it works right now).
It's similar to how people holding low liquidity assets will claim they are "worth" whatever the last person who paid for this assert, even if the real value of it is dropped, the "book value" is still sky high.
If my wife and I are at the airport, and the gate agent offers me (and only me) an upgrade on the flight, your logic says I should take it since that's strictly better than both of us flying economy.
But I'm not convinced the risk-reward calculation fully explains it. You can see plenty of places where they know full well it's not going to rent at the price they're asking. I think there are other factors, including not letting your other high-lease tenants think that they're now occupying a low-rent establishment.
Your jewelry store would rather not suddenly be next to a cheapo nail salon. And if you've got a third property to lease, the high-fashion brand looking at it will see the nail salon and move on.
You'd need perfect information to make a contractual decision on that, and it still has lasting effects.
For instance imagine renting your floors to Pornhub for these 3 years on the cheap because the market it low. Assuming you made the right calculation and demand recovers 3 years later, you'll have to first kick out the company (= months spent restoring it), then try to convince the insurance company that eyes at your building that they should pay a hiked price to move into Pornhub's previous floors.
And that's assuming you haven't completely blown it where the market actually recovers within 6 months for reasons nobody anticipated.
If you’re levered up to the eyeballs you don’t want your bank reviewing your file.
I can build a building that charges a billion dollars a month rent, and sits completely empty. A forecast suggestion I'll be making hundreds of billions with no renters is clearly silly.
Suppose there is a building that was built in 1970, last rented out in 1975 and then bought by a company that has used it as their own offices until now. The last transaction was in 1975, what's the value if they apply for a mortgage today? Surely they have some formula to use for this based on e.g. other buildings in the area.
Moreover, "failure to find a tenant" is also a type of transaction. It's the landlord acting as the high bidder for the space, essentially the involuntary edition of imputed rent, and implies something negative about the financial prospects of the building when it continues for a significant period of time or large percentage of units. Ignoring that it is either incompetence or some kind of perverse incentive.
There is no escaping the powers of supply and demand.
https://www.investopedia.com/terms/d/dscr.asp
Lower income for the building means lower numerator, which means being unable to meet the agreed upon DSCR, which means default. Whether or not the lender acts on this default is a separate matter, as they are usually loathe to get into the property management business, but renegotiation of terms and eventually foreclosure does happen.
Actual commercial real estate professionals could give you many more reasons than I can
I am so tired of listening to people with little to no experience with commercial real estate try and explain the vacant storefront thing. Maybe this explanation in the article is correct, but it raises more questions than it answers, and it’s unclear why we should trust this person’s explanation.
I don't know much about microbiology, but that shouldn't stop me from asking someone who "did their own research" to shut up and let the experts talk.
The other side of this is that landlords hate to reduce rent to rent vacant spaces because their paying tenants will demand rent reductions or move. That can crash the rental market. A building half rented at rent X is more profitable than a building fully rented at rent 0.5 X.
[1] https://propmodo.com/the-end-of-extend-and-pretend/
[2] https://www.newyorkfed.org/research/staff_reports/sr1130
There are buildings that seem to purposefully keep commercial space vacant to devalue the building:
https://therealdeal.com/chicago/2021/09/10/trump-gets-anothe...
That too is a "it depends". For a failing mall, getting anyone into the empty spaces starts to become important to the other tenants because anything that draws people into the mall is a potential customer. Customers will even no shop you just because they know there is nothing else in the mall. Thus some malls near me have museums and the like inside - anything to get traffic.
That's assuming rents would decrease by half, and also that it's still half occupied. A building half rented at X isn't more profitable than a building fully rented at 0.7 X. A building 25% rented at X isn't more profitable than a building fully rented at 0.5 X.
At this point I think that's exactly what we need in a lot of places.
If the land isnt being used efficiently the owning entity should fail and a new productive use made.
Whether thats tearing it down for the public to get better use of the land; rerouting roads, community swimming pool, park etc. Replacing with a more economic building; factory, stadium, appartments (zoning not withstanding). Or a more productive entity getting use of it.
Bagholders being entrenched and protected are becoming a weight around the neck
Since when have tenants known each other's rents?
As described, the landlord can't offer a traditional lease for the actual value of the space.
However, the landlord could offer essentially day rentals without creating a lease. There are systems for this already, such as Peerspace and their ilk, which I've used for small events. I believe these don't trigger the foreclosure clauses.
I think that a property management company managing deeply underwater buildings could play in this, reducing their cost structure by offering day rates. They've often already got a solid NFC entry system. Most of what you need is automated pricing, onboarding and offboarding, and figuring out how you avoid needing physical cleaning/setup/teardown overhead.
And the downside is loads of reasonably successful decent small shops in the UK now have to close after 12-24 months when the rents get jacked-up from sensible to astronomical levels. None of them become permeant tenants unless they are a front for money laundering (hence the explosion of nail bars and barbers on the UK high street) or illegal goods (dodgy vape shops).
https://www.bbc.co.uk/news/articles/cqj1rkqqrgro
Your local press (if yours still exists) will also be full of such stories.
I don’t enjoy dealing with property management or the fees they charge.
I know regardless of the vacancy I would not consider day rates, I’d eat the loss and deal with the cashflow via other means. Consider what sort of fit out would be necessary for what’s lets be honest is being suggested - hot desking - compared to a standard office: lots of IT systems necessary, lots of additional security, lots more cleaning, and likely lots more repairs for wear & tear which probably isn’t recoverable easily.
I've seen companies provide some moveable furniture in a space like this - some desks, some extension cords - but it has to be up to the temporary user to configure and put things away when they're done.
viz. wework could apply the "single-use low-priced shampoo sachet" model [0] to SaaS-style rent-seeking of long-lived infrastructure. Infra. that is guaranteed to be always under-utilised... even in boom markets, because nothing functions at 100% capacity.
Adobe, as another example of (software) infrastructure --- i.e. traditionally, lifetime licence and ownership desktop software --- figured out their own "shampoo sachet" pricing. viz. how to make and ship desktop software product but kill-switch them with metered SaaS subscriptions.
The monthly price is just high enough to make gobs of cash for Adobe, while causing the typically-feast-and-famine freelancer to take the capitalist shellacking because it's just convenient enough. They can align software spends with active projects, and avoid the anxiety of cracked software doing nefarious things to their computers and data.
But over a long enough time, they pay Adobe a (presumably) huge premium over up-front priced software. And they stay locked into a planned obsolescence cycle controlled by Adobe... "The new version of your beloved editing software will only work with the latest Windoze which means hardware upgrade and oh, you have to do it because well we are soon kill-switching the current version you are dependent on."
Wework like operators can do exactly similar shenanigans with access to commercial infrastructure. Crowd out competition by aggressive long-term leasing on their buy-side, and on their sell-side build daily-subscription-dependency (buying ease, google-ish facilities which feeds into cult-and-status-signalling games), and convert a percentage of that into routine-subscription-dependency. Meanwhile also run rent-seeking games inside the main rent-seeking game... now you have a captive wallets who will buy the add-ons and extras because it's easier than walking two blocks for some cheaper and better alternative (e.g. food, coffee, lovely meeting space etc.).
edit: add reference for "daily sachet pricing".
[0] Buying less, more often: An evaluation of sachet marketing strategy in an emerging market
https://www.researchgate.net/publication/233676293_Buying_le...
The "solution" is that you should have to pay tax on what you claim the rent is after a small grace period (Less than 24 months certainly. Probably less than 12 or at least prorated starting before that.).
If your financial agreement requires and claims that the rent is $5000, no problem! Then the tax authority should expect to receive the tax revenue they would expect if someone was actually paying $5,000 in rent to you. If you want to leave the space vacant even after paying the tax on the revenue--have a blast.
That would short circuit all the financialization shenanigans.
* maybe if the operator goes bust, the rents on the building can be lowered with a new property value for future loans. Then perhaps it can be occupied. But that's very uncertain, especially if this happens to a whole city at once.
For example, "Big Pink" is an office tower in downtown Portland. It's last sale was for about $370 million. Out of desperation in a saturated market, the owners sold it last year for about $45 million. No one - the owners, the city, or the citizens - wants to have the vicious downturn of values, and there is no easy solution. Adding a vacancy tax just exacerbates the problem.
The point of the vacancy tax is also to prevent the over speculation before it happens. If the operators know that they are looking at having to cough up more cash than they expect in the future, they might reign in the rampant real estate speculation. If the bank knows that they might have to start coughing up cash, they'll be more inclined to actually just drop the property into bankruptcy.
I agree it's stupid, but that's what you get when you let the invisible hand bind human hands
Where do we draw the line between reality and fantasy then? If the terms of a deal are not reflecting the reality of the moment (i.e. the office rent market demand quotes) but some figure people come up with on their own, then let's call it what it is -- gambling (in which case it should be treated as such).
Weirder still, many of them were on the market, theoretically for rent, but if you called them up it turned out they weren't actually available, and the landlord wasn't interested in renting them. I couldn't figure out why you would pretend something was for rent at $X, and let it sit empty for years, rather than actually rent it at something <$X. Now it makes sense.
Might not be available unless your name ends in 'tarbucks'.
In others they would just have too high a price, and it is still empty six years later so they are clearly not unaware that they have it priced too high. Simple math showed they would be better off renting at a lower price than going years without anything, but it was quite common so it didn't seem like it could be simple stupidity.
The test, I guess, of this explanation is whether or not the flow of money out of private credit causes the end of "extend and pretend", and the market finally clears.
Who even is the fraudster? The operator of the building is losing money, so clearly they're not making a gain from anyone
The defrauded parties might include secondary lenders (to the property mortgage holders), regulators to whom financial instruments and solvency are being misrepresented, tenants who are paying higher-than-market rents, potential tenants who are denied market-rate rents on existing space, and arguably communities in which business and commercial opportunities are depressed due to the denial of access to real estate at market terms.
The operator of the building isn't the key point to fraud, as their interest (reducing rent to attract tenants) is actively thwarted by their creditors. The element of fraud is misrepresentation of true market value / income potential by projecting partial tenancy at elevated rates as if it were full tenancy, rather than the actual income stream at full occupancy (allowing for a nominal vacancy rate) at actually-supportable lease rates.
The thing that feels fraud-ish to me is that the loss doesn’t just disappear because nobody books it. A huge amount of capital and useful urban land is tied up preserving a fictional valuation and someone is paying for that somewhere.
Maybe it’s not a clean “X stole from Y” thing here, but it still means real businesses are displaced, worse downtowns, and less of the city that could have existed otherwise. I haven't seen this sort of thing as much in Australian cities where I'm from, but have a lot in the US where I live.
So maybe a better way phrasing "fraud on the public commons" is closer to what I mean. Everyone involved is probably acting rationally inside the system. The public still gets stuck living inside the dead space created by the fiction created by it and ends up eating that cost.
> The obvious thing cities could try is to put more pressure on building operators to fill their spaces, but the building operators are already under a ton of pressure — they’re losing a bunch of money! So, cities could do something like put a vacant storefront tax and… make them lose even more money? If that “worked,” the mechanism would be to force a lot of commercial property to default, which could put a lot of new space on the market at lower prices, which should lower the commercial rent. But it would also hurt the banks a lot, which has a history of leading to bad consequences and subsequent bailouts.
I agree that this is the obvious remedy. I don't know if it's exactly the right answer, but it's the natural place to start the conversation, and I think it's at least in the ballpark of the right solution. It's the city (and bigger) government's job to create policies that incentivize the right behaviors for the benefit of the community. There clearly has been an oversight here, if extremely valuable commercial properties are literally just sitting unused for no good reason. In my opinion we'd all be better off if the market did correct itself, at least getting us all on the same page about what these properties are actually worth, rather than the current situation.
The city stepping in also helps put the fuckup back in the right place, in the hands of the property owners and lenders who seem to have made these bad bets, rather than externalized to the residents and business owners of the city, who haven't done anything wrong. The article suggests that this leads to "bad consequences" and even bank bailouts, but I'm pretty unconvinced that the problem is widespread enough that the federal government would literally need to start bailing out banks. From what I've seen, it's really bad in a few specific metro areas and not so much in others.
There’s no actual problem here to be solved. If people feel they have better uses for a property they should put their money where their mouth is.
i see this all the time in china and in developing countries in general. they build huge malls, and then they can't fill them because there are not enough businesses who can pay the rent being asked. at least there is growth and the place will fill up eventually. but until that happens the place is less attractive.
seeing the same in europe in malls or shopping streets is even worse because it feels like the economy is declining. you have to apply the broken window theory here. the more shops stay empty the less people will go there to visit the remaining shops. their revenue goes down, they can't afford the rent anymore and another shop is empty. if this becomes a trend then you risk that the shops will never come back.
it is therefore in the interest of landlords and the city to keep the streets alive and fill them with businesses that attract people.
ignoring this problem is just a sign of greed. instead of building a vibrant space they just want to extract as much money as possible.
instead of being forced to foreclose the banks should be forced to extend the loan and eat the loss. foreclosing will cause them a loss too. so the banks are not better off either way.
the article says the building is an income stream.
no, it isn't.
the building is part of a community. the needs of the community top your need to make a profit. yes, this means the community should probably contribute to make your work financially viable, and one way they can do that is by making policy that gives you more reasonable conditions to pay off your loan so that a foreclosure is not necessary.
>> If the system allows you to pretend that the vacancy is temporary, why doesn’t it allow you to lower rents on the pretense that lower rents are also temporary?
> This does happen sometimes: it’s packaged as “incentive offers,” like 50% off the first 12 or 24 months rent, or 6 months without rent, etc, that lower the average rent over the life of the lease without lowering the “list price.” That’s common in residential leases, and I know it happens sometimes in commercial leases, but I don’t know how prevalent it is.
So as a blind guess, it probably depends on how legal incentive offers are. The axis being optimised here will be what the regulatory bodies can tolerate before they start handing out fines and punishments.
Could the situation be improved then if financial regulators started treating both versions ("temporary" vacancy / "temporarily" lowered rent) equally? Tolerate both or crack down on both.
People are actually advocating for looser lending requirements, which I’m perfectly fine with but the result might not be what they expect either.
> Half empty, the building is only generating $500k per year in net income instead of $1M.
> Let’s imagine the owner lowers the rent by 30% to fill the building.
> Now, reality has proven the operator can only make $700k per year.
No. When the building sat half empty, reality had already proven that it could not generate what they thought it could.
This is the insane fallacy driving this whole thing, and no amount of explanations about commercial mortgages will prove anything other than that a larger number of people than we thought are participating in the same delusion. If you cannot rent the space for what you thought it could rent for, your building is already worth less than you thought, and it is sheer folly to think that you can alter that fact by pretending you are waiting for higher rent later.
> So, cities could do something like put a vacant storefront tax and… make them lose even more money? If that “worked,” the mechanism would be to force a lot of commercial property to default, which could put a lot of new space on the market at lower prices, which should lower the commercial rent. But it would also hurt the banks a lot, which has a history of leading to bad consequences and subsequent bailouts.
There is another problem. What we need is to dig deeper into that theory and push harder and harder for solutions where all the financial loss gets pushed onto the people at the top who have a lot of money. If the banks are making money off this kind of nonsense then they should fail.
> I’ll give this some more thought, but if any actual commercial real estate professionals have ideas I’d love to hear from you in the comments!
No! Commercial real estate professionals are mostly just more people buying into these same fallacies! What we need is more people outside that self-deluding system saying "this is nuts, I'm taking $100 million from you" and resetting the entire system.
Thought I'd comment with some concrete numbers. New buildings near me (West LA) are at $4100/month for a studio, where average rent in the area is $2300 for a studio, $2650 for a 1-bedroom. To fit in with "average" rent they'd need to lower 44% however 30% might be about right. Otherwise at 4% inflation wait 9 years? 1.04^9 = 1.42 ~ 100/(100 - 30).
Congratulations, you have just described high finance.
This financial model is also the main reason why it's so hard to convert these buildings to residential. Somebody has to eat the markdown.
The system described in the article is basically that the risk is not explicitly planned for, and just washes out that it is managed by a vacancy and building owners eating the cost of the vacancy.
Any solution needs to provide a new answer for how that risk is managed, preferably one that doesn't result in foreclosures. Some possibility:
* The bank takes on the risk, by loans having a provision for writing down value if rents have to drop. This is tricky, because if the operator decides when rents need to be revised down, they have no incentive to protect the bank's position. If the bank decides, then they have no incentive to ever accept a rent drop, they'd rather force the operator to eat the vacancy. You'd need some trigger like duration of vacancies.
* The operator takes on the risk but with a mechanism for lowering the rent. I can't really figure out a way this would work without requiring the operator to have capital on hand though.
* The risk is insured. If rents need to drop then insurance pays the write-down in property value. I'm not sure any insurance company would be able to take this business though, as it is highly correlated between customers. A downturn would just wipe-out the insurer.
Loans can be called by the lender if the value of the collateral (building) falls too low.
Lowering rents lowers the building value. Not lowering rents and leaving spaces vacant ‘maintains’ the value of the building, as long as you can keeep making the loan payments everyone pretends the building is worth more money than it probably actually is. As long as the borrower keeps making payments to the lender, nobody really cares.
Store-fronts were already in decline due to 'internet shopping', but Covid probably brought a lot of physical close-down plans forward, such that any likelihood of recovery should be measured in decades or, more realistically, start being written off progressively to minimise a big hit down the track.
The longer extend and pretend lasts, the bigger the hit will be when it that strategy breaks.
There is a lot of talk that "there are excessive vacancies on the Ithaca Commons" but doesn't seem that bad except for the bottom of the first floor of Harold's Square, a market rate apartment development that was recently developed.
It also does look like San Francisco has a vacant storefront tax although the penalties are fairly light.
https://abc7news.com/post/remember-vacant-storefront-tax-san...
Or could be a shareholder lawsuit for banks as they are putting out riskier loans than the rate reflects?
this is why those win - it's cheaper to build & maintain them & easier to turn a profit on them.
the fancy big glass downtown skyscrapers are mostly for ego.
usually the tallest one determines who has power in that economy/city.
way back then churches used to be the tallest.
now in most cities it's the banks.
in SF - it's SalesForce Tower i.e tech is dominant
So it's a choice between honesty and profit towards investors ...
Oh and obviously the "solution" is waiting for inflation to change the price of the rent effectively. So the real fix is for government to take the initiative and start paying people (by now, a lot) more.
