The one thing that is as turbulent as the world of AI these days is that of commercial real estate due to more reasons than one. Especially in the United States of America. While the stars do not seem to align in favour of the current status of the property market in general, the problems that are specific to commercial real estate have actually metastasized throughout neighbourhoods and communities, making it a concern of more than just office spaces and commercial buildings. And this problem has expanded to the point that it has been labelled as ‘The Urban Doom Loop’.
What is the urban ‘doom loop’?
It is definitely not the latest Netflix sci-fi show, but rather a real-life scenario that has taken the world of property and finance by storm. A professor from the Columbian Business School of Real Estate and Finance, Stijin Van Nieuwerburgh, explains the crux of the issue whilst speaking to CNBC. He states that ever since the concept of remote work and hybrid work came into the picture, there has been a significant drop in the demand for office spaces over the last couple of years. This has led to an all-time high vacancy rate in the office market and is adding to the stress on the valuations of these offices. Since the valuations are already down by 20-30% and are likely to keep plummeting further, it will increase the downward pressure on property tax revenues. For a considerable number of cities, office tax revenue is a big portion of their tax revenues. Nieuwerburgh also says property taxes are as much as 40% and that office taxes alone could account for 10% of overall tax revenue in cities. And if those offices lose more than 50% of their value, tax revenues decrease, causing an irreparable dent in the budget. And because of the crashing office real estate market, there is an economic doom loop looming over a handful of America’s largest cities.
According to Forbes, an urban economic doom loop means that the persistent dips in property and income tax revenue result in a decrease in city services – fire, police, water, sewerage and schools – which paves the way for an entirely new “wave of departures, further squeezing the city revenues”. Owing to this, Professor Van Nieuwerburgh has consistently sounded alarm bells for months at large to mid-size US cities such as Atlanta, Chicago, and Denver.
According to the National Association of Realtors, the US office vacancy rate reached a record high of 13.1 at the end of the second quarter of 2023. And this was even after there was a surge in people who were returning to the office. This number exceeds the levels seen in 2022 when it remained above 12% throughout the year. Before the plague, in the two years leading up to it, the quarterly vacancy rate was maintained at a relatively stable level of 9.5%. Moreover, companies have downsized the average amount of square footage allocated per person in office spaces. As a consequence, during the second quarter, this contributed to an additional 102 million square feet of office space available compared to the same period in the previous year. As stated before, once the valuation of offices declines, so does its contribution to the tax revenues. Because of this, some cities reportedly lost $360 billion from 2020 to 2022, as per the numbers reported by the National League of Cities.
Economic and financial repercussions
What we are looking at currently is a very accurate economic forecast of a commercial real estate apocalypse, especially in midsize cities that could and will spread into the broader economy. While cities big and small are preyed on by this issue, small and medium-sized cities have it worse because they often rely heavily on their downtown areas. Especially the commercial office districts, as a key attraction and economic driver. However, when placed against larger cities, these smaller cities may have a scarcity of diverse amenities or attractions in their downtown areas. As a result, when the commercial office area in a smaller city faces difficulties or decline, it has a significant negative impact on the entire city. In simpler terms, if the central business area struggles, it can have a ripple effect, negatively affecting the overall vitality and economy of the smaller city because there aren’t many other prominent features to compensate for the decline.
This could eventually lead to an increase in taxes and a drop in property values in the affected cities where prices of office buildings can diminish from around 35%, according to Jennifer Sor and her article “The crashing office market will deepen the economic ‘doom loop’ for America’s cities” written for Business Insider. She too quotes Professor Van Nieuwerburgh in her article, where she mentions that “banks with high exposure to office debt could also run into trouble, as there’s around $600 billion in office building debt that’s potentially in trouble”.
In a recent article, Bloomberg warned that empty office buildings are posing a serious financial risk, and they referred to it as a “debt time bomb”, as they threaten to harm regional banks. These banks have a considerable portion of their loans, around 43%, linked to commercial real estate, with around 40% specifically invested in office spaces. This is undoubtedly a major concern. However, what tops this concern is that the rapidly shrinking property value is exacerbated by political intervention. And this is dragging larger cities further down the list of residents’ location preferences.
Moreover, in large cities like San Francisco, owners of prestigious office buildings are defaulting on their debts. For instance, the largest mall in San Francisco was abandoned by its landlords, resulting in a $558 million mortgage default. Two of the city’s largest hotels have defaulted on their loans, leading to $725 million in outstanding debt. A $1 billion portfolio of apartment buildings has also faced non-payment issues. In essence, this highlights the economic challenges faced by major cities, particularly as commercial real estate values decline and property owners struggle to meet their financial obligations. Therefore, just because the name Urban Doom Loop may sound like a pop-culture reference to many people, it is far beyond mere fiction and it is very real. And it could ultimately be the reason why many cities die.
