CRE Office Property Value Reset

CRE Office Property Value Reset

Here is hoping that the Federal Reserve allows the Office segment of the CRE market to crash. The Office sector overbuilt circa 2011 through last year as rates were low and deep-pocketed investors were flush with cash. I recall the skyline changing across cities such as Washington D.C/ Northern VA, Boston, New York, San Francisco etc. to the point where you wondered how property owners of these towers would ever fill their office space inventory. Today, the front page of the WSJ suggests that 350 California Street in San Francisco which once sold for $300 million may only fetch $60 million in today’s Office market. How did we get here?

Low interest rates: When The Federal Reserve set interest rates artificially low (via the Fed Funds Rate and Quantitative Easing), market participants got aggressive in the pursuit of yield, in the pursuit of leverage, in the pursuit of various investment outcomes that may otherwise be unnatural were it not for zero interest rate policy (trading options with leverage comes to mind).

CRE developers/owners took the “IfI build it/buy it, they will come” approach and overbuilt the CRE Office segment. “They” of course being Office tenants. I remember the hyperbole. I recall hearing how young engineers, developers, financiers only wanted to work in the city. They only wanted to be in downtown San Francisco, New York or Boston where there was plenty of activity outside of the office. Suburban campuses and offices in neighborhoods adjacent to the city would never work I was told (until city rental prices got too high, then people changed their tune).

COVID, Work from Home (WFH) and Headcount Reductions: It was foolish to shut down an entire economy and it was foolish to allow people to work from home. Central Government again had a hand in creating a monster. Not only did it create massive inflation when it printed trillions of new US Dollars in 2020-2022 (more is coming this summer once the debt ceiling is lifted), it created enormous moral hazard. Now we have a cohort of people that believe it is OK to not show up for work, or in the case of white collar office jobs, work entirely from home in many cases (I was shocked in 2020 when I learned of friends who had never worked from the road and never owned a laptop for work).

Companies were/are guilty of coddling employees. “We don’t have any leverage over our employee base” CEOs complained. Many of those CEOs have since found religion as interest rates climbed rapidly in 2022 and 2023. Headcount cuts were back in vogue. Now there are fewer white collar workers and therefore less demand for Office space.

Crime: Violent crime has been back in large cities such as New York for years now. Midtown was great from 2003-2015. It’s a bit violent now as liberal politicians and left-leaning judges won’t allow law enforcement to do its job. Cops won’t risk their pensions. if you want to be a cop, get the heck out of blue states such as MA, NY, CA, CT, IL and move to FL, SC, TN, ND, MT, NV, AZ etc. The boys in blue can’t do their job in blue states/big cities. In short, crime puts a damper on Office space demand.

Taxes: Blue states such as NY, NJ, CT. MA and CA have punitive taxes and regulatory climates. Guess which states companies are leaving? Yes, they are leaving high tax states for more favorable tax climates such as TX (my former employer moved from CA to TX for this reason as have Tesla and Oracle), FL, TN, NV and other low tax, business-friendly, freedom-friendly states. This migration has been taking place for over a decade and has accelerated in recent years across industries, perhaps most notably Technology and Financial Services.

Net, Net: All of the above is bad new for the CRE Office segment across most major markets, especially San Francisco which has got to be the U.S. city with the most unfriendly business climate of any city I have ever visited. I recall many of my former Bay Area clients complaining about state and local politics and the regulatory environment at one point or another. The Office segment is finally hollowing out. Here’s hoping Powell & Company will allow the Office market to find natural price equilibrium. No Fed rescue is required. Ever.