00:00:00
Dan Loney: I guess we're still in
a time right now where it's
00:00:02
fluctuating a little bit, and how
companies are thinking about, do
00:00:05
I want to bring my employees
back full time? Do I need to
00:00:08
bring them back three days a
week, four days a week, whatever
00:00:11
that is. And that's going to
determine how a lot of this
00:00:13
plays out, right?
00:00:14
Joe Gyourko: Right. Although I think
there's increasingly widespread
00:00:18
agreement that unless you're in
a person to person services
00:00:23
business, a restaurant worker,
and the like, five days a week is
00:00:27
not going to be the norm. It's
not the norm at Wharton. It's
00:00:30
not the norm in most office
using firms.
00:00:34
Loney: Welcome to The Ripple Effect,
the podcast that takes you on a
00:00:38
journey through the minds of
Wharton faculty. I'm your host,
00:00:41
Dan Loney. And in each episode,
we'll be diving deep into the
00:00:44
inspiration behind the
groundbreaking research that
00:00:47
Wharton professors have
conducted, and exploring how
00:00:50
their findings resonate with the
world today. - Well, obviously,
00:00:53
when you talk about real estate,
there is a lot of conversation
00:00:56
about new and existing homes.
There's another side to real
00:00:59
estate that you also have to
look at as well, especially in
00:01:02
the wake of the pandemic, and
now things like work from home,
00:01:05
and that's commercial real
estate. And pleasure to be joined
00:01:07
here in studio by Joe Gyourko,
who's a Professor of Real Estate
00:01:10
here at the Wharton School. Good
to have you in here. Thanks very much.
00:01:13
- Thank you for having me.
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- This has been obviously such a
unique time for real estate in
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general. But when you think
about commercial, how do you put
00:01:21
into perspective what we've
seen play out over the last
00:01:25
several years because of the
pandemic and work from home and
00:01:28
inflation rates and how
companies are thinking about
00:01:30
what their footprint is going to
be in the future? - Well, the
00:01:33
the big shock is work from home.
And by commercial, you mean
00:01:36
office, because there are many,
many sectors of commercial real
00:01:40
estate. Data centers are doing
extremely well with
00:01:45
developments in AI. But office
has been hit by what I think
00:01:50
of as an obsolescence shock,
akin to what Amazon and the web
00:01:55
did to malls 15 to 20 years ago.
It is a very deep and big shock.
00:02:02
And it is roiling that sector of
real estate.
00:02:05
- And so part of the concern is
obviously the vacancy rates that
00:02:08
a lot of these office buildings
are dealing with. And I guess
00:02:11
we're still in a time right now
where it's fluctuating a little
00:02:14
bit in how companies are
thinking about, do I want to
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bring my employees back full
time? Do I need to bring the
00:02:20
back three days a week, four
days a week, whatever that is.
00:02:23
And that's going to determine
how a lot of this plays out, right?
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- Right. Although I think there's
increasingly widespread
00:02:30
agreement that unless you're in
a person to person services
00:02:34
business, a restaurant worker, and
the like, five days a week is
00:02:38
not going to be the norm. It's
not the norm at Wharton. It's
00:02:41
not the norm in most office
using firms. So I think there's
00:02:46
agreement it will be one to two
days on average with a huge
00:02:50
amount of variation across that.
And, Dan, that's somewhere
00:02:56
between a 20 and 40 percent drop in
demand for offices. It's why the
00:03:00
vacancy rates are above the
levels we saw in the worst of
00:03:06
times in the GFC. - So
00:03:07
how will companies then adjust
that? Because I think when we
00:03:11
talk about, you know, companies
taking two floors in an office
00:03:15
building, or whatever it is, and
you have that five year lease,
00:03:19
10 year lease, whatever that
number is, it feels like the
00:03:22
companies want to try and keep
that as a presence. They
00:03:24
obviously have to kind of
readjust that thinking, because
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presence is one thing. But
bottom line is another thing.
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- Right. I don't know of many companies
at all who are increasing their
00:03:36
footprint in office. There -- it
is not true that everyone's
00:03:41
going to work virtually. It won't
work. One of the ways is, again,
00:03:45
at Wharton, we we teach in
person. It's clearly superior.
00:03:49
If we teach in person, that
means I need to come in and work
00:03:53
on campus. But for many offices,
that's not true. And I think
00:03:59
we are seeing a permanent decline
in demand. It's an obsolescence
00:04:03
shock. And it's led to a
bifurcation in the office
00:04:08
sector. The newer, better
buildings are filling up with
00:04:12
tenants taking less space than
they would have five to tem years
00:04:16
ago, but they're filling up and
they have good rents. But then
00:04:20
we have this other sector, class
B it's called, in office,
00:04:25
where typical vacancy rates, 15
to 20 percent, with a big dispersion
00:04:32
about that. Which means there is
a decent amount of product out
00:04:35
there with 30 plus vacancy rates.
And you will lose money. That
00:04:40
building will fail unless those
conditions change. - So
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for some of those properties,
then, I guess are they ones that
00:04:48
kind of fall into this theory
that's out there about the
00:04:53
refurbishment of some of these
office buildings into
00:04:56
potentially other types of uses?
- Apartments.
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- Apartments being one. But it
seems like there's so much potential
00:05:06
of that type of space out there,
that how could we even -- you know,
00:05:10
do we need to even serve that
level of apartment use?
00:05:13
- It's too expensive to convert.
It will happen. It will happen
00:05:17
in markets where apartment rents
are really high. There's a
00:05:20
really wonderful paper by a
group of economists at Columbia
00:05:25
who have looked into this. And
in New York, where, believe it or
00:05:29
not, monthly rents can reach as
high as eight bucks a month, a
00:05:34
foot a month, in parts of
Manhattan, you will see
00:05:37
conversions of offices. Because
those folks, those authors,
00:05:41
estimate five to six hundred dollars
a foot in conversion costs. In
00:05:46
Philadelphia, I know a firm
who's working on one building
00:05:49
downtown. It's about $300 a foot
conversion costs. That means in
00:05:55
Philly, that will happen no more
than five times throughout this
00:05:59
cycle. The conversion costs are
just too high, given our level
00:06:03
of rents. So conversions are not
going to solve this problem.
00:06:07
They will happen, but they won't
solve the problem. - What
00:06:10
then is the expectation for new
build? And are we talking
00:06:15
about rates that maybe are
similar to what we saw before
00:06:18
the pandemic? Or is it at lower
levels? And I'll throw this into
00:06:21
the mix. Obviously, we have seen
new office buildings going up
00:06:25
with more environmental friendly
components that are in the
00:06:28
mix as well.
00:06:29
- That's for sure. Those are
expensive. It's expensive
00:06:32
to be environmentally friendly.
But that's what-- if you're going
00:06:35
to have a footprint in office,
you want that for your
00:06:39
employees. That helps you get
your employees back. So that's
00:06:42
going to happen, and those rents
will be high enough for those
00:06:44
folks to make money. It's the
other buildings which are going
00:06:49
to fail, and they're a real
threat to urban centers and to
00:06:54
the public fiscs of
governments like Philadelphia,
00:06:57
- Are we seeing, or will we see
real estate investors really
00:07:02
struggle and and potentially
really have to fight at
00:07:06
their bottom lines as we move
forward because of some of
00:07:09
these issues? - Oh, in
00:07:10
office, you're already seeing
it. You are seeing office
00:07:13
trades, in some markets, at
anywhere from 25 to 50 percent of
00:07:20
purchase price pre-pandemic. So
you're seeing deep, deep
00:07:25
discounts already. That means a
bank is basically working with
00:07:29
the owner. The owner is going to
give back the keys, and the bank's
00:07:33
facilitating a sale to get as
much of its loan balance back as
00:07:37
it can. That's how problematic
it is for buildings that simply
00:07:41
cannot convert.
00:07:42
- One of the other things I wanted
to ask you about then is, as
00:07:45
well, how this shift in and around
commercial real estate is going
00:07:49
to be impacting the cities and
the governments and their tax
00:07:54
footprint. Because, and we see it
here in Philadelphia. - We sure do.
00:07:57
- About how much the city is
giving back to employees who
00:08:03
have a contract to work outside
the city with their
00:08:06
company, and they're paying wage
tax, but they're gonna get it
00:08:09
back. There are a lot of
components that city governments
00:08:12
are really having to rethink
right now.
00:08:14
- I don't think any city
government has -- understands the
00:08:17
magnitude of the problem.
Because of long leases, five to
00:08:21
tem year leases in office, this
is like a slow motion train
00:08:25
wreck in a bit. The buildings
won't fail. Some are failing
00:08:29
now. Some will fail next year,
but over the next five years.
00:08:32
And the problem for the cities
is not just that the office
00:08:36
won't pay property taxes
anymore. Around office nodes,
00:08:41
business ecosystems built
up. Bars, restaurants, sometimes
00:08:46
hotels, small shops. They will not
be profitable. They were built
00:08:52
and created, their business
models were flows five days a
00:08:56
week of people in the offices.
You're gonna see, it's a threat
00:09:00
to whole neighborhoods, and it's
many neighborhoods in every
00:09:04
large city. It's unavoidable.
I think this is a
00:09:08
true permanent obsolescence
shock. It will not kill all the
00:09:12
office market, but it will kill
a meaningfully large number of
00:09:16
buildings that will negatively
impact public finance in cities.
00:09:20
- So how
00:09:21
does the real estate owner then
go about trying to mitigate that
00:09:24
part of the problem? Because if
you have small businesses that --
00:09:27
- I don't think they can, right?
I don't think they can.
00:09:31
Ultimately, this is -- you know,
invite me back in a few years.
00:09:35
Ultimately, I think the federal
and state governments will have
00:09:40
to support workouts to prevent
these neighborhoods with office
00:09:45
buildings that won't make it
through this. Otherwise, you're
00:09:49
going to see real problems in
cities. Real fiscal problems in cities.
00:09:53
- What's your expectation on rent
prices, just in general, of where
00:09:57
they are probably going to have
to go with all of these dynamics
00:10:00
at play? Because I think for me,
I think the thought process is
00:10:04
some of these landlords are
going to have to cut back a
00:10:07
little bit in order to not have
mass exodus from companies or
00:10:12
even some of these small
businesses. - For sure. Although
00:10:14
it's remarkable, rent growth
is still pretty strong in the
00:10:18
best buildings. They're the ones
filling up. Those are the
00:10:22
environmentally friendly
buildings, they have outdoor
00:10:25
space, they're configured right.
It just takes big
00:10:30
capital costs to get that
building created. I think you're
00:10:34
going to see more of a
bifurcation, where a number of
00:10:37
buildings actually fail. They
literally disappear. Some
00:10:41
will get converted into
apartments, but most will be
00:10:46
torn down and replaced by
something else over the next
00:10:50
decade. It's going to be a long
story and struggle for cities in
00:10:55
this regard.
00:10:56
- I guess what's interesting about
it is this -- if you think about
00:10:59
before the pandemic, when you
look at something like malls, we
00:11:03
were seeing a little bit of an
exodus to begin with. - Oh, you saw
00:11:06
more than a little before the pandemic
in malls. - Yeah, but nobody, I think,
00:11:09
could forecast seeing something
like this develop the way that it has.
00:11:14
- The pandemic
00:11:15
was uniquely bad for lower
quality office product. And again, I
00:11:21
view it as a true obsolescence
shock. Just like Amazon and its
00:11:26
competitors made a decent amount
of mall space obsolete, the
00:11:31
pandemic forced all businesses
to work from home for a while.
00:11:35
And then they realized, wow, at
least for a short period of
00:11:38
time, we could actually run a
business. I don't know a
00:11:42
business in any sector who
doesn't think their finance and
00:11:45
accounting ran just fine. Work
from home. So why do you need
00:11:50
those folks in the office?
That's what's shrinking the
00:11:53
footprint. You talk to a law firm,
you know, managing partners, and
00:11:57
they'll go, "You know, there are
certain days we need to be here,
00:12:01
but not -- it's not five." So they
just shrink their -- somebody's
00:12:06
got to be a big loser, and it's
going to be the lower quality B
00:12:09
offices, which are going to be
the big
00:12:11
losers. - And all the while, still
having the component of, you
00:12:15
know, companies looking for the
best deal within cities, you
00:12:18
know, on their rents, on their
tax rate, on all of those components.
00:12:21
- Yeah, for sure. - So there's
a lot of, I would say double
00:12:24
whammy. But it feels like
there's like three or four
00:12:27
whammies going
on right now. - Yeah,
00:12:28
I mean, it's all driven by
the decline in demand. I think
00:12:32
it's a permanent decline in
demand, that over a very long
00:12:35
period of time, the economy will
grow, and we'll grow out of it.
00:12:38
But that's a decade or two. In
the short run, it's sobering.
00:12:44
There'll be a number of
landlords who just give back the
00:12:46
keys. And there will be cities
facing this fiscal threat of they
00:12:51
no -- once they give back the
keys, they no longer pay
00:12:53
property taxes, and the
businesses around them start to
00:12:56
fail too.
00:12:57
- So there is potentially a path
to kind of alleviate some of
00:13:01
this, but it's still a ways off?
- Yeah,
00:13:03
I don't think anybody but a few
academics are starting to think
00:13:08
about it. It will take real
resources. I can't imagine
00:13:11
cities like Philadelphia dealing
with this on their own. It will
00:13:17
take state and federal
resources.
00:13:20
- All right. Joe, great to have
you here today. Thanks very much.
00:13:22
- Well, thanks. I appreciate it.
00:13:23
- You got it. Joe Gyourko, who's a
Professor of Real Estate here at
00:13:26
the Wharton School. - Thank you
for listening to The Ripple
00:13:29
Effect. We hope you found this
episode informative and
00:13:32
engaging. Don't forget to
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00:13:35
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00:13:38
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