Ferdinando Scianna / Magnum Photos

Cause to Worry, Reason to Act

Stijn Van Nieuwerburgh and Arpit Gupta

The researchers who popularized the idea of the “urban doom loop” assess the state of the evidence.

The researchers who popularized the idea of the “urban doom loop” assess the state of the evidence.

Three years ago, we set out on a research agenda that studies the impact of the pandemic on the market for office real estate — and on cities more broadly. We documented how the pandemic had shifted the tectonic plates of how we live and work. It caused migration from urban to suburban areas and from our largest metropolitan areas to smaller cities. House prices and rents grew much faster in suburban areas and smaller cities than in urban areas of first-tier cities. That study’s sample ended at the end of 2020, but updated data show that these trends have continued to play out in the three years since then. The latest Census data indicate that New York City has lost a grand total of 550,000 residents since April 2020, despite large international immigration flows. While the exodus slowed to 78,000 in 2023, numbers consistent with the outflows just prior to the pandemic, it did not reverse.

Our research indicates that the flexibility provided by being permitted to work from home was a key driver behind the shift to the suburbs and toward smaller cities. Once people buy houses in the suburbs or farther afield, it becomes more difficult to bring them back to the office. When people leave cities that are already seeing their tax collections fall, tax revenues decline further — forcing cities to either increase taxes or decrease services or both, potentially leading to more people and employers leaving the city, and to further decline. That’s what we mean when we talk about a “doom loop.”

Since our initial work during the pandemic, we have gone back and updated our estimates, but we see no reason to revise our conclusion: Many American cities, including New York, will face significant tax revenue shortfalls in the years ahead. The urban doom loop isn’t inevitable, but it remains very much on the table.

This brings us to the second major topic of our research, which is the impact of work-from-home, as well as higher interest rates, on the value of urban office and retail. Our work, titled “Work From Home and the Office Real Estate Apocalypse,” documents large reductions in leasing volumes and revenues and increases in office vacancy rates to levels not seen for at least 40 years. According to Cushman & Wakefield, the Manhattan office vacancy rate stands at 23.4% at the end of the first quarter of 2024, up from 9% prior to the pandemic and nearly double the average vacancy rate of 12.7%. This amounts to just about 100 million square feet of vacant office space, or 36 Empire State Buildings. The San Francisco office vacancy rate increased even more dramatically, from 3.6% before the pandemic to 33.9% in the first quarter of 2024.

The other shoe is yet to drop on the office market.

Our paper uses a model to calculate the value of the stock of New York City offices under various scenarios for the future evolution of work-from-home and the state of the economy. The latest version of our model predicts a 50% loss in value for the New York City office stock in the average scenario. The value destruction is even larger if current work-from-home practices were to continue for the next five years. We show that the losses are larger in cities that have more employment in the professional service sector, and in particular in technology, which has been permissive toward remote work.

While the 50% value drop for urban office value was a bold prediction in June of 2022, the data have caught up with that prediction. Real estate analysis firm Greenstreet now reckons that office space has lost 37% in value nationally since its peak in March 2022. Every day, a large office building somewhere in America is sold for a massive discount compared to its prepandemic sale value.

One silver lining is that the highest-quality offices — the youngest, most centrally located and most amenitized, sometimes referred to as class A+ — are holding up better than the older, less well-located class A-, B or C buildings. (These are all informal categories, and people may disagree on which building falls into which class.) Indeed, the data bear out that A+ properties have seen smaller vacancy increases and have been able to increase rents. A common occurrence is for an office tenant to leave a large swath of class-B office space in one building and to relocate to a nice class-A+ building, but to take less space in that new building. The tenant does not need as much space as before the pandemic, since many of its employees are on a hybrid work schedule, but the employer wants nicer space to “earn the commute of its workers.” While the tenant’s rent bill may not be lower than before, total demand for office space declines.

But the overall picture is not rosy.

To understand all this more clearly, it helps to think in terms of three interlocking cycles: the Fundamentals Cycle, which considers the demand and supply in the space market; the Financial Cycle, which considers banking and financing mechanisms that underpin commercial real estate; and the Fiscal Cycle, which looks at the interplay between commercial real estate values and municipal tax collections. All three cycles are at different points — but in no case is there fundamental reason for optimism, at least not if the city doesn’t evolve in some big ways.

Out-migration and the emptying of downtowns cost cities billions in lost sales tax revenue, personal and business income tax revenue, and revenues from other services such as parking meters.

The Fundamentals Cycle

Since office leases are long-term in nature, about eight years on average in New York City, only about half of prepandemic leases have come up on their lease renewals over the past four years. The other shoe is yet to drop on the office market. With work-from-home practices solidly ingrained in corporate America, and office visits plateauing at 50% of pre-COVID levels, surveys show that many more tenants will likely reduce their office demand when their lease comes up for renewal in the next four years.

There is downside risk to this prediction. The reduction in office demand we have experienced so far has taken place against a backdrop of strong economic growth. The U.S. economy rebounded sharply from the COVID recession, and “office-using” employment now stands substantially above pre-COVID levels. However, many of these “office users” are not in the office. Office demand and professional service sector employment appear to have decoupled.

Broader economic weakness, while not imminent, could further undermine the office market in the medium term. In the longer run, artificial intelligence could weaken hiring in professional services and/or improve the quality of the remote work experience.

In the middle of the Fundamentals Cycle, things do not look great.

The Financial Cycle

This brings us to the Financial Cycle. Commercial real estate is financed with lots of debt, about $6 trillion. About half of that debt sits on banks’ balance sheets. About $2 trillion sits with regional and smaller banks. All banks suffered a massive interest rate shock between March 2022 and July 2023, as the Federal Reserve increased short-term interest rates by 5.25%. The 10-year yield, which is more relevant for real estate, increased by nearly 3% since March 2022. The increases wreaked havoc with bank capital. Smaller banks were most exposed; several regional banks collapsed in March 2023.

Now add to this large interest rate risk exposure of regional banks a substantial commercial real estate exposure, and the danger comes into sharper focus. Many smaller and regional banks have commercial mortgage loans that exceed 300% of bank equity, a threshold for concern among bank regulators. Banks are in a race against time to set aside enough profits to cover future losses from commercial real estate loans.

Local government spending has gone up during the pandemic, much of it on items that are hard to reverse. Much of the increased spending was funded by the federal government, but the pandemic federal aid has now run out.

In 2023, only one-third of maturing commercial real estate office loans paid off. One-third defaulted, and the remaining one-third were modified and extended. In the first quarter of 2024, nearly 44% of maturing office loans defaulted. These defaults resulted in a sharp rise in the office mortgage delinquency rate. More than 10% of office loans are in special servicing, which means that they are at least two months late and at risk of default.

About $930 billion in commercial real estate loans are coming due in 2024. While extensions will again be part of the playbook, many loans have run out of extension options. For others, extensions make no sense since there is no hope for salvation, and it is time to eat the losses. When banks are told by regulators to be careful of commercial real estate exposure, this, in turn, makes it difficult and expensive for property owners to get a new loan to refinance an old loan that comes due. Credit is the oxygen of commercial real estate and the patient is suffocating.

We are still fairly early in the Finance Cycle, but the prognosis here is also grim.

The Fiscal Cycle

That brings us to the Fiscal Cycle, which concerns the impact of work-from-home on local public finances. Out-migration and the emptying of downtowns cost cities billions in lost sales tax revenue, personal and business income tax revenue, and revenues from other services such as parking meters. Tax revenues from commercial property account for anywhere between 3% (Phoenix) and 36% (Boston) of tax revenues in major cities. In New York City, that number (based on our own calculations) is 12%. The decline in property values will lower property tax revenues for years to come.

The reason is the slow pass-through from market value declines to property tax assessments. For example, New York City assesses commercial properties based on the net operating income over the previous five years. As net operating income from offices continues to decline and the losses in value crystalize, tax revenues will begin to fall.

A recent report calculated that Boston’s tax revenue from commercial buildings could fall by $1.5 billion over the next five years. Boston’s mayor has moved to increase the commercial property tax rate. While such an effort can potentially raise revenue in the short run, it amounts to an amplification of shocks borne by office owners, who may see the values of their buildings reduced further as a consequence, diminishing the future tax base.

In other words, we are only at the beginning of absorbing the impact of the decline in commercial property values on cities’ budgets.

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The pandemic has reduced tax revenues in several categories, but the brunt of commercial property tax declines is yet to come. That’s especially troubling given that local government spending has gone up during the pandemic, much of it on items that are hard to reverse. Much of the increased spending was funded by federal pandemic aid that has now run out. Many major cities are dealing with escalating costs from the migrant crisis. New York City faces a $7 billion to $8 billion annual budget gap in the next several years, according to the Citizens Budget Commission, even before considering the impact of declining commercial property tax revenues.

Cities must balance their budgets but are between a rock and a hard place. Raise taxes and they risk losing more residents and businesses. Cut spending on public safety, sanitation, transportation or education, and they risk undermining the quality of life.

Still, a doom loop is not inevitable. It is a possibility, a warning. Cities must act swiftly to upgrade the office stock; facilitate conversions of offices to alternative uses; invest in public safety, reliable transit and vibrant neighborhoods; and create a business climate that encourages innovation and the creation of jobs that benefit from in-person interaction.

For centuries, cities have reinvented themselves. Once again, society faces the challenging task of imagining the city of the future.