Commercial real estate apocalypse threatens economy and midsize cities

In Indianapolis, the technology giant Salesforce is paring back a quarter of its office space in the tallest building in Indiana, where it has been a key tenant for the past six years. In Atlanta, the private investment giant Starwood Capital defaulted on a $212 million mortgage on a 29-story office tower. And in Baltimore, a landmark building sold for $24 million last month, roughly $42 million less than it fetched in 2015.

All across the country, downtowns, office spaces and shopping centers are at risk of becoming ground zero for a new economic hazard: the urban doom loop. The fear is that a commercial real estate apocalypse could spiral out and slow commerce, wrecking local tax revenue in the process. Ever since the pandemic drove a boom in remote work, hubs such as New York and San Francisco have drawn attention for their empty offices in previously bustling skyscrapers. But many economists are even more worried about midsize cities that have fewer ways to offset the blow when a major company slashes office space, the sale price of a building craters, or a downtown turns into a ghost town.

The worst-case scenario would go like this: With more people working from home, companies from Milwaukee to Memphis are rethinking their leases or pulling out of them altogether. That drives vacancy rates up and makes it harder for landlords to attract new tenants or sell buildings for a healthy price.

Then property owners might struggle to pay off their mortgages or clear other debt. Business districts would dry up, stifling tax revenue from commercial properties or employee wages. Shoppers and tourists would have fewer reasons to venture downtown to eat or shop, choking off spending and forcing layoffs at restaurants and retail stores.

“Once those offices are empty, there are few alternatives and not a lot of life after hours,” said Stijn Van Nieuwerburgh, a professor of real estate and finance at Columbia University’s Graduate School of Business who is one of the authors of a paper that coined the “urban doom loop” phrase. Midsize cities “have a much bigger chasm to cross than what New York City has to go through. The situation is worse in those places with so little else in place.” He added, “It is a train wreck in slow motion.”

Economists caution that such a train wreck is not guaranteed, and the spiral has not kicked into gear anywhere yet. There are a few reasons: Many cities are still leaning on historic levels of state and local stimulus aid from the 2021 American Rescue Plan, and those funds may not run out for another year or two. A large share of the outstanding business and mortgage loans are also not due for a few more years. Plus, the economy continues to defy the odds, dampening concerns that widespread layoffs or drops in consumer spending could trigger this dangerous loop.

Yet the Federal Reserve has highlighted commercial real estate as one of the risks to financial stability. And troubling signs are piling up, often in places that are already vulnerable. Midsize cities have some of the highest rates of office delinquency, where loan payments on buildings are behind schedule, and the lowest rates of office occupancy.

The average delinquency rate across the 50 largest metro areas in the country is about 5 percent. But in places like Charlotte in North Carolina or Hartford in Connecticut, it is almost 30 percent, according to data from the real estate analytics company Trepp.

Likewise, occupancy rates average about 87 percent. But in Oklahoma City, it is just 71 percent, and 76 percent in Memphis and St. Louis.

Experts caution that the trend could easily escalate, especially as properties come up for refinancing. “You are going to see some trickle effects, but the downpour is yet to be seen over the next 18 to 24 months,” said Lonnie Hendry, senior vice president at Trepp. “It is very early in the cycle.”

The concept of the doom loop took off in the past year on the heels of research from Van Nieuwerburgh. Next came a kind of buzz that rarely follows academic papers, with media requests pouring in and at least one headline dubbing Van Nieuwerburgh “the prophet of urban doom.” But all of the research makes clear the doom loop is not inevitable anywhere.

Some cities will not face the downward spiral at all, while others might experience different harms from vacant commercial space than others, said Tracy Hadden Loh, who specializes in commercial real estate and governance at the Brookings Institution. She noted that some cities were already struggling with office vacancies before the pandemic, so they are not facing an entirely new phenomenon. It also matters how cities have been using stimulus funds and when they will run out.

Crucially, wonky tax rules mean certain places are more exposed than others: Chicago and Boston, for example, have large office footprints and rely heavily on property tax revenue. Philadelphia, meanwhile, depends more on wage taxes from commuters than on real estate, and that revenue could dry up if people are not venturing into the office. “It really depends on the city,” Loh said. “The local tax structure matters tremendously in the United States. You can’t make a 100 percent true general statement about any class of cities because they each have their own bespoke revenue structure that has evolved over time.”

Still, each day, with every new mortgage default and every distressed building sale, it is clear how few solutions there are. In cities large and small, some property owners have tried to turn vacant offices into something else altogether, like apartments, kitchen spaces or even spas. But those workarounds can be prohibitively expensive, if they work at all. Plus, these solutions have not taken off on a massive scale.

Take Minneapolis, where many of the stressed loans are concentrated in downtown buildings struggling to attract new customers. In March 2021, Target announced plans to vacate a major complex there, cutting its lease of almost 1 million square feet, or roughly three-fourths of space available in the entire building. The big box retailer held onto other large leases in Minneapolis and said the 3,500 corporate employees who worked at City Center would instead transition to other major headquarters in town.

The move was a massive blow to downtown Minneapolis, said Brian Anderson, director of market analytics at CoStar Group. The empty space has not drawn much appetite from prospective tenants. “The more those companies opt to utilize remote-hybrid work, that is going to matter. That is going to create big shifts,” he said.

Downtown Washington is in another kind of bind. In the District, office leasing activity reached a historic low in the first quarter, with only 900,000 square feet of office leases signed. That is down from the five-year quarterly average of 2 million square feet, according to Trepp.

The takeaway: There is less and less appetite for office space, with little sign the trend will turn around. Much depends on what happens with the more than $5 trillion in commercial real estate debt sloshing around the economy, and the $2.75 trillion in commercial mortgages that are slated to mature by 2027.

The tidal wave of looming deadlines could hit regional banks the hardest, as they hold roughly two-thirds of the total commercial real estate debt in the country (not just including office space) and are more susceptible to what happens in individual cities. Economists have been worried about regional lenders since the banking crisis earlier this year, when the demise of two midsize firms suddenly jeopardized the economy.

What else happens in the broader economy also matters. The Federal Reserve is still trying to tame inflation and has pledged to keep interest rates high for as long as necessary. The goal is to slow the economy by cooling demand for loans and investment, which appears to be working. A July report said lenders have been seeing less demand for commercial real estate loans at the same time banks are tightening their standards.

In that way, Hendry said he worries the doom loop could stem from factors large and small. “If you have a mortgage with an interest rate in place at 3.5 percent, and you want to refinance at 7 percent, that is unavoidable, regardless of geography,” he said.