Photos of Manhattan office towers vanishing into the smog provide a splendid metaphor into what’s become of the business. Even the most attractively-located buildings are grappling with large drops in rental income and the prospect of losing flagship tenants. A report from Wedbush Securities this week assessing whether lenders are ready to deal with a wave of defaults asked, “Is the market whistling past the graveyard?”
And with that, let’s introduce someone with a contrarian take: Jim Costello, head of real estate economics at investment firm MSCI.
“I’m a little optimistic about offices moving forward, especially in big money-center locations,” he told an audience Wednesday at the National Association of Real Estate Editors’ annual meeting in Las Vegas.
His position is worth exploring because it is so out of step with the market.
Costello made his case the way any good economist would, with lots of charts and reams of figures. But in the end, his optimism is based on a simple observation: Humans love to gossip. Whatever benefits remote work and Zoom meetings bring, gossip is usually not part of the equation. He believes the power of gossip ultimately will rescue Manhattan office buildings.
“The only reason to be in the office is to build and spend social capital,” he told me later. “That only happens in areas with clusters of talent—Manhattan, Miami, etc.”
But he thinks the outlook for offices could get worse before it gets better. If interest rates don’t fall, “there’s another shoe to drop,” he said.
The biggest source of distress—“chaos” is the word he used—lies in buildings that got short-term financing from private equity firms and other nonbank lenders in the last year or two, just before interest rates rose quickly. As those loans mature, it will be impossible to refinance them, and that could be the catalyst for a wave of defaults.
Most lenders are working with landlords to restructure loans because widespread defaults are in nobody’s interest. But the can might not be kicked much further. Later this month, the Federal Reserve is expected to release the results of examinations into how bank portfolios could weather economic downturns. Should those stress tests reveal uncomfortably high commercial real estate exposures, regulators will push banks to foreclose on struggling borrowers and auction off properties.
Yet Costello added that vulture investors are waiting to swoop in. Indeed, he recently had drinks with a guy looking to acquire debt or preferred shares in commercial real estate on behalf of investors in the Middle East. The fellow said he’s compressing his expected investment returns for deals exceeding $100 million because there’s so much competition for distressed assets.
“That dry powder has an impact and I only learned that by being in the city and walking around,” Costello said. “You can get some of that on Zoom, sure, but just by sitting down with people over a drink you learn so much more.”
Sure, that’s anecdotal. But one person’s anecdote is another’s information edge. In a market with as little transparency as commercial real estate, good information is literally money.
Still, I was skeptical. I approached Costello after his presentation and asked how he could be even “a little optimistic” given that Manhattan office landlords face a double whammy of falling cash flows and rising borrowing costs.
He didn’t back down. Remote work can kill demand for what he called “commodity space” in low-cost locations, he said, but money is going to be made by people who interact in person with others and are better informed because of it.
“The truth is low-value jobs have been leaving the city for many years and high-value workers have increased in numbers,” he said. “That will continue because there is more opportunity in New York than anywhere else. It’s not complicated.”
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June 09, 2023 at 12:38AM
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Economist Jim Costello: Power of gossip will save New York offices - Crain's New York Business
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