Downtown Disaster, Suburb Safety in Real Estate?

News headlines are increasingly predicting a blowup in commercial real estate. But the risk is actually concentrated in the office markets of just a few cities. Digging into the details you will find that most commercial real estate categories and locations are actually doing well. Properties in the suburbs and other types of commercial real estate, like industrial and multifamily, seem to be doing just fine. Even some downtown office markets are doing well, like Miami and Savannah, where we have invested.

However, there is a real problem concentrated in a few downtown office markets. This might not represent the majority of the commercial real estate market. It certainly doesn’t represent a big percentage of land. But there is a lot of money at risk in office high rises in a few pricey downtowns. So, there is some truth to risk of some downtown disasters, with more safety in the suburbs.

Don’t be surprised to see more worrisome headlines, even some defaults, some new struggles for regional banks in particular and a few cities facing budget crisis. This isn’t a problem for the commercial real estate sector in general. But do some cities have reason to worry? The answer to that question is an unequivocal, YES. Looking at an over 5 percent increase in vacancy, Chicago has a problem. So, also do cities like New York, Los Angeles and Seattle at more than 7 percent. Then in a category by itself is San Francisco at an over 25% vacancy increase.

We can expect to see some large landlords default or threaten to default on loans in order to force favorable debt restructurings with banks. It is likely some cities wrestling with budget shortfalls, will cut spending and services. We might even see some cities declaring fiscal emergencies and requesting state or even federal bailouts. This may even cause stresses in the banking system, particularly for any smaller, regional banks with overexposure to any of these downtown markets. This situation is likely to get uglier.

But this isn’t a problem around all of commercial real estate or even all of downtown office space. Despite the headlines you read, the story here isn’t about remote work trends negatively impacting all office properties. In September of last year we actually highlighted this issue in our blog, “SF Real Estate Falling, Miami Rising.” And a key issue, you will see very little attention focused on is quality of life.

Some cities, like San Francisco are suffering from public policies reducing quality of life and spurring a migration into the suburbs. Downtowns in Miami and Palm Beach are conversely benefitting from a perceived advantage in quality of life over downtowns in Chicago and New York. Businesses and people with the money to move are doing so in many cases. There are both winners and losers in this current cycle.

This is a natural part of the business cycle in the real estate market. Areas perceived to be advancing, benefit from areas viewed to be declining. Investors who bet big on downtowns suffering from public policies reducing quality of life are going to suffer some losses. Maybe with enough downside, some of those policies will even be reversed. Until that happens, we would largely recommend not trying to catch a falling knife and avoiding those downtowns in decline.

Despite rampant property crime and drug abuse on its streets, San Francisco has some of the most beautiful real estate in the world. For the San Francisco downtown to have become a ghost town is entirely a manmade disaster. But these downtown disasters are not representative of the entire commercial real estate market. Yes, there is a real problem. And it involves some serious sums of money. But it is not a problem of the entire commercial real estate market or even for all downtowns.