Eric Rosengren, the president of the Federal Reserve Bank of Boston, was one of two members of the Federal Open Market Committee who dissented from last week’s vote to cut interest rates by a quarter point. On Friday, he gave a speech about why. And a lot of media outlets focused on one specific observation Rosengren made: that low interest rates appear to be encouraging commercial landlords to take on more risk than they may realize by renting to office-sharing companies like WeWork.
What does WeWork have to do with interest rates? Rosengren starts by talking about how low rates affect investors generally: Because low rates mean lower returns on loans and bonds, investors look for other kinds of assets (like stocks and real estate) that can produce a greater return. But because investors become more inclined toward those kinds of assets, they bid up the prices, meaning they also produce lower yields, expressed as the ratio of, say, a property’s price to its net income from rentals. Basically, when interest rates are low, any asset you buy is going to produce a lower yield than if rates were high (not just bonds).
In that kind of environment, owners of office buildings may become eager to increase the income from the buildings they just paid so handsomely for. Enter WeWork: It may be willing to pay higher rents than traditional tenants, because it uses the real estate more intensively (more workers in less space). And landlords might demand that additional rent because WeWork poses some risks that a normal tenant would not.
WeWork’s business model is risky in part because it agrees to long-term leases with the owners of office buildings, and then effectively subleases that space on a short-term basis. WeWork’s leases are years long, but its clients are often on month-to-month terms, and if the economy goes south, WeWork could face a sudden exodus of clients whose businesses are failing, or who are even choosing to work from home to save money. WeWork would still be stuck with its own leases, set at rents that reflect stronger economic conditions than actually exist.
That’s not just WeWork’s problem. Much of that risk is transferred to WeWork’s landlords, because if WeWork is no longer receiving enough income from customers to cover its lease obligations, it could default on its leases. It wouldn’t have to go bankrupt to do this: WeWork’s IPO prospectus notes that many of its leases are not in WeWork’s own name but those of special-purpose entities owned by WeWork. That means WeWork is not fully on the hook for its own rent; if there is a default, the landlord can only pursue the special-purpose entity, which has limited assets.
There are mitigating factors: WeWork notes that capriciously defaulting on its leases would damage its reputation and make it hard to sign leases in its future. The company also notes that it has, in some cases, posted letters of credit and security deposits that would lead to financial penalties if it stops paying rent. But our worry is about a negative economic condition, where WeWork likely isn’t looking to sign new leases anyway and is trying to triage major financial obligations in the face of declining demand for flexible office space. When companies are running out of money, they do things they never expected to do, like break their leases.
Plus, a key source of cash WeWork has used to finance money-losing operations — eager equity investors willing to invest at high valuations based on expectations of massive growth — has already dried up.
Those are real risks, and if you’re WeWork’s landlord, they should probably keep you up at night. But should the rest of us care? In 2007, home-mortgage defaults weren’t just a problem for banks; they led to a cascading effect that took down financial institutions, home prices, ordinary consumers, and the broader economy. This is an example of what Rosengren is warning about: high leverage, possibly exacerbated by low interest rates, that encourages risk taking (such as leasing to WeWork) that could have contagious effects when investments go bad.
But office sharing is a tiny slice of the economy. In May, the office brokerage firm CBRE estimated that WeWork and its flexible-office competitors (like Regus) take up approximately 2 percent of all office space in the U.S. Even markets with “high” office-sharing penetration, like San Francisco and Manhattan, are only above 3 percent. The thing about the housing bubble is it was both huge and hugely central to the economy. WeWork is not.
This is where it’s important to note that Rosengren was talking about WeWork as just one example of a broader phenomenon. He’s also worried about leveraged loans to corporations: These have gotten more leveraged in recent years, meaning a relatively small decline in economic or corporate performance can push the borrowing corporation into default. And he’s worried about these two stories (office sharing and leveraged loans) as examples of how the low-interest-rate environment may be encouraging investors to take on risks they may regret in an economic downturn.
I do not find this story to be convincing overall — and neither, apparently, does the full FOMC, which cut interest rates over objections from Rosengren and his colleague Esther George, of the Federal Reserve Bank of Kansas City. You can point to specific areas where investors are being silly, but overall I do not see an economy full of risk appetite.
Growth has been moderate for a decade and businesses have, if anything, been reluctant to expand and grow too fast. Homeowners are much less leveraged than they were in 2006. In fact, the low appetite for risk is a reason interest rates are low: People are not that interested in borrowing money, and the rates have to be cut to low levels to induce them to do so.
So while I do expect some economic pain from the shaking out of the WeWork bubble and some similar phenomena in other parts of the economy, I don’t think the effects will be big enough to matter very much to those of us who are not directly invested.