San Francisco’s iconic Transamerica building — owned by the insurer of the same name since its construction in the 1970s — is being sold. But these being COVID times, it’s being sold at a discount. A group of investors had struck a deal to buy the property for $711 million back in February, but now the San Francisco Business Journal reports Transamerica has agreed to a 10 percent price cut to keep the deal on track.
Since cities physically consist of real estate, you would expect a pandemic that has severely disrupted life in cities to disrupt real-estate markets. And it has. There are disruptions on two time horizons. In the short term: Unpaid rents and vacant spaces mean financial losses for building owners as the crisis continues; in the long term, if the crisis changes certain real-estate usage patterns for good, it could lead to permanent reductions in the value of certain kinds of real estate, especially commercial real estate, even after society gets back to normal.
This isn’t just a problem for people who own buildings. When buildings fall in value, that’s usually because fewer people have cause to work and shop in them, which corresponds to reductions to income and consumption for individuals. And because cities and states depend heavily on taxing commercial properties and the activity that occurs in them, a shock to commercial real-estate values is likely to cause yet another problem for state and local government budgets.
The outlook seems diciest for retail real estate. Retail landlords report the highest rates at which their tenants are failing to pay rent, with nearly half of retail rents going unpaid during the crisis as tenants face dire financial straits. Landlords have little recourse when tenants don’t pay — what are they going to do, evict a restaurateur and find someone new to sign a lease for the space, in this economy?
The shift toward online retail had already been reducing the demand for physical retail space for years. The coronavirus crisis turned this slow decline into a steep drop: Many department stores that might have closed gradually over the next decade will instead never reopen after their sudden closure this spring, and their closure will reduce foot traffic at the malls they anchor, imperiling the stores that do reopen.
Pre-COVID, retail-property owners had been responding to the pressure on brick-and-mortar retail by finding “experiential” tenants like restaurants, bars, gyms, and spas, where consumers’ need to visit in person is supposed to provide protection against online competition. But these are exactly the sorts of businesses whose models are most seriously disrupted by the pandemic — and in some cases, like gyms, consumers are shifting toward at-home versions of these experiences out of necessity. If some of those shifts become permanent, then some experiential retail businesses will turn out to have been more exposed to online competition than they thought. (What fraction of gym members who took up a home-fitness product or service during COVID are going to stick with it permanently and drop their gym membership? Not zero.)
The outlook for offices is less dire. Most office tenants have been paying their rent — SL Green, a major Manhattan commercial landlord, said it had collected 95 percent of April office rents by the start of June, compared to just 63 percent of April retail rents — because most office-using businesses remain operating, even if their employees aren’t in the offices. To the extent tenants keep paying as agreed under their leases, office landlords have some insulation from changes in the rental market due to multiyear leases. But in the long run, if companies like Facebook make good on their plans to have many more employees work from home, there could be a permanent decline in demand for office space that should lead to lower rents and less new construction.
Because a lot of real estate is owned by publicly traded real-estate investment trusts, we can get an idea of what financial market participants think is happening to real-estate values even when there are few transactions in the market. And SL Green’s stock, for one, has taken a beating, down by nearly 50 percent since the start of the year. After accounting for SL Green’s debts, that implies that the company’s real-estate properties have fallen in value by roughly 18 percent. (Because a REIT’s stock price reflects the value of the equity interest in a portfolio of buildings, net of mortgages and other debt the REIT takes out, it should move up and down more sharply than the value of the underlying buildings.) Office REITs in other regions, like Highwoods Properties in the South and Kilroy Realty on the West Coast, have experienced stock-price drops that imply similar declines in property value.
The outlook is probably best for residential real estate. It’s important to be careful how you read data on home rents and prices — average transaction prices have fallen sharply in New York and in some other markets, but that may be because transaction volumes have fallen more sharply for the most expensive kinds of homes, not because individual properties are getting less expensive. Price indexes from Zillow, which compare prices and rents for similar properties over time instead of calculating a simple average of transaction prices at a given time, show much more modest changes in residential rents and prices than you may have seen in some headlines. Zillow estimates after these adjustments that residential rents were 2 percent higher nationally than they were a year ago as of May, and were down less than a percent in the New York area.
It is possible that home prices and rents will fall in the future, especially if economic pain starts to be felt more acutely at the household level. So far, household finances have been, for the most part, robustly protected by aid under the CARES Act that actually caused household incomes to rise and household saving rates to rise sharply during the spring. If Congress allows that aid to expire, more and more households may have difficulty affording their current homes, let alone shopping for new ones. But essentially, residential real estate faces just this one kind of risk, while commercial real estate faces additional risk of permanent COVID-driven changes in usage patterns.
The risk to commercial real estate poses a challenge for city governments. In New York, commercial real estate is taxed at rates several times higher than owner-occupied homes are. New York, like many cities, depends heavily on sales taxes generated in restaurants and retail stores, and New York state benefits from income tax it collects from residents of New Jersey and Connecticut who work in the state but consume few public services here. (Their children do not attend New York schools, for example.) Less-intensive use of office and retail buildings would mean a weaker commercial tax base, forcing the city and state to rely more on taxing residents on their income and residential property — or to cut back public services. That’s on top of all the other fiscal trouble that cities and states face due to the COVID crisis.
Hopefully, the haircut to the Transamerica pyramid price is indicative and we will be looking only at a significant but manageable decline in real-estate values. Otherwise, more costs may fall on you than you might have expected.