How remote work is reshaping commercial real estate

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Commercial real estate is cratering.

In cities like Los Angeles and Chicago, more than 20% of office space lies vacant.

Nationwide, vacancy rates are higher than they were at the height of the 2008 financial crisis.

What does that mean for America’s cities?

Today, On Point: How remote work is reshaping commercial real estate.

Guests

Dror Poleg, economic historian researching the evolution of work, cities and buildings. Author of Rethinking Real Estate: A Roadmap to Technology’s Impact on the World’s Largest Asset Class.

Ted Egan, chief economist for the City and County of San Francisco, California.

Also Featured

Joe Eskenazi, managing editor of Mission Local.

Transcript

MEGHNA CHAKRABARTI: As long as Joe Eskenazi can remember, life in downtown San Francisco followed a predictable pattern. The hustle and bustle of 9 to 5, and then … nothing.

JOE ESKENAZI: In pre-pandemic times, it could get very crowded and then it would you know, it’s almost as if, you know, the whistle goes off and Fred slides down the dinosaur and says, Yabba dabba doo, and everyone empties out of the financial district because it’s not a place that people really hung out.

CHAKRABARTI: Eskenazi is managing editor of Mission Local, a news website that covers San Francisco’s Mission District. He’s also a native San Franciscan and has spent much of his life there, including the last 20 years.

ESKENAZI: Nobody says, I’m going to go downtown. I’m going to go to a place where there’s very little in the way of amenities (LAUGHS). And there’s nowhere fun to be. You know, and it kind of looks like an emptied-out movie set after hours and during weekends. What’s different now is there are just fewer people. It’s not like there are tumbleweeds or newspapers blowing through the streets. There are just fewer people.

CHAKRABARTI: The bright bell of San Francisco’s cable cars ring out a lonely peal these days. What better way to gauge human behavior in the tech city than through people’s cell phone activity?

One study did just that. And found that foot traffic in downtown San Francisco is just 31% of what it used to be prior to the pandemic. Yes, an almost 70% drop. That’s according to the University of California, Berkeley’s Institute of Governmental Studies.

CHAKRABARTI: And Joe says, it’s not just the corporate offices that cleared out during the pandemic, either.

ESKENAZI: For all the ancillary economic outlets, restaurants and whatnot that depend upon foot traffic from office workers. They are really suffering. You know, it was very hard to make rent from five lunches a week. Because the downtown closes, you know, shuts down at the weekend pretty much. And now that’s not possible.

CHAKRABARTI: It’s a fundamental issue of San Francisco’s downtown, he says. The district and its surrounding amenities were always built for commercial real estate … at least since the 1970s.

ESKENAZI: You’re going back a very long ways, you know, since the Bay Area Rapid Transit came in, which is our intercity rail. The entire purpose of Bay Area Rapid Transit, which stretches out quite a long ways, like down towards San Jose and well off into leafy suburbs in the east.

The entire purpose is to bring people into downtown San Francisco to work and then bring them out again. So it’s devoting an entire quadrant of the city to office space and office space only. In retrospect, you’re looking vulnerable.

Eskenazi says it’s unclear whether pre-pandemic levels of foot traffic will ever return to his city’s downtown. But he does hope that if and when it does, San Francisco will earn back the people who are invested in the city’s success, and not just as the giant tech hub we know it as today.

ESKENAZI: In retrospect, offering tax breaks and whatnot to big tech companies, which were all doing pretty well. And if they were looking for any kind of loyalty reciprocated from those companies, they absolutely did not get it.

Because it turns out that having offices for lots and lots of people is a major expenditure. So, you know, in the deep past or not that deep past, there were, you know, patriarch types, San Francisco natives who ran big businesses and would bleed for the city. Those people don’t exist anymore.

CHAKRABARTI: Joe Eskenazi is the managing editor of the San Francisco news website Mission Local.

Elizabeth Weil, Another San Francisco writer, puts it this way: “Before the pandemic, we thought that tech would save us. … Now it was clear that tech wouldn’t save us. Tech wouldn’t even stay in town.”

CHAKRABARTI: This is On Point. I’m Meghna Chakrabarti. Downtown San Francisco is suffering – office vacancy rates there are near 30%. But it’s also not alone. Commercial real estate in big cities across the country are cratering. Office vacancy rates are close to 13% nationally. That’s higher than during the peak of the 2008 financial crisis.

And the financial crisis and the residential housing bust that followed … the commercial real estate crash may not stay confined to commercial real estate. Taxes form the conduits that connect office space to your city services. And if companies aren’t paying rent, it hits a city’s bottom line. Let’s try to look into the future a bit, to what might happen if commercial real estate doesn’t rebound.

Joining us now is Dror Poleg. He’s an economic historian researching the evolution of work, cities and buildings. He’s the author of Rethinking Real Estate: A Roadmap to Technology’s Impact on the World’s Largest Asset Class.

DROR POLEG: Hi, Meghna. Great to be here.

CHAKRABARTI: First of all, tell me, give us a little bit more detail about the health of commercial real estate in cities across the country. Because an average number like 13% can obscure the details of what’s happening in various places. So what information would you add to that?

POLEG: So, in some cities, notably San Francisco and New York, even Boston, even places like Dallas, which people often assume that are kind of doing relatively well now, it’s closer to a 20% vacancy. Now, when we speak about vacancy, we’re basically talking about space that is not leased.

So it’s not under contract. But beyond that specific figure, there’s also space that is just empty and is still under contract. But maybe that contract will not be renewed once it comes due. And when we look at that, the number in many cities is closer to 50%.

CHAKRABARTI: 50%?

POLEG: Yeah. Compared to the level that it was at before COVID. So if we assume that even before COVID, of course, not everyone was sitting at their desk every day, 9 to 5. There was some kind of a built-in vacancy. So we’re currently in many cities at half of that. Now, at the height of COVID, we were close to 100% vacancy or let’s say 15%, 20%. So it did climb up. But actually, over the last few months, it looks like it’s even kind of retreating a little bit.

So it’s not clear that it’s just continuing to climb, but it looks like it’s starting to settle somewhere. Which the concern now, looking ahead and not too far ahead, is that as a lot of those leases come up for renewal, and most of them didn’t come up for renewal since COVID, most of them were signed before COVID, then many of them, or a significant portion of them, will not be renewed.

CHAKRABARTI: Okay, So pause there for a second. Because I want to slice this a little more finely. Because you actually you describe several different scenarios here that lead to that, you know, 50% vacancy rate here. First of all, some of it is just leases that have expired and have not been renewed. Is that that 20% number, you said?

POLEG: Yes.

CHAKRABARTI: Okay. So that is income then, that’s not going at all to the commercial real estate companies that own that office space. They are losing income on that.

POLEG: Correct.

CHAKRABARTI: Okay. And then there’s the sort of just empty office space portion, which presumably, are companies still paying their leases on those until the leases expire?

POLEG: Yes. And there is a process here also. We’re focusing now on landlords and the owners of their buildings. But even the employers themselves, some of them are still hoping that employees will come back and they’re fighting that fight internally, regardless of the lease itself. They’re trying to convince people back there, trying to hope that they will come back and to figure out what exactly they need in terms of space for the next few years.

CHAKRABARTI: Okay. So we’ll talk about the companies. We’ll also talk about sort of all the businesses that rely on that, you know, that commercial real estate traffic that workers brought. We’ll talk about that in a minute. But I think you said that many of those leases, if workers don’t come back into the office, those could soon expire and not be renewed. So how far into the future are we looking at for? Could there be like another major turning point in this kind of slow motion commercial real estate bust?

POLEG: So, these leases are staggered generally. Industry professionals try not to have all of their leases renewed at one single point in time, particularly because of what’s happening right now. They assume that the economy fluctuates, that there are surprises.

So, you want to make sure that most of your tenants are not even in a position to make a decision at any given moment. So, it does kind of trickle, but it looks like as we move away from COVID, vacancy is only going up. Which basically tells us that as more and more leases come up for renewal, vacancy tends to increase.

So at the moment, we don’t really see a reason why the leases that will come up for renewal over the next one or two years will just be renewed completely. Based on what we’ve seen in the last year, many companies are cutting their space needs, whether they give up the office completely or just eliminate 20 or 30% of it, and that’s an important point. They move it somewhere else, or they spread their offices differently.

They open satellite offices closer to people’s homes. So, it’s not necessarily a story about overall demand for office, but it’s a story about that demand also getting redistributed and moving away from the buildings that used to benefit from it up until three years ago.

CHAKRABARTI: The buildings and the downtown cores of many cities. Exactly. Okay. So, let me ask you again, not being an expert in commercial real estate myself, are leases typically, what, on a ten-year horizon?

POLEG: Yeah. So, ten years would be like a nice average. This has been trending down over the last two decades already. So if in the past companies would sign 15- or 20-year leases, fewer and fewer companies would do that. But even before COVID, we started to see that the tenants themselves have a preference for more flexibility, that they are no longer able to project and predict their own needs so far in advance.

So if in the past, both the company and the landlord had an interest to kind of secure the space for as long as possible. And know that they have a space. We started to see kind of a divergence there over the last ten, 15 years in particular where companies actually started to show a tendency to sign shorter leases, but landlords still insisted on them signing longer leases and landlords had more of the power.

CHAKRABARTI: I think you described that we’re looking at in some places a 50% underutilization rate, let’s put it that way, for commercial real estate in some cities. How does that compare to the vacancy rates in commercial real estate that we saw in the 2008 financial crisis?

POLEG: So that was more moderate. I don’t have exact numbers, but one, it didn’t happen so suddenly. Even that crisis, it kind of warmed up over time with an economic slowdown. And even after the kind of heart of the crisis, things still got worse.

But they got worse gradually, kind of into 2009 and in some places into 2010, even. And then as severe as the crisis was, we still knew that it’s just another crisis, just like all the other ones. We didn’t think that something fundamental changed in the nature of work itself. But that’s a concern that we currently have.

CHAKRABARTI: I want to lean on the historian portion of your expertise here. Other than spend the pandemic shifting expectations of where many, not all, but where many people can’t work, how far back in time should we go to see what could perhaps be the seeds of this current commercial real estate crisis that we’re in?

POLEG: So, we can go back about 100 or 120 years. One of the most interesting figures about the history of cities and, you know, Manhattan is an example of it. The residential population of Manhattan 100 years ago was 600,000 people higher than it is today. So more than half a million people extra lived in Manhattan 100 years ago than today. And what happened during those hundred years is that the city changed its orientation from a place where people live and, of course, conduct commerce, but kind of are in a very mixed-use environment.

To a city that is very much focused on offices where the skyline is dominated by offices, where the streets, the transportation network, even the retail is all designed to cater to this assumption that people come here to work, then they commute out. We need to build services around their schedule and around their needs, and all other needs are secondary. And I think we’re starting to head to a place where there’s a rebalancing, where cities have a chance to become places to live and enjoy and do other things. And work, as well, but not just to be those kinds of proxies of the office, but to be mixed-use cities.

CHAKRABARTI: In many of the cities that we’re thinking about, you know, New York is a great example. It went through a period, you know, in the 60s and 70s where the city itself was changing. It wasn’t necessarily a place where a lot of people wanted to live. But then comes, you know, the nineties and the series of tech booms. How did that accelerate this concentration of office space being the core of what cities were building in their downtowns?

POLEG: As you mentioned, people thought cities were over already from the 60s onwards, cities were becoming less dense, sprawl was increasing. You know, a lot of people were moving to the suburbs and a lot of jobs were moving to the suburbs. So most overwhelmingly, most job growth in the U.S. from, let’s say 1960 to 1990 happened in the suburbs, not in the center of cities.

But something interesting happened with the emergence of the Internet that was actually expected to finish cities off in a way. To like destroy offices even more and move people into remote work and distributed work. But actually, as the economy shifted to depend more on innovation and technology and creative and services, actually cities became more important, and more jobs moved back into the cities.

And offices became larger than ever, and work became more concentrated than it has been in many decades. And in many ways, a lot of urban economists thought that this would be the ultimate impact of the Internet. So if you look at the economic theory from ten years ago, they almost like celebrated that they figured this Internet thing out. Like, okay, cities are actually going to be okay. They’re becoming even more important.

Because creative people want to live in cities, because employers now want access to specialized talent. So they’re moving into those cities, and they want to hire from the largest possible talent pools, which you can only have in a handful of very large superstar cities. Hence, employment in those cities will continue to grow and offices will be even more concentrated. That was the theory.

CHAKRABARTI: That theory then also met the reality, that while all that growth happened, things got really expensive in those very same cities. So a lot of their workers couldn’t actually even move to the core of those cities and perhaps were commuting a lot in and out of downtowns.

And those are the workers, again, who can work remotely, who don’t necessarily want to go back into the office. So let me let me just ask you. I mean, you said something earlier that I want to emphasize. Because it’s really important here. This isn’t necessarily like a story of exclusive bad news regarding commercial real estate, because as there’s an occupancy decline in cities, we are seeing a growth in suburban office space and demand.

POLEG: I don’t know if I would call it a growth. Because I don’t want it to sound like, okay, you know, offices are going to be great, but they’re just going to be in the suburbs. Suburban offices have been struggling for a long time overall, but now over the last year, I think for the first time in many, many decades, vacancy in the core of cities is actually higher than it is in suburbs.

So there is a certain revival of suburban offices or in some cases a revival. In some cases, it’s a softening of the suffering, I would say. But even here, a lot of the new demand that will emerge for office is closer to where people live, is not necessarily satisfied by the type of offices that currently exist on the suburbs.

So a lot of people want offices that are walkable, that are closer to their home, that are near restaurants, even if they are outside of the city. But a lot of suburban office parks, as you know, are not exactly the most happening or interesting places, particularly for people that moved out of the city and are looking for at least some kind of urban vibe. A suburban office often is not exactly the thing that is going to answer their prayers.

CHAKRABARTI: You know what’s interesting to me? I don’t know if this is an appropriate analogy or not. But, for a person, if they have enough money to have a financial portfolio, you’re always advised to diversify that portfolio in case that, you know, something happens to a certain area in which you’re investing.

It sounds like, would that advice actually have been appropriate for cities as they started concentrating their investments in commercial square footage, vs. trying to keep their downtown cores more diversified, in terms of the kinds of businesses that came? Housing, restaurants, all the things that make for that kind of lively, livable environment you’re talking about.

POLEG: Yes, it would have been prudent. But in a way, even when you look at it financially, office buildings seemed like the most conservative, stable, predictable thing in the world, second only to maybe government bonds, in terms of an investment grade asset. It looked like the thing that will always be there. You know, it’s a building, it’s very solid. The tenants inside are the largest corporations in the world.

They signed the lease for ten or 20 years and promise you that they’ll pay you, indefinitely. And as the economy is growing and land remains scarce, you would assume that this thing, if anything, would maintain its value, like we saw it. And even when people moved out of the city, the offices remained, in some decades even became more important. So it was very hard to imagine, for most people, that this is what would happen.

In addition, in this country, as you know, about 100 years ago, we saw the emergence of zoning laws and kind of land use laws, often because of, you know, racial reasons and trying to exclude different people and different uses from different parts of cities or suburbs. And what that meant is that cities became somewhat ossified, that some plan that somebody made sometimes 100 years ago, when they decided, okay, here, we’ll have offices. Here, we’ll have houses. Here, we’ll have other stuff. We’re still living the consequences of those plans, and it’s very hard for cities to adapt.

CHAKRABARTI: Okay. So let’s talk a little bit more now about the ripple effect that those empty offices have, well outside of the buildings. Like the effect that they’re having on local economies, on people who may not ever step foot in in those offices. So, first of all, I want to hear a little bit from Wall Street Journal reporter Konrad Putzier, because he talked to us a little bit about the impact it’s having on the landlords that own that commercial real estate.

KONRAD PUTZIER: What I heard a lot from landlords, this is just a brief phase, the pandemic’s going to be over soon and then we’re just going to go back to normal. Once it sort of became clear that that wasn’t going to happen anytime soon, it shifted towards, well, everyone wants to be six feet apart. So actually, every tenant needs way more space now. Right?

Actually, this is going to be awesome for us as landlords. And then you start to see that companies actually didn’t really care about the six feet thing. And then gradually, you know, landlords kind of accepted reality. And part of, I think, what made this realization so slow is that a lot of companies are just locked into these long-term leases, which kind of allows landlords to live in this world of denial.

CHAKRABARTI: So that’s Konrad Putzier from the Wall Street Journal. Respond to that.

POLEG: So Konrad is describing what I called in my book, The Five Stages of Real Estate Grief. And that’s exactly what we’re seeing. So starting with denial of like, no, this is not happening. Everyone will be back in two weeks. Then a little anger. Okay, You must come back. Maybe we will get the city to force you to come back or try to get the government to get involved. Then some sort of, you know, negotiation. Okay. Maybe come back for two days. Three days, four days.

Now, I think we’re entering the depression stage where we starting to understand that something bad is happening and that something was lost and it’s never coming back. And some people are already at the acceptance stage of starting to think, okay, what do we do now?

How do I convert my building to something else? Or how do I change my building, so it appeals to people that want to work, but want something else? And also at the city level, starting to think of, okay, if we really accept the fact that some of this office demand is not coming back, what else can we do in order to remain attractive and to flourish? And there’s plenty to do.

CHAKRABARTI: Well, we’ll talk about that in a moment, because it’s an important sort of how to move forward question. But, you know, I imagine a lot of listeners are hearing this and saying, you know, it’s going to be hard to shed a tear for billion-dollar commercial real estate companies. But let’s say there’s someone, you know, listening in Montana who may never go to a giant downtown office building in New York or San Francisco. Is it possible that that person may have an actual investment in those same buildings?

POLEG: Definitely. So starting with a direct impact, many pension funds, many pension systems, you know, whether you’re a teacher or whether you’re a freelancer or whether you work for a large private corporation, a lot of your pension money is invested in real estate investment trusts that basically own a lot of office buildings, a lot of apartments and types of other commercial property buildings.

And they invest in them, because they’re almost ideal for a pension portfolio, because they’re very stable. The value goes up over time, but gradually. You know, they’re not a Facebook or Snapchat stock, and they pay regular dividends that are derived directly from rent.

So they’re ideal for someone who’s retiring and just wants to collect a check from their investments every month or every quarter. Now, again, the pension funds are not fully dependent on those type of offices, but they’re a major investor in these types of buildings. So we’ll start with that.

Then there’s other industries that you may be invested in, you know, fast food chains, hospitals, anything that there have been economies based around, is again built around the assumption that there’s a lot of people that come in every day from 9 to 5 and they need to eat, they need to get their clothes cleaned, they need to go to the doctor.

They need to do all sorts of things that happen around the office schedule. And once you destabilize that schedule or take some of that demand away completely, or just move it somewhere else, those businesses get hurt. And then we mentioned the fact that, you know, all of those businesses employ people.

So we might be some of those people. And the final impact or actually not the final, but one of them is the cities themselves. So property taxes are a huge portion of municipal budgets. In New York City, before COVID, it was about 40%, 44%. During COVID, it actually went down because there was a lot of external help from the federal and state government. So the share of offices and property actually went down, but generally it’s around 40%.

And of that 40%, about a third to a half comes from office buildings. So once you take that chunk of municipal budgets away, there’s less money for schools, there’s less money for policing, there’s less money for culture and for public spaces. So a lot of things get worse for a lot of people.

And there’s also a risk that you get into an urban doom loop. Basically, things get worse. Fewer people come to the office, fewer people come to the city, more businesses shut down. It’s even less attractive to visit. And, you know, we’ve seen that happen before in in some of our largest cities in the 70s and 80s.

CHAKRABARTI: Okay. So hang on here because it’s almost as if we planned it. You gave me the perfect segue way to actually once again talk about a specific city. Actually, to be perfectly honest, we did plan it. But Ted Egan joins us now. He’s in San Francisco and he’s the chief economist for the city and county of San Francisco, California. Ted, welcome to On Point.

TED EGAN: Hi, Meghna. Nice to meet you.

CHAKRABARTI: Okay, so we wanted to have someone from San Francisco back to give us a reality check on this conversation, because we can talk, you know, in terms of data and theory. But I want to know exactly what’s happening in your city. First of all, how much would you say that that you think downtown San Francisco has changed since 2020?

EGAN: It’s changed a lot. And I think most of the things that you’re talking about today are reflective of what’s going on in San Francisco. You know, San Francisco was obviously a major national center of the tech industry. Tech is the industry among office industries that most adopted remote work and has been the slowest to return to the office.

As for the city, about 80% of the city’s GDP, the value of everything produced in San Francisco is produced in an office building or in an office industry. And so when something as significant as remote work happens to office work, it obviously affects every aspect of the economy in San Francisco.

CHAKRABARTI: Can you say that again? Because I’m not sure I heard the right number. How much of the city’s GDP is coming out of things happening in offices?

EGAN: About 80% between industries like professional services, financial services, information government. So, it’s important, I think, for people to have to keep in mind that these industries haven’t left San Francisco. In fact, the tech industry has employed more people now in San Francisco than before the pandemic, but they have dramatically changed how they need office space. And so that has had, yeah, the ripple effects that you’re talking about on downtown businesses, on transit, potentially on the city’s budget going forward.

CHAKRABARTI: Okay. You know, a little bit earlier, I quoted Elizabeth Weil, a San Francisco writer who said, “Before the pandemic, we thought that tech would save us. Now, it was clear that tech wouldn’t save us. Tech wouldn’t even stay in town.” What’s your response to that, Ted?

EGAN: Well, I mean, again, it’s easy to think tech left, because they’re not in their office buildings. They’re not walking around, but they didn’t leave. Some of them moved to the suburbs. And it is true that San Francisco had a major drop in population between 2020 and 2021, the first year of the pandemic. But most of the people who left weren’t tech workers. They were low-income workers in restaurants and retail and personal services who lost their jobs.

And so actually, that’s the group that’s making San Francisco feel empty. Some techies move to the suburbs, but they’re still there. I think the reality that she’s saying, though, is we had gotten used to … in San Francisco to a certain ripple effect from the growth of tech, which was so profound in the 2010’s, driving demand for everything else in the economy and paying a lot in taxes. And those effects have been smaller when they’re not physically in the office.

CHAKRABARTI: We’re going to talk more about the on-the-ground impact that these vacancy rates are having. But I wonder, are they also having an impact on the actual value of the buildings themselves? Because I’m thinking about all the different ways that banking and finance are involved in the commercial real estate sector.

POLEG: Yes, they’re definitely having an impact on the buildings themselves. And those buildings are actually facing now a double or triple whammy, because even if work would have been great and everything would have been just like before, interest rates are now significantly higher than they were before COVID. Which means that if your loan is coming due, and you have to get a new mortgage for your building, which happens every ten years, let’s say on average for an office building.

Suddenly, even if your income was great, you have to pay two or three times more in interest. So that’s a problem. Now, if your income suddenly is 20% lower, because vacancy is 20% lower and rents are probably even lower. So even the space that you are leasing, you’re getting less for. Now … your mortgage burden becomes sometimes unbearable. And we already started to see some large financial players start to basically give their buildings back to the bank instead of repaying their loans or getting new loans.

So companies like Brookfield and PIMCO, so large owners of commercial property or commercial debt have basically already decided that they’re just not interested in refinancing their building. They would rather give them back to the bank, rather than try to pay for them. So at the same time, even if everything goes well and your building is doing okay, the lenders themselves are actually not that interested in touching offices at all. They’re trying to avoid that category, just like they try to avoid retail five or ten years ago. So there’s kind of like a headline fear of dealing with offices. And again, that might turn into a self-fulfilling prophecy that kind of creates a downward spiral.

CHAKRABARTI: You said the company named PIMCO, you’re talking about the investment management company.

POLEG: It’s a subsidiary of them that invests in real estate.

CHAKRABARTI: Yeah, okay. That’s a surprising name to hear, though, because PIMCO has, what, one and a half trillion dollars of assets under management. And so even their subsidiary is like, no, we’ve got to dump these buildings off of our books.

POLEG: That’s why it’s concerning. I mean, they’re not dropping them because they think they can’t pay. They have the money to pay probably, although again, every investment is in a separate fund. It’s a different story. It’s not like you can take money from their investment in their technology or health and move it to pay their real estate loans.

But they’re basically making a … financial decision and saying, okay, is this building worth more to me in my hands, or is it actually better to just let the bank take it and deal with the fallout? And also, I think tactically, they want to signal to other lenders that they may have to deal with in the future that they’re willing to go all the way. So sometimes, you know, you let go of a few buildings so that the next bank that you renegotiate your loan with would know that you’re actually willing to drop the whole building on them. And the banks don’t want that either.

CHAKRABARTI: Can then this aspect of the commercial real estate challenge that we’re facing now, can that ripple out into the broader economy?

POLEG: Yeah, it puts pressure on banks, particularly on regional banks. Which are the biggest lenders, like the bulk of the commercial property lending happens in regional banks. So some of the banks that have been in the news recently, like First Republic and Silicon Valley Bank, they’re among the largest lenders to their local office buildings. This is by design. It’s actually not a bad idea. You want people who are closer to the city and to the ground to be lending out money to local developers and owners.

And those banks, they’re not heavily dependent on those office buildings, but they’re somewhat dependent on them. And what happens when they’re suddenly under pressure for other reasons, again, partly because of increases in interest rates, which means that they make less money, because their savers are now expecting to get more interest payments in return for their money. They turn to those safe things on their balance sheet, such as government bonds and offices, to basically provide some cushion. But at this point in time, both of these things don’t provide that cushion. So they kind of even push them. And they even cause them more damage, basically. And that exacerbates the kind of low intensity crisis that we currently have with regional banks.

CHAKRABARTI: This is feeling very grim. Ted, let me turn back to you here, because, again, asking specifically what’s happening on the ground in San Francisco. A little earlier we talked … about all the businesses. And actually, you had mentioned this too Ted, that sprung up around those tech giants that were sending their workers into downtown San Francisco, the businesses that sprung up to support them. You know, food, other services. Have workers in those businesses suffered a pretty bad impact from all that empty office space, Ted?

EGAN: Well, it’s hard to say that the workers have. I mean, San Francisco’s unemployment rate is less than 3%. You know, it’s one of the lowest in the state of California. It’s up from 2% in the past few months. But it’s hard to say that this adjustment has really impacted workers or at the very least, the impacts that were felt during the pandemic. And people responded, many of them, by moving out of the city. But it really is affecting the small businesses.

You know, the sales that we’re seeing near downtown are still down in some cases, you know, a third from where they were in 2019. And that is just completely at odds with what you’re seeing in retail trends in other central cities. And it’s because of office workers, but it’s also because of a lack of business tourism, which is connected to offices. That’s another industry that’s been hard hit. And it’s connected to our office sector. So without the tourists, the business tourists, the conventioneers, the office workers, those downtown businesses just don’t have the customers.

CHAKRABRTI: Okay. So then take us to the bottom line, Ted. I mean what impact is this having and do you predict will have on San Francisco’s tax revenues.

EGAN: Well, you know, San Francisco is an unusual city in a lot of ways financially. And our property tax, which in many cities makes up the bulk of our revenues in San Francisco, is only about 20% of our revenues. We also have in California Proposition 13, which basically limits your property tax revenue during the good years, but cushions you during the bad years.

So we’re forecasting bad years for all the reasons that Dror has talked about. And we have tried to forecast what rising interest rates and reduced property income in our office building means to the market value of these properties. But most of these properties are essentially under assessed. In other words, they pay property taxes if they were worth less than what they are. And that means that they can experience a real loss in value without actually owing less tax.

There’s a great example of this. Last week, we finally had a major office building sale. You know, office buildings haven’t been transacting very fast. And that building, it looks like it’s going to sell for maybe 75 to 80% less than what it was worth before the pandemic. But because previously it hadn’t been sold since the 90s, it doesn’t look like it’s going to pay less in taxes. It’s just that cushion is cushioning us. That is an only in California, only in San Francisco thing. But for our specific fiscal situation, it’s going to help us.

CHAKRABARTI: Okay. The glory of unrealized gain, I guess. But Ted, you still said that 20% of tax receipts are coming from commercial real estate for the city of San Francisco. I mean, correct me if I’m wrong, I don’t imagine that, like the city budgets have been bursting with excess cash over the past many years. So even any reduction in that 20%, I mean, is it not likely to have an impact on funds available for other city services?

EGAN: I think going forward it will. It’s actually 20% for all property and most of the property tax is residential. Of that 20%, less than 20% is office. But you’re right. I mean, from a financial planning point of view, from not just our property tax, but we have a major business tax that’s affected by remote work. We’ve got to enter a mentality of sort of slower growth than we’ve seen in the past.

Whether or not we actually see budgetary losses kind of depends upon the magnitude of this. But we’re moving out of a period where we had a lot of support from the federal government during COVID that has ended. We’re kind of swimming by ourselves at this point and our economic situation is not as strong as it was.

CHAKRABARTI: Is it a doom loop scenario?

EGAN: I think not at this point. I think that we have some serious challenges as a city. But I’m not seeing the dynamics that are driving the industries that lead our economy out of town yet. I do think that if we start seeing tech workers moving out of the Bay Area because they can get a bigger house somewhere else, we should worry about that. We’re not seeing that yet. I think if we see crime conditions in downtown get worse and keep people away from downtown, we should worry.

But actually crime, the facts about crime are getting better. And so we have to worry about transit. Our transit recovery has been weak, and we need to have transit service to downtown. There is no downtown recovery. So that’s a challenge. So we have a number of challenges. You know, there are some risks of a doom loop situation, but I don’t think we’re there yet. And I don’t actually think the risks are high. There are just a lot of them.

CHAKRABARTI: Okay. So what connects all of these things? The buildings, the transit, the businesses, etc. is people, right? You need people there. And so, you know, in thinking about what could be done with all this square footage, I know listeners are screaming at their radios or phones right now. Housing, housing, housing and housing, which of course, is an incredibly intense issue in San Francisco. So is there any possibility that some of these buildings can be converted to housing for people who need it?

EGAN: I mean, there is some chance that it could happen. Sure. But I think people have to keep in mind that housing in San Francisco is also connected to office. And it’s been a phenomenon since the start of the pandemic that the housing market has been the weakest in downtown cores, and it’s been the weakest in San Francisco among any other downtown.

So if you’re a housing developer eyeing an office building, say, gee, I’d like to buy that and turn that into housing. You’ve really got three hurdles to cross. The first hurdle is the office building owner is unlikely to give it away, at least until recently, office building owners have been resistant to sell at a tremendous discount that you need. Because especially in San Francisco, office buildings were so valuable.

So getting an office building at the right price is one hurdle. The second hurdle is the price. I mean, there is less reason to live in downtown San Francisco when you don’t need to walk to that office as often. And the businesses that would have created the kind of amenity rich environment that would have attracted residents downtown, those businesses aren’t open in many cases.

So what’s the attraction of downtown? And as a result, your prices are lower. And finally, construction costs are very high in San Francisco, and they haven’t come down. In fact, they’ve increased a lot with the inflation we’ve had. So the economics of that conversion are very, very difficult for reasons that, you know, may not change quickly. I could see some of this happening maybe years in the future. But I think the thing that’s going to happen first is we’re going to see a shakeout in office rents, which we haven’t seen yet. Our office rents are still, you know, around 2017 levels. They fall a little bit. I think they may fall more and then we may see really what office tenants want.

CHAKRABARTI: Dror, I have a couple of questions left for you. But first, I’d love to hear some of your ideas of what can be done with this commercial square footage.

POLEG: So first, after listening to what’s going on in San Francisco, I can be a little optimistic and say that in a lot of other cities, things are actually better both right now and also in terms of where they can go in New York City. I like in San Francisco. There’s plenty of people who would love to come and move and live in the center of Manhattan and even in Brooklyn and in Queens if you let them. And there’s plenty of good stuff and fun things to do beyond going to work.

And we’re actually feeling that on the street. So, while San Francisco is significantly emptier than it has been, Manhattan and Brooklyn and Queens are full of people and they’re very vibrant. So apart from the offices being empty, the restaurants are full, the parks are full, the streets are full. So if we convert more offices to apartments, that’s going to make a big difference. There are significant hurdles, as Ted pointed out, even just purely from an engineering front. You know, it’s just really, really difficult to convert most of those office buildings into apartments and to actually have normal apartments that have windows and bathrooms.

CHAKRABARTI: I was going to say, yeah, the construction requirements are different.

POLEG: … In addition, one thing to note is that the kind of macro perspective that Ted just gave us, it’s just correct to the extent that it goes, might miss all sorts of things that are happening beneath the surface. So while a lot of employees, for example, are still registered and employed in San Francisco, many of them actually are not there physically anymore.

So if you look at more granular data from companies that handle the employment and options contracts, and there’s a company called Carta that does that. In the tech industry, I think last year about 60% of new employees were actually located in a different place than the company that officially hired them. So if you look at the company’s employees, you might think that they’re all kind of growing. … but in reality, there might be kind of undercurrents that are sending people and spending elsewhere, which we should keep an eye on.

But generally, I think we’re headed to a world where cities have an opportunity to be more important and more vibrant than ever because they can do all sorts of things that we can’t do anywhere else. Again, density, walkability, diversity of people, access to culture, even reality itself. You know, we can’t even know what’s real anymore online, right? There’s so many deepfakes and things.

If you want meaningful interaction with humans, cities are kind of the last place where you can actually get that. But to capitalize on that potential, cities need to be willing to change. They need to allow conversions, they need to allow new businesses to open more easily. and they need to try to make themselves more affordable so that people that actually want to live in them would be able to.

This article was originally published on WBUR.org.

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