There’s a lot of uncertainty surrounding commercial real estate, with all eyes on the office space. From research notes published by the big banks to academic papers, it’s not looking too good for the sector that has been plagued by remote work.
But is the office the next shoe to drop in an already turbulent economy? To get an answer to the question that’s on all our minds, we asked Fred Cordova, chief executive officer and founder of Santa Monica–based commercial real estate brokerage and consultancy firm Corion Enterprises.
With Cordova’s wildly entertaining, and relevant, analogies, he basically suggests the office sector is crashing—and that his firm predicted it over a year ago. Following Cordova’s breakdown of the state of office properties, there’s one thing separating office from all other commercial real estate, making it the sector most at risk, and that’s demand.
All commercial real estate is vulnerable to high inflation, which equates to high interest rates. But the widespread shift to working from home, triggered by the pandemic, has largely wrecked the need for a physical office. In major markets like Los Angeles, San Francisco, and Manhattan, office vacancy rates are at record highs.
Below is Fortune's conversation with Fred Cordova. Portions of the Q&A have been edited and condensed for clarity and brevity.
Fortune: Banking giants from Morgan Stanley to Goldman Sachs seem to be sounding the alarm, stressing that the office sector is at risk. Is the office sector headed for a crash?
Cordova: They’re not sounding the alarm, they’re ringing the bell when the horses are all out of the barn. This has been coming for some time. What’s happening in the office sector is apocalyptical: We’re creating this huge class of zombie buildings, buildings that no one wants to put any money into because the capital structure is broken.
What’s happening is buffeted by three headwinds. You have, obviously, inflation, which drives up occupancy costs and puts pressure on the landlord across the spectrum of their operating costs. So unless their leases are triple net (and some are, but most are not), the occupancy costs and the costs to really deliver service in an office building keep rising. So that’s one. Two is interest rates. The real estate industry is fairly leveraged, and in some cases a highly leveraged industry. So interest costs can be extremely impactful to performance. With the dramatic increase in interest rates, the net cash flow available to ownership has dropped, and virtually all of that is being swept to pay debt.
The third, that’s unique to office, is the demand profile, and that was really caused by the pandemic. It takes about 50 repetitions to create a habit, and once you do that, it’s hard to break it. The pandemic created a habit of people working from home. That habit, first of all, gave people a raise in take-home pay. It also, more fundamentally, gave people the power of choice, so it gave workers the choice of whether to work from their desk or from the kitchen, work in their pajamas, and work while they’re walking their dog. It changed the whole work-life balance and quality of life and became a habit. That means tenants need less space. If all of a sudden you don’t need 100,000 square feet, and you can get by with 50,000 or 25,000 square feet, that affects the utilization of that office building, so it crushes the rent profile of the building.
What does that all mean for property valuations?
Let’s say an office building was purchased for $230 million. I think it’s going to sell for like $100 million. But you are signing up to spend at least $100 million more on your tenant improvements just to lease it up and hope that it gets leased up. That’s just the cost. What about carrying the interest rate? If you’re lucky enough to get a loan—which no one is, by the way—there is no liquidity for office right now on the debt side; you’re paying just for the money. That’s not creating any value.
The modeling for this, the underwriting is extremely stressed. People are pretty much just throwing the models out right now; models don’t mean anything. What’s going to really be happening is people are going to be buying these assets on just a square-footage number. They’re going to buy it on a really discounted basis, and so the asset values will plummet.
What can we expect for office properties moving forward?
The buildings need an injection of capital, it’s the only way it works ever. So right now, most of the bank debt is already paired, meaning there’s no equity in it, so they’re all zombie buildings. The owners aren’t going to put good money after bad because they’re not going to get it out. The lenders aren’t going to put any money in because they’re just throwing a glass of water in the ocean—they’re not going to get any value out. Office properties are going to be sold; lenders are going to get control. The lenders want to preserve their assets, so the best way to preserve the loan balance is to short-sell the asset.
Why would anyone, at this point, buy an office building?
That’s a very good question, and the short answer is, no one is just yet. No one knows where interest rates are going yet, no one knows where inflation is going yet. No one is going to lend on these office buildings when they don’t know what the cost of their capital is, so there’s no liquidity for debt.
What I suspect you’ll see, and I wouldn’t be surprised to see this, is to have one or more of the REITs [real estate investment trusts] taken private. And then once the Fed takes its foot off the gas, it stops raising rates, and signals that they’re going to hit the pause button, and maybe even lower rates at the end of the year, and inflation comes in check, then you will see buyers re-enter the marketplace.
What are the effects of these losses in property values?
From the ownership standpoint, and the, let’s say, evisceration of equity in these buildings, it has very little impact on society because these are investors who are smart and move on. But where it really hurts is the public group. Property taxes are going to get slaughtered across the board with every asset class, so the budgets that rely on those property taxes are blown up. Absolutely blown up. Then, the community in which these assets are located is devastated. Downtown L.A. has become almost a wasteland in some respects.
Tenants are moving out of L.A.; their staff doesn’t want to be there. It’s a snowball effect: You can’t support the restaurants, you can’t support all the service businesses that are there, so they’re all closing.
There are conversations circulating about converting vacant office properties into housing. Tell me about that?
The big dramatic change that’s needed is the recapitalization of these assets and the repurposing of some assets. I think you’ll see some more conversions from office to multifamily. The values still have to come down to about $100 per square foot, and they’re not there yet. $100 per square foot for the office space translates into $125 per [rentable] square foot for multifamily because you lose about 20% of the rentable space when you convert; that’s the magic number. It costs about $250 to $350 per square foot to convert these buildings, so there’s a gap right now. But if you can plug that equity gap, which I think there’s a play to do so through a private partner with the city and state and that’s what we’re working on, then you can convert some of these buildings.
It seems to me that you think that the office sector has already crashed or is currently crashing?
Have you seen the Denzel Washington movie Flight? Well, the wings of the plane are on fire, the plane is coming down. It’s just a matter of how hard it’s going to hit. It is apocalyptical.
We have too much office space that just needs to go away, whether it’s torn down or repurposed. The whole office sector needs a reset. I think we’re going to need to create this new employee, someone who gets to choose when they work from home but within certain constraints. Then once we get these people back to work in the buildings, all these assets need to have a new capitalization on them. And then, we have to get rid of a lot of these office buildings that are no longer purposeful.
None of that’s going to happen until interest rates settle down. They have to stabilize and inflation has to stabilize, so that we have the ability to underwrite and prognosticate, and we have some visibility as to what costs, returns, and values are.
If you’ve ever been skiing in a whiteout and you can’t see your skies, it’s pretty crazy, it’s pretty scary. You go real slow. And that’s where we are. We’re in a whiteout, we’re in an economic whiteout for the office space. So everybody is going to move very slowly until the cloud can clarify.
