Foreign, most white-collar workers were forced to start working from home. One of the worst hit sectors of the economy was commercial Real Estate. specifically. Office Buildings With people working from home, thousands of them were sitting empty.

Despite this, companies had long-term lease contracts, so they were still forced to pay rent. So commercial landlords actually did okay during 2020 and 2021. With the pandemic now behind, Us, companies are gradually forcing their employees to return to the office for most days out of the week. This should be great news for landlords as a means, the work from home era is finally coming to an end.

Despite this apparent Tailwind commercial property stocks have been suffering catastrophic losses if you look at the biggest office landlords in the U.S almost all of their share prices have declined below their trough levels at the peak of the pandemic. Publicly traded real estate holding companies are called real Estate investment Trusts or REITs For short, how is this possible? Shouldn't these REITs be recovering now that employees are returning to the office. There are two problems. Firstly, most companies sign multi-year tenancy contract tracks that cannot be broken without significant penalties.

Many companies want to stop renting in 2020, but they had to wait until their lease is expired, which is happening now. Secondly, real estate is expensive because of this. REITs tend to take on huge loans to buy properties like Office Buildings with the Federal Reserve hiking interest rates REITs will have to refinance their loans at higher rates at the same time that their rental revenue is under pressure. As if all these headwinds weren't enough, the banking crisis we've seen since March has put Regional banks in a defensive stance, making it even harder for REITs to refinance their loans.

According to Morgan Stanley, one and a half trillion dollars of commercial real estate debt is coming due, which could lead to a wave of defaults across the sector. With commercial real estate being a multi-trillion dollar market, this has a potential to cause a severe recession. In this video, we'll take a deep dive into the commercial real estate sector to see just how dire the situation is. Foreign: The pandemic created a forced experiment where almost all workers who could work from home were forced to and with new tools like Slack and Zoom, many companies were pleasantly surprised that white-collar workers could do just about everything they did at the office.

from the safety of their homes. there are a few major benefits to working from home. Firstly, workers don't have to waste time on long commutes to the office. Secondly, many companies are located in large cities with expensive real estate and high taxes.

Because of the High Cost of Living, they're forced to pay their workers very high wages. with work from home. Companies can hire people living in Suburban or rural areas where the cost of living is much lower. This will allow them to get away with paying far lower gross wages.

And finally, if all employees are working from home, there is no need to rent an expensive office building in a large city. In 2020 and 2021, many companies announced that they would continue work from home policies even after the pandemic. For example, in 2020, Mark Zuckerberg said that working from home makes him more productive and he would allow most employees to work from home indefinitely. It wasn't just Facebook many companies announced that they would never require workers to return to the office, but over time it became clear that this may have been a mistake.

While it is theoretically possible for a lot of jobs to be done fully remotely, there are far more distractions and far less accountability. It is very difficult to quantify the effect of remote work on productivity. So the best proxy is the performance of students who have to take standardized exams when students were forced to take classes remotely. Academic achievement decreased substantially in 2022.

4 and 10 8th graders across the U.S failed to grasp basic math concepts, which represents a 30-year low in New York which was hit especially hard by the pandemic. The state decreased minimum proficiency scores. Otherwise, the number of students flunking would be catastrophic. While it's technically possible to study remotely, many kids lack the discipline to listen to lectures for hours on end when they could easily play video games without anyone noticing.

While adults should have greater discipline than kids, they too are not immune from slacking off when their bosses and co-workers can't see them By the end of 20 A20, and especially since the beginning of 2023, more and more companies are changing their tune on work from home policies and a 180 degree U-turn Zuckerberg Said that workers get more done when they are physically in the office and Meta is currently evaluating return to Office requirements. Meta has been monitoring the quantity and quality of their employees work output and found that workers who come into the office perform better on average. Amazon Apple Disney Goldman Sachs and Salesforce have all recently announced return to the Office requirements just to name a few. According to a recent study from Resume Builder, 90 of companies are planning to require their employees to return to the office for at least some days per week.

In 2023, the return to the office is real and we don't have to rely on surveys or estimates to measure its magnitude. There's a company called Castle Systems which makes the electronic card readers workers use to enter Office Buildings by looking at the number of swipes on their card readers. Castle knows exactly how many workers are physically coming into the office. They show that in April of 2020, the number of card swipes increase your trough of 15 of pre-covered levels.

Since then, it has gradually been recovering. As of May 2022, this has increased to 50 percent of pre-covered levels. The recovery looks highly encouraging for the industry. So why is it the case that office rates are continuing to decline in value even below their pandemic lows? Foreign to data compiled by Axios, the vacancy rate for Office Buildings has been increasing consistently since the beginning of the pandemic.

It currently sits at 13, which is even higher than the peak of the 2008 Global financial crisis. This completely contradicts the recovery that we've seen in the Castle card swipe data. So how can this be the case? It's because they're measuring different things. A landlord doesn't care how many workers come into the office, they just care how many floors they can rent.

The vacancy rate is a square footage of the building that is not being rented, divided by the total number of square feet in the building. Let's say you own an office building with two floors. There are five seats on each floor for 10 seats. In total, you have one tenant who has 10 employees.

so they fill up the entire building, giving you a 100 occupancy rating. During the pandemic, all 10 employees are forced to work from home, so the percentage of seats filled decreases to zero percent. but the tenant signed a long-term lease so they have to continue paying rent despite the fact that the building is empty so your occupancy rate is still 100 percent. In 20 23, the lease finally ends.

Your tenant has a new hybrid working arrangement, so their employees come to the office half of the days and work from home on the other half. On any given day, only five employees will come to the office, So the tenant renews the lease, but only rents one floor instead of two. As a landlord, your occupancy rate and Rental Revenue declined by 50 percent. We know that workers are more productive when they come into the office, but if the workers come to the office three days a week, this is often good enough to maintain a sense of accountability and develop professional relationships with their colleagues.

Many companies come to a compromised solution of hybrid work, which still requires office space, but far less than before. The main expenses of operating an office building are interest expense and property taxes. These expenses are fixed regardless of the occupancy rate. To make matters worse, office reads are also seeing their interest expense increase as they have to refinance their debt at higher rates.

This is creating a situation where for some Office Buildings the rental revenue is not enough to cover the interest expense. In the first half of the year, the massive of Real Estate Investment Company Brookfield defaulted on hundreds of millions of dollars of loans tied to Office Buildings in La including the iconic 52-story 777. Tower This past February A giant Reed called Columbia defaulted on almost 2 billion dollars of loans tied to office buildings in New York San Francisco and Boston The New York-based Real Estate fund Rxr Realty currently plans on defaulting on loans tied to 10 percent of its New York City Office Buildings The good thing is that these loans are non-recorders The reason these funds are defaulting is because these buildings have low occupancy and their values have decreased. The value of the property is now less than the mortgage.

Even if they had cash on hand to make the interest payments, they're better off defaulting and handing the keys over to their lenders. to the extent that the building is worth less than the mortgage. The lender eats the loss. Brookfield claims that 95 percent of their real estate is high quality buildings, which they can easily rent for high rates.

They are intentionally defaulting on the worst five percent of their property portfolio because they believe that the value of these properties has declined. Given that the loans are non-recours The biggest losers from this property crash may be the bangs and this problem could not have come at a worse time. Rising Defaults in the commercial real estate sector could have a particularly disastrous effect on Regional Banks Regional Banks Prefer making commercial real estate loans because they have significant expertise about the local real estate market in relationships with local landlords. Large National Banks Lack the Deep expertise in the communities they operate in.

They don't know which parts of a given City are up and coming and which parts are in decline. Because of this, they prefer things like single-family mortgages or Consumer loans which are far more standardized, only requiring a credit score and income verification. Or they'll give loans to large multinational corporations which are usually not tied to real estate according to an analysis by JP Morgan commercial real estate loans make up 29 percent of Regional Bank assets, compared to less than seven percent for big Banks Regional Banks have also faced deposit outflows and higher funding costs due to the failures of Silicon Valley Bank and First Republic earlier this year. If we see the trend of Office billing defaults continue, this could prove disastrous for regional Banks.

However, there are a few reasons to be optimistic. The the broad category of commercial real estate includes Office Buildings multi-family apartment buildings, shopping malls, and Industrial facilities. Office Buildings only make up an estimated 25 percent of total commercial real estate in the U.S So, while commercial real estate loans make up 29 of Regional Bank Assets Office Billing loans likely only make up around seven percent other than office, the other categories of commercial real estate are all doing well according to data compiled by JP Morgan. Residential, retail and Industrial real estate all have vacancy rates at or below pre-coveted levels.

So while office rate defaults is certainly a concern, it is unlikely to be catastrophic. Alright guys, that wraps it up for this video. What do you think about the office building? Market Let us know in the comments section below. As always, thank you so much for watching and we'll see in the next one.

Wall Street Millennial Signing out.