Lately I have been looking at commercial real estate a lot more closely.
This started in 2019 when I was trying to find a venue for running some events out of. Extremely short term leases were available where you could rent a space out on a daily basis, but those arrangements were extremely expensive compared to renting a place longer term if you started to do many days per year.
I remember looking at commercial real estate back then and being struck by the extreme lengths many of the participants in that industry would go to in order to avoid dropping rents. It was around that time I first came across Louis Rossmann's Youtube channel where he had a series of videos documenting what he saw happening in New York City and the extreme trouble he had finding a new place to lease in NYC despite enormous numbers of vacant properties all over the city.
It's easy to see why businesses that actually have to turn a profit, have a lot of trouble with finding commercial real estate when there's such dishonesty like outright lies about the square footage of the properties. When questioned about lies on the listing a real estate agent replied "it's not lying it's commercial real estate" now available as a meme mug and we saw a fascinating window into the mindsets of some of the people who were working in that industry. Apparently this is so common that there's a term called "loss factor" where people justify how much square footage is lost between what's advertised and what's actually available as floor space in the building. What that means is that the square footage for office space in reality costs more than what it's advertised for and how much the discrepancy is will vary depending on who's advertising it. With all of this bullshit going on it probably comes as no surprise that when a business does find a good lease and can enter into a good contract there's a whole lot of reasons why they won't want to leave in a hurry.
At the time I remember thinking that some of the same things happening there were also happening here in Melbourne. Little did I know that a few years later Melbourne would have an even higher vacancy rate than New York City.
There's a tipping point that gets reached when the property prices are too high to sustain real businesses and eventually the businesses just leave. For example Rossmann has since given up on New York City entirely and has moved his business elsewhere.
Why does it take so long for the rents to drop?
I just got back from a trip to Sydney and I remember people there commenting on how vacancies in commercial real estate had gone up there. This immediately caught my attention because vacancy rates are far higher in Melbourne compared to Sydney and people are now commenting on high vacancy rates in Sydney.
With these extremely high vacancy rates many people are wondering why rental rates on commercial real estate have not dropped. The first obvious factor is that there has been an insane amount of base currency creation in the last few years, the series I have on monetary policytalks about this. It's entirely possible for rent to go up in nominal terms but yet decline in real terms if inflation runs hot enough. But despite inflation running hot it seems the decline in rent in real terms has only just begun now with the higher interest rates and multiple years of economic problems.
A large part of why landlords don't drop rental rates is because a lot of commercial real estate is purchased using some form of financing that directly relies on the rental rates of the property. Many of the loans are created with some assessment of how much rental income the building can theoretically generate. From the perspective of the bank offering the loan a drop in rental income makes the loan a lot more risky to the bank. As a result some of these loan contracts prevent rental rates being dropped except in extreme circumstances like defaults. This causes a lot of strange downstream effects like keeping commercial properties vacant for long periods of time instead of dropping the rents to a level closer to the market rate and actually getting a paying tenant for the time.
From the perspective of the businesses requiring real estate there's a number of reasons why they rent commercial premises rather than buying. Having available cashflow can be more important to a business than having real estate depending on the company cashflow and a number of other factors. If a company has cashflow issues keeping cash available might be the difference between the company succeeding and failing. While a real estate purchase might be profitable for a company it might harm the cashflow too much.
If you have a bubble where the real estate prices are going up just because people expect the prices to go up it is a somewhat feasible strategy to purchase the commercial real estate with the intention of selling it to someone else later. Some sort of gains might be made just attempting to find a "greater fool" that will buy the property for a higher price. But if the market drops this plan starts to fail and fail badly. If enough people are just buying because it's a bubble and they think they can sell later then the bubble bursting will be very severe.
So when the time finally rolls around to when enough of the loans on these properties get refinanced taking into account the new realities of the market, eg higher interest rates, I suspect we will see complete capitulation if the vacancy rates also remain high.
WALE - weighted average lease expiry
I was looking at some listings for purchasing commercial real estate and I came across an acronym WALE in a number of postings.
WALE stands for weighted average lease expiry and is an indicator of how long you have until the leases for the current tenants expire. The reason for taking an average is for convenience of investors in assessing the profitability of commercial real estate deals. Because different tenants will have different spaces and rents taking an average of their lease expiries would be a bit misleading. If you had a huge building and one tenant has a 10 year lease in a tiny office and all the other tenants have huge expensive leases for 1 year then taking the average expiry time just on the calendar dates would be a bit misleading from the perspective of how important the leases are to the profitability of the investment.
WALE can be calculated in a few ways, the weighting can be based on the amount of rent paid or the amount of floor space. The idea is that you get some equivalent number of months at which time all the tenants would have their leases expire.
This hints at another part of the dynamic of why the commercial space is so slow to react to the changes in the market, many companies have leases that span multiple years.