Should the citizens of Chicago be concerned? The answer is unequivocally yes – even if your first reaction is “I don’t give a hoot” about the financial devastation being experienced by most commercial property owners.
-Joseph Pagliari, Jr., Clinical Professor of Real Estate, University of Chicago Booth School of Business
By: Mark Glennon*
Vacant downtown commercial property is one of Chicago’s ugliest problems because of the absence of any solution to what’s shaping up as a monumental bust. Fleeing retailers have gotten most of the press on commercial real estate, especially those leaving North Michigan Avenue, but little attention has been paid to the office market.
The consequences of vacating what was among the most bustling spots on the planet could be overwhelming for taxpayers. City revenue from property taxes would plummet, leaving an enormous budget gap for Chicagoans to somehow cover. Assessed valuations would tank for even the best properties that are able to survive. Sales taxes paid by commuters in restaurants and retailers would likewise suffer. Some older buildings could be entirely abandoned. A downward spiral might well be set off with an unknown bottom.
About half of downtown office space is going unused. Tenants therefore won’t likely re-up for nearly as much space as they have under lease today, which is about 80% of what’s built. Most commercial leases are for a term of about 10 years.
That means the problem could grow for years as leases come up for renewal.
To be specific, the traditional index of a commercial property market – the vacancy rate – hides the problem. That rate averages around 20% in most of downtown, according to most analysts, such as Jones Lang LaSalle. Some nearby areas are better off, such as Fulton Market, River North, West Loop and the Clybourn corridor. Warehouses and multifamily residential are different story, too. But it’s the Loop and adjacent areas with their massive density of office towers that are central to the problem.
Those vacancy rates, however, only capture how much space is unleased today. The problem is how much is actually going unused. The most commonly cited measure of the true occupancy comes from Kastle Systems, a leading provider of security systems, which measures card swipe entries and exits.It reportscurrent office occupancy as a percentage of entries pre-pandemic occupancy. By that measure, Chicago has only recently clawed back to near 50% of pre-Covid levels.
Chicago obviously is not alone with this problem. Crime and work-from-home are crippling the recovery of many downtowns, though sunbelt cities are generally doing better.
A dire warning on the national commercial property crisis came earlier this month from Morgan Stanley in a widely cited report titled “Not a Port in the Storm.” It forecasts a peak-to-trough commercial real estate price decline of as much as 40%, worse than resulted from the 2008 Great Recession. The consequence of a downturn that severe go far beyond property owners, jeopardizing the lenders that financed them and more. “Distress of this type has historically not only hurt the landlords and the bankers who lend to them,” the report says, “but also the interconnected business communities, private capital funders and owners of any underlying securitized debt.”
A board member of New York Federal Reserve also warned last month of potentially systemic, national risks stemming from commercial real estate, highlighting another widely discussed aspect of the risk — $1.5 trillion in commercial real estate debt is set to renew in the next three years.
Commercial property owners, in other words, face the double-whammy of lost tenants and soaring interest rates on that $1.5 trillion. Ten-year interest rates have more than tripled since 2020.
The most recent example of the growing problem is Chicago’s iconic Aon Center. As reported by Crain’s last week, its owner “came up short on its mortgage payment last month and is asking its lender for more time to pay off the loan as a July deadline approaches, red flags that the city’s second-tallest office tower could add to the rampant distress plaguing downtown real estate.”
Soaring property tax bills are contributing to the citywide problem. Amazingly, Aon Center’s property tax billrose by 21.6%year over year in 2022 to $24.3 million, according to Cook County records, Crain’s wrote.
What’s the solution? If only there were something to write about. Mayor Lori Lightfoot’s idea of putting low income housing into empty offices is almost too silly to mention. With no greenspace, schools and scant other standard residential area features nearby, few tenants will likely find an office district appealing.
For a deeper view of this crisis in Chicago and other major cities, I asked for comments from Joseph Pagliari, Clinical Professor of Real Estate, University of Chicago Booth School of Business. He was kind enough to send an entire piece, that we’ve posted separately here.
He summarized both the national, macro-level elements of the crisis and the local, micro elements, which I urge you to read. Regarding Chicago, he wrote, “It should come as no surprise to anyone paying even scant attention that Chicago, along with Cook County and the State of Illinois, are prime examples of local forces adversely effecting these macro real estate trends.”
Most importantly, he addressed why this matters to ordinary Chicagoans. Earlier estimates, he wrote, say commercial properties pay more than 35% of all property taxes in the city, and added,
While this figured has likely shifted with recent events, let’s consider the following thought experiment: What if commercial property values fall in half and the residential values remain unchanged? Then, the residential property owners face an approximate 20% increase in their property taxes. Perhaps a more-likely political reality is that residential property owners face both significant increases in their property taxes and significant decreases in government-provided services.
Most ominously, he wrote this:
Finally, the results of Chicago’s latest mayoral election do not comfort those real estate investors who had hoped for profound and effective changes in the direction of the state and local political economy. The concern is that these strong headwinds lead to a vicious cycle of more of the same — increasing taxes, failing schools, crumbling infrastructure, falling property values, etc.
Not everybody is so gloomy, at least about the national repercussions of the commercial real estate problems, as seen, for example, in this CNBC column. Exposure to commercial real estate loans is widely spread over a vast number of huge financial institutions. Federal Reserve Board Chairman Jerome Powell said at a March press conference, “We’re well aware of the concentrations people have in commercial real estate. I really don’t think it’s comparable to [the recent bank failures]. The banking system is strong, it is sound, it is resilient, it’s well capitalized.”
One source of hope is that workers might return to offices. For whatever reason, that’s what’s happened in many other parts of the world. As recently reported by the Wall Street Journal, actual occupancy is back up to 70%-to-90% of pre-pandemic levels in Europe and the Middle East. Return to office is even more common in Asia, where rates ranged from 80% to 110% — meaning that in some cities more people are in the office nowadays than before the pandemic, says the Journal.
Conceivably, Chicago could also get control of its crime situation which would certainly help return workers to downtown offices. No signs yet of any serious effort there, however.
Or you could just choose to be optimistic for a reason given by Neil Steinberg at the Chicago Sun-Times this week, which is that Chicago had the strength to survive its Great Fire. (He’d apparently have us disregard decades it took to rebuild from the rubble.)
On the most pessimistic end, there’s one word that has popped up several times in conversations about the problem I’ve had with several real estate pros: Johannesburg. The South African city’s central business district was essentially abandoned to squatters in the ‘80s and ‘90s. Only recently has some rejuvenation begun. Big cities are not immune to full collapse.
I’m not predicting that result for Chicago and I don’t think anybody can make a prediction with much confidence, given the novelty of the problems Chicago and some other big cities face. However, it’s hard to deny that the risks of a truly devastating downward spiral are high.
*Mark Glennon is founder of Wirepoints.*
