In this video, Columbia Business School’s Stijn Van Nieuwerburgh shares his insights from his research into how a shift toward remote and hybrid work, combined with rising interest rates and a transition to a green economy, is changing real estate.
Watch the video above and read the transcript below:
My name is Stijn Van Nieuwerburgh, and I’m the Earle W. Kazis and Benjamin Schore Professor of Real Estate and a professor of finance at Columbia Business School.
I teach real estate finance in the MBA program and real estate analytics as well as a PhD class on empirical asset pricing, and my research is at the intersection of real estate, finance and the macroeconomy.
My latest work has been studying the aftermath of the COVID pandemic and how it has reshaped residential and commercial real estate markets, and in particular, I've been looking at the office space.
It’s a very large asset class, with about $5 trillion worth of office assets residing in households’ portfolios, from pension funds to sovereign wealth funds through a lot of institutional investors, and what we've noticed is that these office assets have been affected by a triple headwind.
The first headwind has been a shift toward remote and hybrid work. The second is higher interest rates, and the third is a transition to a green economy.
1. Remote Work
Remote work has permanently shifted the landscape in commercial real estate. With fewer people in the office, at this point, only about half of office workers are back in their office in large cities like New York, that has obviously suppressed the demand for office real estate, and what we've been noticing is that it has adversely affected the cash flows that landlords that own these office buildings have experiencing. Since December 2019, lease revenues on large office buildings in New York City have already declined by about 19 percent by the fact that only about a third of leases have actually come up for renewal yet, so fully two-thirds of leases are still with us. These are pre-pandemic leases and they have not come up for renewal yet, and so the fear is that the second shoe is yet to drop on the office market as those leases come up for renewal, and as those tenants decide that they do not need quite as much space.
2. Higher Interest Rates
The second headwind for commercial real estate is higher interest rates. Long-term interest rates have gone up by about 2-300 basis points in these last couple of years, and that's obviously a strong negative for office markets because so much real estate is financed with debt. And as interest rates rise, the cost of that debt increases. This becomes a problem usually when the mortgage is up for refinancing. Like a lot of commercial real estate that is financed with 10-year fixed-rate mortgages, at the end of that 10-year horizon, the mortgage needs to be refinanced, and when interest rates have gone up so starkly relative to the previous time the mortgage was financed, then that creates a large cash flow problems, potentially even an inability to refinance the debt.
3. Transition to a Green Economy
The third headwind has to do with greenhouse gas emissions. In cities like New York, buildings account for about 60 percent of greenhouse gas emissions, and places like New York City have passed climate regulations a few years back that are scheduled to kick in on January 1, 2024, and by some counts, something like 3,500 office buildings will be fined because they will not meet the greenhouse gas emission standards. Those fines are scheduled to escalate and increase every year until 2030. Now the problem is that there are these older, less energy-efficient office buildings, often called Class B or Class C office buildings, that are not only under attack from the remote work revolution, they basically have less demand for office space, but they are also particularly energy inefficient. And so fixing up those buildings is typically very expensive. And there's sort of low cash flow stability for these assets in the first place. So the combination of these higher interest rates, remote work and the climate regulation risks making these Class B and Class C office assets stranded assets.
So what my research does is it takes those cash flow projections from leasing data and tries to build model for office valuation, and the ultimate question is how did remote work affect the overall value of the office stock?
The headline result is that we think remote work reduced the value of office by about 40 percent, which is of course a very large number. It's a number that's large enough to wipe out a lot of the equity that landlords typically have in buildings, and potentially even impair the debt that is often underlying these office properties.
Given these challenges, our CBS students have their work cut out for themselves. There's great opportunity for them to help reimagine what the cities of the future will look like, effectuate these conversions of existing office assets to better alternative use, and help with the climate transition of the urban environment.
There is a lot of funding available through the Inflation Reduction Act that was passed last year that could potentially be harnessed to turn these brown office assets into green apartment living, thereby solving the affordable housing problem, the remote work problem, and the climate.