"Urban Hell"
Debt... defaults... dereliction...
welcome to the new abnormal...
by Bill Bonner
London, England - "We took the Eurostar to London yesterday. How it brought back memories! Waking up before dawn…finding an early morning taxi…long lines at the train station…For 10 years, we lived in Paris but worked in London. Those were the days when employees were supposed to show up for work at the office. So, we usually took the train up to London on Tuesday morning and came back on Thursday evening. Not much has changed. Except, most of the people on the train yesterday were tourists, few were the business travelers we used to see. The new ‘laptop class’ doesn’t need to come to the office. It reacts to ‘data’…opinions…direction – on line, without even getting out of bed.
It is all a bit puzzling. Leaving Paris in the early morning, the city seemed to be coming alive, just as it always did. It was hard to find a taxi…and young people flew by on their bicycles. The ‘eboueurs’ were noisily tossing garbage cans around. Groups of Arabs and Africans gathered around the Gare du Nord. Then, in London, too…it seemed normal. Normal people. Normal busy-ness. Normal crowds of tourists in the summer. Why do Paris and London seem so ‘normal?’ We noticed the same thing in Dublin. It is full of normal people, not just people on welfare or with gender ambiguity or mental problems.
“London is not normal at all,” said an English friend at dinner. “We English are mad about property. And for the first time in a generation, property prices in London are falling. We have all the same problems as US cities. They’re just not so visible…yet.”
Not So Lucky…Today, we continue our descent into Urban Hell, to find out what’s going on. In Baltimore, our guess is that full-time, in-the-office workers are a relic of the past. In our own business, we are consolidating, putting unnecessary space up for sale. But other companies are doing the same thing. So, who is going to buy it? Fortunately, we never financed our buildings. We bought them to use, not to speculate. But many urban real estate owners are not so lucky.
Which brings us to the third thing to whack US cities (after decades of shyster politics…and then covid panic lockdowns): higher interest rates. Alert readers are probably already racing ahead of us…they are wondering, as we are, if cities themselves are not a relic of an earlier age, soon to be discarded like a beer can along the highway of progress. But we’ll come back to that...
In 2020, the Primary Trend of interest rates had been down for 40 years – substantially boosting prices for almost all assets, including urban rental space...and making leveraged real estate speculators rich. But in July of that year, the interest rate cycle hit bottom; the Fed’s policy rate was ‘effectively zero.’ The 10-year US treasury bond yield dropped under 3%. And so did 30-year mortgages. Since then, most interest rates have approximately doubled, posing a huge problem for people who need to refinance. Here’s Markets Insider:
"Fed economists say a historic 37% of US companies are in big trouble - and warn that could worsen the fallout from fighting inflation "The share of nonfinancial firms in financial distress has reached a level that is higher than during most previous tightening episodes since the 1970s," Ander Perez-Orive and Yannick Timmer said in a recent note. Debt-ridden companies will balk at spending money on new equipment or facilities, hiring more people, and ramping up production… That could lead to the Fed's rate hikes having some of the most devastating impacts of any of its tightening cycles over the past four decades, they noted."
Look at the numbers. Imagine that you paid $100,000 for a building, with 90% financing at 3%. You have $10,000 of your own money at risk…and you expect to carry the rest at a cost of $2,700 per year. If you have $5,000 of net rental income, you subtract the financing cost and are left with $2,300 – a very good return on a $10,000 investment.
But then, let’s say your interest charge doubles, to $5,400. Meanwhile, your rental income has been cut in half – to only $2,500. Now, you are losing money…with a negative return of 29% per year. And your equity capital has been wiped out. The building was capitalized at 20 times rent. Now that rents are only $2,500, that would suppose a capital value of only $50,000 –a 50% loss.
As rents fall and interest rates rise, real estate investors’ sharpen their pencils. They find the Old Time Religion; they don’t want to pay 20 times rent. They want to pay less than 10 times rental income. This will lower the value of the building from $100,000 to as low as $12,500. In other words, it will do to your commercial real estate roughly what the Russian army did to Bakmut.
And this situation is not getting better. It’s going to get worse. The Washington Post: "With inflation in the United States still excessive, most Federal Reserve officials expect to raise interest rates further this year, Chair Jerome Powell told a House committee Wednesday. “Inflation pressures continue to run high, and the process of getting inflation back down to 2% has a long way to go,” Powell said on the first of two days of semi-annual testimony on Capitol Hill."
Moneywise: "Patrick Carroll, founder and CEO of CARROLL, sounded the alarm about the state of the U.S. commercial real estate market in a recent interview with CNBC. “The party’s over, unfortunately,” he said. “The office market’s going to be destroyed, hotels are going to be destroyed - it’s going to be ugly."
And here is where wondering recommences. How long will the ugliness persist? What will it mean for cities? Interest rate cycles last a notoriously long time. The most recent upswing, ending in 2020, for example, began in 1980 – 43 years ago. Before that, the downside moves (higher yields) lasted from the end of WWII until 1980 – about 35 years. Now, imagine how this cycle will affect urban property. What will our cities look like when the cycle finally reaches its end? As always…more to come…"
