[jwarden]

This explanation seems very implausible to me. By lowering the rent by X%, and therefore reducing annual revenue by X%, you admit the building is worth X% less. But by leaving the building X% vacant, also reducing the annual income stream by X%, you and the bank can somehow pretend the building is worth what it would be if full? I doubt owners and banks actually believe this. Is there some policy that forces this?

[zipy124]

The policy is spelled out in the article? Banks have strict regulations that mean they have to have a certain amount of capital backing loans, and by revaluing a building you lower the capital that backs the loan, thus raising its risk, and thus leading you to break the regulation around capital requirements.

[laughing_man]

It's not a question of what the banks believe, but rather what they believe officially. As long as they keep pretending the loss doesn't need to get accounted for.

[nmfisher]

> I doubt owners and banks actually believe this.

I worked for a commercial property company before, and yes this is exactly how it works, and yes it's just as stupid as it sounds.

Margin Call nailed it perfectly:

"It's just money. It's made up. Pieces of papers with pictures on it so we don't have to kill each other just to get something to eat".

[AnthonyMouse]

The argument the article makes is that the bank doesn't want to admit the property is worth less than the mortgage because then they would "have to" foreclose.

The question is, why would they actually do that? The premise is that the landlord has to take out a new mortgage every few years and then the bank won't give them a new one if they're underwater. But that's only true if it's a different bank.

Let's take the same example. Building was expected to be worth $20M, landlord pays $4M down and takes a $16M interest-only mortgage. The only thing the bank ever expected from this was to collect interest on the $16M until it's paid back, which could be never and that's fine as long as they get to keep collecting interest.

Then we find out the building is maybe really only worth $14M. But the landlord is still making the interest payments on the $16M, and over time it will likely become worth more than $16M again due to inflation if nothing else, so why does the bank need to foreclose? The risk that they could "lose $2M" is by that point a sunk cost. It's the thing that happens if they do foreclose (or fail to renew the loan). They'd be calling in the note against an LLC that owns nothing but a building which is now estimated to be worth less than the loan principal. So the obvious thing would be to keep renewing it as long as the landlord continues to make the interest payments.

This feels like some kind of regulatory inefficiency or accounting scam where the bank is listing the mortgage lien as an asset and would have to take a write off if they valued it accurately and therefore transfer their perverse incentive to the landlord to prevent that from happening.

Notice however that doing that also hurts the bank. The landlord is collecting $500k/year at half occupancy, then paying the bank $640k and losing $140k/year to try to avoid the total loss of their $4M initial investment. Maybe they can do that for a year or three but the longer it continues the higher the probability that they run out of money. Whereas if they were collecting the $700k/year from renting out the entire building at lower rents then they could keep paying the bank its $640k/year forever, regardless of whether they're technically underwater. And if the landlord runs out of money then the bank has to take the $2M write off because they get a $14M building instead of collecting interest on a $16M loan. So the bank is really shooting itself in the foot.

[shaftway]

Not if the economy actually does recover, or at least "looks" like it recovered on paper. Inflation helps with that.

The average inflation over the last 10 years has been just north of 3%. If you have tenants today that are paying $500k/year, in 10 years they should be paying almost $700k/year with 50% occupancy. If you can string the bank along for another loan then your valuation is $28M instead of $20M. As the owner you can effectively take money out in this scenario.

If the bank won't refinance at that rate, then you could lower your rents by a bit in the last year. If you lowered your rates back down to $500k/year then you invite a bunch of new tenants, and now you can show high occupancy again.

[AnthonyMouse]

But how does it help the bank to require that? Suppose the landlord lowered rents to raise occupancy so they could get $700k now instead of after several years of inflation. If all goes according to plan then the bank gets its interest payments either way, and then the landlord would be making $900k with full occupancy instead of $700k with half occupancy.

But if the value doesn't recover then the landlord is still only getting $500k while paying $640k at the point when they run out of money to pay their $140k annual loss, and then they default. Which they wouldn't do, even if the value never recovers, if they were allowed to make $700k by lowering rents.

[Nevermark]

The problem is the bank didn’t leave a buffer to meet their requirements, so arbitrage between reality and official reality comes to the rescue.

If a bank only loaned 60% of a buildings value, it could be devalued, the operator would eat the shortfall, but the bank could reappraise, with the loan continuing as before.

[So a regulation setting a banks maximum loan percentage, at a percentage less than they are required to maintain, is an obvious regulatory fix.]

However, another way to look at this from a banks point of view is while they may loan 80%, they might have been happy to loan 100% but for regulations. So perversely, they may not be as concerned about this happening as it appears.

For them, the 80% max loan is already providing a buffer, in terms of the risk they would be happy to take. So if they can avoid acknowledging they have loans that have risen in percentage terms, it is in their business interest to encourage, facilitate, giving operators breathing room.

And in the meantime, inflation, property value growth, and future demand increases provide three statistically “expected” ways for the situation to self-correct over time.

For financial investment products, all value is “expected” value.

And the operator may not be losing money, so much as paying for the buildings accrued value growth. Which would be a wash, but avoids the practical problems of defaults. Not the best, but not losing (as much) money as it appears.

And for the bank, if the loan payments are made there is no problem.

So there are two hidden buffers: banks willingness to loan more than regulators want them to, and natural property value increases, lowering rent prices (i.e. inflation) over time.

[AnthonyMouse]

> The problem is the bank didn’t leave a buffer to meet their requirements

They did though. It was a $20M building and they only loaned out $16M, providing a $4M buffer. It isn't possible to require an amount that the value of the building could never fall below under any circumstances because that would require the loan amount to be zero. It's always possible for the value of the property to crash, e.g. it becomes contaminated with toxic waste and the remediation costs more than the property value, or the area's major employer shuts down and the area becomes a ghost town.

Meanwhile increasing the size of the buffer has costs that can exceed the value of a larger buffer, i.e. fewer people can afford a mortgage, which is both economically bad and not in the interests of the bank who wants to make more loans rather than fewer.

> However, another way to look at this from a banks point of view is while they may loan 80%, they might have been happy to loan 100% but for regulations.

The reason banks require a down payment instead of loaning out 100% of the value of the property is definitely because the banks want the buffer to not be zero.

> And for the bank, if the loan payments are made there is no problem.

But that's the issue. If they prevent the landlord from lowering rents to increase occupancy then they may not be able to make the payments anymore, and then the bank is screwed.

[alper]

The whole goal is not to write off the value of the property which you have to do if you rent it for less money than initially planned. That's not that difficult to understand is it?

[NoboruWataya]

I mean, it's highly unintuitive, which I would say makes it difficult to understand. The main weirdness is that lowering the rent would force a revaluation whereas letting the building sit vacant for an extended period of time apparently would not. If this is truly driven by regulatory capital requirements, then it seems like a gap in the regulations.

Also foreclosure generally isn't the only option: the borrower could, for example, agree to repay part of the loan early, or give extra collateral, both of which would increase the LTV (and this would be better for the bank).

I'm not saying the explanation is wrong, but I don't blame people for finding it difficult to understand. Other factors contributing to this are probably borrower relationships/negotiating strength and the high costs associated with foreclosing.

[grebc]

Banks care that you pay their loan first and foremost, how you do that as the borrower is up to you.

They care about the regulatory requirements in so far as you either meet it, or you don’t at the time of writing a loan. And maybe you get a yearly review.

Also people are looking at this in a very isolated view. Just because a building is vacant doesn’t mean the owner has no other option than just lower the rent. Typically owners of commercial property own multiple properties and various other types of assets. Vacancy rates are also built into calculations.

[bombcar]

That's the missing link on these - the owner is making payments either way - the bank is getting their money.

They don't want to disrupt the flow or trigger contract clauses, so they cover the missing cashflow from elsewhere.

[mlsu]

They are extending loans though. In a normal market, requesting an extension when the bank knows you're underwater should set off some risk alarm bells and trigger a denial. The "normal person" intuition about how loans work is correct here: if I try to refi my house when it's underwater and I've lost my income, the bank denies the refi. That incentivizes me to do what it takes to make the bank whole, or, make the appropriate decision to leave my house and let someone else who can afford it take over payments.

When everyone, the regulator, the operator, and the bank, are whistling a tune, when the whole sector is fucked, everyone has a big problem. How big? About as big as hundreds of buildings in the downtown of every major city sitting half-empty!

That's a pretty big problem. Maybe not as large as 08 but definitely structural. We're all paying indirectly for this office space to sit empty, instead of being able to use it.

[bombcar]

I recommend getting out there and getting involved - it's surprisingly easy to end up talking to the actual owners of these buildings, and they're more often than not just a guy and not some weird conglomerate REIT and they'll make a deal but they'll also tell you what and why - listen!

Capital is weird.

[grebc]

You don’t have knowledge into the borrowers capacity to pay based on a single vacancy.

[alper]

> lowering the rent would force a revaluation

Commercial leases are often for say 5+5 years, so once you lock it in, you know for sure what the property revenue is going to be for the next so many years. Your uncertainty equation has collapsed.

I think the main insight here is that commercial real estate is an entirely different animal than the residences that you may be used to.

You can apply this same reasoning to the "back to the office" pushes done on behalf of the institutional investors who have exposure to large commercial properties in inner cities. That too is a financial house of cards built on assumptions and vibes.

[doctorpangloss]

Nobody said commercial real estate was risk free free money in some abstract financial product, other than the doofus who wrote this long "note." The hard fact is these are real buildings in real places that aren't really fungible at all. So it seems kind of ridiculous that CRE investors should be insulated from every possible externality. Obviously the right thing to do is to tax vacant properties, and then we shall see how many stay vacant and how many foreclosures there are (hint: owners suddenly find capital and are able to pay the tax or rent things out and nothing ever gets foreclosed in every one of these scenarios where it actually happens).

[grebc]

What you’re proposing is a brand new tax just because you don’t like people who play by the rules as written.

Well done. Way to encourage people to not do things.

[scraptor]

The specific proposal is not great but changing the rules is in fact the correct solution of the current rules lead to systematically bad outcomes.

[grebc]

How is it systematically bad? Is there a banking crisis?

[BrenBarn]

Have you heard of this thing called people being happy. . .

[doctorpangloss]

i think you are on the first step of the journey to seeing that neither math nor maximizing $ is the solution to all problems. it's not even the solution to most problems.

[pweaver]

What is being missed is that most commercial leases are much longer term than residential leases. Businesses will want to renovate the space and sign a 10 or 20 year lease. So if you lower the rent by 30% you will really be reducing the income of the building over the long term and face those consequences when refinancing. Landlords will frequently try to rent out unused space to temporary tenants like popups or non profits that they can move in without renovation and kick our on shorter notice to generate some cash-flow and keep the storefront occupied.

[Sohcahtoa82]

> Landlords will frequently try to rent out unused space to temporary tenants like popups

and Spirit Halloween.

[ReptileMan]

Think of it that way - until you haven't climbed on the scale, you haven't gained weight, even if your pants are bursting at the seams.

[GJim]

At some point, you don't need to stand on the scales for it to be obvious you are a fat bastard. Ditto, it's obvious to all that commercial property has lost a huge amount of value.

I suggest that like the dotcom/2008/AI bubbles, people will just keep dancing and making money until reality catches up and the music stops.

[makeitdouble]

Here the bank cares less about annual income than future income.

Keeping it vacant only impact current income, lowering rent impacts future forecasts.

[AnthonyMouse]

> Keeping it vacant only impact current income, lowering rent impacts future forecasts.

Does it though? Suppose you can't find a tenant right now because the market is soft but is predicted to improve in a few years. If you leave the unit vacant, you lose money right now. If you rent it out with e.g. a 3-year lease, you make more for the next 3 years than you would with a vacancy, and if the market price has increased by then you can increase the rent on the unit and either get it from the current occupant or the one you get to replace them in the high demand market when the higher rent causes the low-paying tenant to not renew the lease.

So taking a tenant now only improves prospects (you fill a current vacancy) with no negative impact on future returns. The only thing it does is imply that current rents are lower than before and future rents might be too, but a vacancy implies that even more strongly.

[fl4regun]

it's because the expected future income is based on what current tenants are paying, extrapolated to the number of units in the building, ignoring vacancies. I get what you are saying, it should be based on total rental income from the building - full stop - but that isn't how it is done, and this is the result.

Simply stated, if you rent a new unit for 25% lower, then the value of the building just dropped 25%. If you don't rent to a new tenant, your value must be the same, that's what the existing tenants are paying (not that I agree with this, it's just how it works right now).

It's similar to how people holding low liquidity assets will claim they are "worth" whatever the last person who paid for this assert, even if the real value of it is dropped, the "book value" is still sky high.

[jamilton]

Why do banks calculate it that way? Do they all do it that way, is it legally compelled? It seems obviously incorrect.

[AnthonyMouse]

> but that isn't how it is done, and this is the result.

And the result is dumb, which is the point. The bank should stop doing that if they don't want to cause problems for themselves.

Review again how this works. The landlord put in $4M and the bank $16M on what was supposed to be a $20M building. They can't find enough tenants, which means in real life it's only worth $14M and the incumbent system is for everybody to pretend that isn't the case when it really is.

As a result, the landlord is collecting $500k in net rent instead of the $700k they could get by lowering rents and getting more tenants, while paying the bank $640k/year in interest. The landlord does this because if the value of the building eventually recovers then they don't lose their initial $4M investment, whereas if they hand over the keys to the bank it's definitely gone. And even if that money was gone, they'd still want to keep operating the building if they were at least turning any annual profit instead of making continuous losses.

This is bad for the landlord (they lose $140k/year instead of making $60k/year) and it's even worse for the bank, because now if the landlord runs out of cash or concludes the value of the building isn't going to recover, the bank has to eat a $2M loss by foreclosing instead of continuing to collect $640k in interest every year, which they could have done indefinitely if the landlord was allowed to keep renewing the loan while making more money by lowering rents and increasing occupancy.

Worse, this is happening at scale. If landlords could lower rents without getting foreclosed on then banks would keep getting their interest payments until inflation catches up to the nominal amount of the mortgage. But if the landlords are required to keep taking a loss, they eventually start to give up -- the article implies that they don't want to give up until the annual loss eats the original $4M, but it really happens as soon as they think the value of the building isn't going to recover. But that's only a problem for the bank if they default on the mortgage, which they do if keeping it makes them lose $140k/year but not if it's still earning them $60k/year. And that's especially a problem for the banks if it happens not just at all but all at once.

[amenhotep]

That's the trick, isn't it, though? Rationally it's especially a problem if it happens all at once, but realistically if your bank has an awful quarter then you're at fault whereas if every bank has an awful quarter then no one's at fault, it's a systemic issue, chances are you get to collect a bail out and keep going. It's a sort of prisoner's dilemma, a critical mass of banks needs to defect and each individual bank's incentive is to cooperate.

[fl4regun]

I'm not defending the status quo, I'm just laying out how it is. I think it's stupid too.

[charcircuit]

If you let a family member move in for free that doesn't make the value of the building go to $0. That valuation strategy is too simplistic.

[Nemi]

Prices are set at the margins

[bandrami]

Humans are not Pareto efficient.

If my wife and I are at the airport, and the gate agent offers me (and only me) an upgrade on the flight, your logic says I should take it since that's strictly better than both of us flying economy.

[jen20]

> If my wife and I are at the airport, and the gate agent offers me (and only me) an upgrade on the flight, your logic says I should take it since that's strictly better than both of us flying economy.

This has happened many times to me - the answer is to take it and give the upgrade to your traveling companion if you are the one who flies a lot.

[larubbio]

This happened on the flight to my honeymoon, and my wife took the upgrade.

[senordevnyc]

I assume you mean your ex-wife? ;)

Jk of course

[schlipity]

You should take it and then switch seats with your wife. Happy wife, happy life.

[makeitdouble]

> Happy wife, happy life.

Why wouldn't that happy cycle work with the husband ?

[canucker2016]

In the USA, women initiate divorce proceedings ~70% of the time. see https://www.bbc.com/worklife/article/20220511-why-women-file...

[theowaway]

haha

[vel0city]

From a Christian perspective:

> Husbands, love your wives, just as Christ loved the church and gave himself up for her...In this same way, husbands ought to love their wives as their own bodies. He who loves his wife loves himself

Too many people ignore this part of that "submit yourselves to your husbands" quote.

For those of us who think of themselves as Christian, I think sitting in a less comfortable seat is probably small potatoes to what Christ did on the cross.

Just throwing out some biblical ideas here. I know there are a lot of other perspectives.

[AnthonyMouse]

Business tenants know perfectly well that when it comes time to renew a commercial lease and local rents have increased, the renewal rent is going to approximate the current market price.

The landlord doesn't want you to to leave but only to the extent that finding a new tenant costs more than the discount against the current market price they'd have to give you to stay.

[jfengel]

A three year lease locks in the lower revenue. If the market recovers tomorrow you can have the full price for nearly as long.

But I'm not convinced the risk-reward calculation fully explains it. You can see plenty of places where they know full well it's not going to rent at the price they're asking. I think there are other factors, including not letting your other high-lease tenants think that they're now occupying a low-rent establishment.

Your jewelry store would rather not suddenly be next to a cheapo nail salon. And if you've got a third property to lease, the high-fashion brand looking at it will see the nail salon and move on.

[fdgfikgfv]

This is the same reason in housing market where landlords let their property sit empty instead of accepting lower rent. There is a perception that lower rents attract problem tenants and it’s not worth the headache even if that means losing money.

[makeitdouble]

> Does it though? Suppose you can't find a tenant right now because the market is soft but is predicted to improve in a few years.

You'd need perfect information to make a contractual decision on that, and it still has lasting effects.

For instance imagine renting your floors to Pornhub for these 3 years on the cheap because the market it low. Assuming you made the right calculation and demand recovers 3 years later, you'll have to first kick out the company (= months spent restoring it), then try to convince the insurance company that eyes at your building that they should pay a hiked price to move into Pornhub's previous floors.

And that's assuming you haven't completely blown it where the market actually recovers within 6 months for reasons nobody anticipated.

[grebc]

How you think about it is different to how the multiple different players think about it.

If you’re levered up to the eyeballs you don’t want your bank reviewing your file.

[nitwit005]

But that just means the bank is creating deliberately delusional forecasts.

I can build a building that charges a billion dollars a month rent, and sits completely empty. A forecast suggestion I'll be making hundreds of billions with no renters is clearly silly.

[grebc]

You’re paying the loan, go for it son.

[nitwit005]

I commented about the logic of the bank's forecasting. Your response doesn't make sense in that context.

[grebc]

Your fictional scenario doesn’t make sense either? Why should it warrant a serious reply.

[postepowanieadm]

How do you asses the value? You use the x last transactions. No transactions, no data, the last value remains.

[AnthonyMouse]

"Last value" is pretty meaningless when it's stale though.

Suppose there is a building that was built in 1970, last rented out in 1975 and then bought by a company that has used it as their own offices until now. The last transaction was in 1975, what's the value if they apply for a mortgage today? Surely they have some formula to use for this based on e.g. other buildings in the area.

Moreover, "failure to find a tenant" is also a type of transaction. It's the landlord acting as the high bidder for the space, essentially the involuntary edition of imputed rent, and implies something negative about the financial prospects of the building when it continues for a significant period of time or large percentage of units. Ignoring that it is either incompetence or some kind of perverse incentive.

[embedding-shape]

> "Last value" is pretty meaningless when it's stale though.

For who and in what way though? Every entity involved wants to keep the price high, except the renter/new buyer, so with that in mind, "Last Value" seems optimal for achieving that.

Maybe it's different in the US, but in Spain there is a ton of properties that sit completely empty and unused, even since earlier than 2008, just because the owners don't think the value is enough to sell yet, and they wouldn't earn enough renting it out, so everyone (except renters/new buyers) seems to prefer it just sits empty for decades.

[AnthonyMouse]

> For who and in what way though?

For anyone who wants an accurate accounting.

Suppose the building is supposed to be worth $20M, has an existing $10M mortgage and is actually only worth $10M. The landlord comes to you and wants to borrow another $5M against the building. Pretty important to the lender at this point that they're not overvaluing it, right? Or the same if they go to a different bank trying to refinance an existing mortgage they're already underwater on when using an accurate accounting.

[grebc]

Commercial borrowers have to pay for a valuation report by a bank approved valuer.

[AnthonyMouse]

Then why does anybody care if they rent out some of the units for a lower rent?

[PaulHoule]

... who therefore agree with the assumptions of this broken system.

[bluedino]

There are buildings in my town that haven't been used in 20-30 years. And that's in the 'modern' shopping area. In the old 'downtown' area there are some that have been empty for 40+ years.

[throwburn202605]

There's a building near my office. Never technically finished so empty for 10+ years. I believe the two owners had a disagreement.

One day a crew turns up and starts jack hammering away a gangway. Its technically now two buildings; one of them is still unfinished and empty, the other has now been finished and is up for rent.

In terms of my utility I would prefer things renovated, changed, or rented out to funky things than have ghastly empty buildings

[wewtyflakes]

This sounds like the worst case outcome for society; real estate permanently allotted to some entity that chooses not to use it. It is not an envious model; it is a model that should be eliminated.

[arcza]

If a coffee shop is charging $25 for a latte and sells none, we don't say everything's fine because no sales data. The sales are $0 and it's not fine.

There is no escaping the powers of supply and demand.

[lotsofpulp]

“You” require a continuous analysis of cash flow to continuously determine value, and proper management. A simple, and common, requirement in commercial lending called the debt service coverage ratio.

https://www.investopedia.com/terms/d/dscr.asp

Lower income for the building means lower numerator, which means being unable to meet the agreed upon DSCR, which means default. Whether or not the lender acts on this default is a separate matter, as they are usually loathe to get into the property management business, but renegotiation of terms and eventually foreclosure does happen.

[senordevnyc]

Agreed. From the article:

Actual commercial real estate professionals could give you many more reasons than I can

I am so tired of listening to people with little to no experience with commercial real estate try and explain the vacant storefront thing. Maybe this explanation in the article is correct, but it raises more questions than it answers, and it’s unclear why we should trust this person’s explanation.

[em-bee]

do you have a better explanation?

[probably_wrong]

It's on the person who willingly took the public stage to prove that their ideas have merit.

I don't know much about microbiology, but that shouldn't stop me from asking someone who "did their own research" to shut up and let the experts talk.

[em-bee]

they already gave their explanation. if you disagree then it is on you to provide a counter argument otherwise anyone could just shoot down any argument by claiming that it has no merit.

at best you could say that you do not find the argument convincing, but even then you should explain why. you are not even claiming that the argument in question is wrong, you are only questioning the credentials of the author. that's appeal to authority, and therefore not a valid argument. https://youtu.be/N5k4yUSPHI8

I don't know much about microbiology, but that shouldn't stop me from asking someone who "did their own research" to shut up and let the experts talk.

yes it should, unless you can provide a convincing argument that the person is wrong, expert or not.

on the internet anyone can claim to be an expert and nobody can prove it.

[senordevnyc]

I’m agreeing with the person I first responded to about why I don’t find this explanation credible. I don’t feel the need to reiterate what they said.

AND I’m also saying I’m tired of non-experts giving their theories on this particular phenomenon, since they never make much sense.