WeWork’s lessons for US real estate

When it comes to cautionary global business tales, all roads seem to lead to WeWork. I have been thinking about the short-term office space company, and not only because of the lawsuit some of its board members issued last week against investor SoftBank over its decision to pull out of a share buyout.

What is striking is the broader lessons WeWork’s travails provide — especially for a post-Covid-19 world. Among them: debt matters; corporate valuations were unsustainable even before the crisis; nobody is going to be rushing to lease office space anytime soon; and real estate in many parts of both the residential and commercial sectors has far, far further to fall.

The coronavirus pandemic has triggered a corporate debt crisis that has been long coming. WeWork epitomises the excess that led to this crash. Its troubles also offer a hint of what is still to come — namely a long period of falling property prices in prime global cities in North America and parts of Europe, as the second big global real estate bubble of this millennium deflates.

Much has been written about how Covid-19 will reshape travel, tourism and retail. Less has been said about what it will mean for real estate. But this sector plays a far greater role in the global economy than the former two.

The value of global real estate is more than all the world’s stocks and bonds combined. It’s also a key growth driver. Construction in all areas of real estate in the US, for example, accounted for 18.1 per cent of gross domestic product in 2019. Unfortunately, what we are seeing in many parts of the global real estate market right now is an explosive combination of oversupply, under-demand, and the very worst aspects of financialisation.

Let’s start with supply, focusing in particular on the US, where prime markets were overbuilt and starting to trend downwards even before the pandemic struck. Low interest rates fuelled a bubble in commercial real estate in particular. Since the aftermath of the 2008 financial crisis, prices had more than doubled, and the US Federal Reserve was warning about froth.

In the US, the bubble was most pronounced in digital centres, where an increasing amount of wealth and job growth has been concentrated. This is exactly the market fed by WeWork, which the president of the Boston Federal Reserve, Eric Rosengren, flagged last year for its role in exacerbating the property bubble. The WeWork business model, which relied on a lot of short-term financing but also long-term lending commitments, was an eerie throwback to problems within the banking sector during the subprime crisis.

The demand side of real estate was becoming problematic too, even before Covid-19 hit. The US-China trade war had driven away many overseas participants in both the commercial and high-end residential markets.

This came as landlords, not only in the US but many other countries too, were already struggling thanks to the rise of ecommerce, which has hurt retail tenants. That shift to the virtual world will now be put on steroids by national lockdowns in response to Covid-19.

For landlords, rent growth is correlated to job growth. We will not be seeing either for some time. Meanwhile, home buying among younger Americans, already constrained by debt and underemployment before the crisis, will be even more so. Even when the recovery begins, companies that can will replace as many laid off workers as possible with software. Some will realise that work at home arrangements during the pandemic were more productive and climate friendly. This will be more reason not to lease space in expensive cities — although it might support residential buying among the small group of high-end workers who have job security.

The result of Covid-19 will be to exacerbate both the wealth divide and the politics that surround it. That may reshape the regulatory landscape in real estate. The people most affected by the virus are poor, and in terms of economic impact, young. Bernie Sanders may be officially out of the Democratic presidential primary race. But his supporters will still be inclined to elect local and state governments that will raise taxes on large, and rich property owners and reshape zoning laws to create more affordable housing. That may be good for society but it will also put pressure on profit margins and valuations, at least in the short term.

The deflation we are likely to see for the next few years as the result of this downturn will be yet another challenge for real estate, across the board. Deflation and low interest rates will allow some buyers to scoop up property on the cheap. But deflation means lower prices, lower incomes and less buying power. That may well translate into higher borrowing costs for many companies as markets realise the depth of the trouble they are in. Consider how the pandemic has already pushed “blue-chip” companies, such as Ford and Kraft Heinz, into junk bond territory.

A multitude of debt-ridden zombie firms will go bust, leaving still fewer tenants to fill the empty office buildings. Highly leveraged hotel developers and individual mortgage borrowers will beg for government aid. Financial assets underwritten by mortgage debt will start to go bad, exacerbating the default cycle. Credit will be hard to come by. Cash will be king. It’s the WeWork lesson, writ large.

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