Despite recent conversations around phasing out shelter-in-place constraints, pundits are still discussing the possibility of a protracted economic downturn on par with the Great Depression. While at first glance such discussions may seem unduly negative, from a policy perspective, the heavy lifting still awaits because it may not be possible to just “switch” the economy back on by lifting workplace constraints. Aside from consumer demand shifts resulting from the pandemic, even small changes in resource utilization can have complex dynamic influences on local economic growth going forward.
For example, consider a reopening with (demand-driven or policy-driven) capacity constraints on commercial property occupancy so that offices, hotels, and restaurants are restricted to a fraction of previous occupancy. With fewer employees and/or customers per square foot, revenue per square foot is constrained.
In such a case, either rent per square foot may be reduced or revenue per person may have to rise for pre-COVID equilibria to return. The dominant strategy for lessees and landlords, however, will vary with each market’s capacity to either dilute rent or otherwise increase productivity. In markets with high commercial property vacancy rates like Dallas-Fort Worth or Minneapolis-St. Paul, landlords may choose to rent out vacant space previously earning zero dollars for a positive return at below-market rates, thereby reducing vacancy rates and concurrently reducing the effective blended per square foot rate to the lessor. Investors in such properties may profit, despite adverse economic performance elsewhere in the country, and perhaps in the aggregate. In contrast, market regions with low vacancy rates like in the Bay Area or Manhattan may not have the capacity to adjust similarly, so that firms in these locations are forced to try to drive up their own productivity or else they may be forced to consider relocating. Of course, the departing firms in the low-vacancy regions will reduce demand so that vacancy rates may rise in such previously constrained areas, leading to the opportunity for landlords to blend rates downward as in other high-vacancy regions.
The complex dynamic will play out over time and be driven by the depth of the regional variations of COVID-19 impact. The table below identifies metropolitan markets with the lowest and highest commercial office vacancy rates:1
Markets such as Seattle and Manhattan, where COVID-19’s public health toll has been large and vacancy rates are low, may see least occupancy response effects whereas in other markets, slackness in the office markets may provide opportunities for vacant properties to resume revenue generation.
Those business adjustments, however, may take three to five years, or even more than ten years. Even envisioning that capacity constraints lift after one to two years when a vaccine is developed, that additional reversal may lead to even more complex economic dynamics.
Such complexities should come as no surprise. As the US economy emerged from the Great Depression, economists and policymakers struggled to understand why the economy did not launch much faster when the Reconstruction Finance Corporation and the Fed were clearly providing substantial credit and capital. A general understanding eventually emerged that persistent imbalances remained across industries and regions that inhibited growth on an aggregate level. Probably the most famous of those efforts were two studies seeking to disentangle the effects of loan supply from loan demand. Both studies concluded, in part, that firms demanding credit were not necessarily good risks, and firms that were good risks did not really need much credit. The conundrums of growth lasted at least until the start of WWII, at which time global attention shifted from Depression recovery to war production, never really looking back at the issues until many years later. While the conundrums have never really been solved, we nevertheless face these challenges again today.
1CBRE Q4 2019 US Office Figures Report.