Could Boston face an ‘urban doom loop’?
Office vacancies at record levels could portend threat to municipal finances
AT FIRST, the emptying out of downtown Boston office buildings looked like a seismic, but temporary, reaction to a once-in-a-hundred-year pandemic. Once we got a handle on the mysterious new virus ravaging the globe, the initial thinking went, things would more or less return to normal.
But we are now coming to terms with a new normal that is decidedly different from the “before times,” with no sign of a return to the work patterns of pre-pandemic life.
“I think now it’s pretty safe to say, three years into this, that we are not going to see what we saw in 2019, with five days a week in the office,” said Tamara Small, CEO of NAIOP Massachusetts, the trade group representing commercial property owners in the state. Work-from-home and hybrid are here to stay, with some workers remaining entirely remote while lots of others are heading into offices only two or three days per week.
What that means for major cities like Boston is still very much in flux. But some prognosticators see very rough days ahead, with half-empty buildings in Boston that could make for a very different city than one that’s been on a decades-long boom.
In a paper released in November, Van Nieuwerburgh warned that this scenario could set off a vicious cycle that he dubbed an “urban doom loop,” which could precipitate a municipal financial crisis. Cities are facing “certainly in the short run a pretty rocky ride,” Van Nieuwerburgh said in an interview. “And in the long run a potentially painful transition where a good chunk of office space will need to get converted to other use.”
While Boston officials are taking stock of the need to think and plan differently when it comes to the vitality of downtown streets, they insist that the city’s taxing structure means it does not face the kind of dire revenue constraints that other US cities might have to contend with.
At the end of 2022, the office vacancy rate in Boston stood at 17.6 percent, “the highest on record,” said Jeffrey Myers, research director in the Boston office of the real estate firm Colliers. That figure masks an even bigger problem in Class B office space, where the vacancy rate was a whopping 23.6 percent. In more desirable Class A space, generally in newer towers with higher-end amenities, the vacancy rate stood at 15.5 percent.
If downtown Boston’s streets remain eerily quiet it’s because the amount of vacant space on the market represents only a fraction of the office suites that are actually empty in buildings.
Occupancy rates on any given day in Boston office buildings are just 30 to 50 percent, said Tyler McGrail, executive managing director of the Boston office of the commercial real estate firm Newmark, during a market forecast presentation last month sponsored by NAIOP. A recent city report said downtown foot traffic is 55 percent below its pre-pandemic levels.
A good chunk of the empty downtown Boston office space is still under lease, with commercial tenants typically signing leases ranging from 5 to 7 years. That means owners are continuing to collect rent from leases signed before the pandemic in what are now half-empty buildings. But that is only delaying the day of reckoning with the new work patterns that could see companies dramatically downsize their office footprint when it comes time to sign new leases.
McGrail said a lot of commercial leases in Boston are due to expire this year, a period that coincides with what he said will also be a “record level of debt maturities” – when final payments come due on loans building owners got to finance purchase of commercial property.
Small, the NAIOP CEO, said there are mounting concerns among owners of Class B buildings in Boston about their ability to stay afloat with high vacancy rates and lowered rents. “There’s going to be a point where the cash flow can’t support the mortgage,” she said. “There may be cases where the building owners literally have to hand the keys over to the banks.”
Gary Kerr, managing director of the Northeast region for the real estate firm Greystar, said the problems will be particularly acute for buildings with loans coming due. “I think there’s going to be a massive problem securing refinance debt,” he said. “A lender is going to say, ‘I’m not going to give you more debt on an empty building.’ That’s going to lead to a place where values start to fall. If you can’t lease it and you can’t get a loan on it, It’s worthless. It’s potentially worth the dirt it’s on at that point.”
Van Nieuwerburgh and two colleagues have estimated a long-term decline of 39 percent in the value of New York City office buildings. While the exact impact in other cities will vary, he said most other major markets will be hit hard and that a decrease of 30 to 35 percent in office building values in Boston seems plausible.
Boston’s assessing commissioner, Nicholas Ariniello, said the issue of long-term office vacancies “is something that we’re trying to keep our finger on.” He acknowledged that a lot of currently leased space will be coming up for renewal under very changed circumstances. “The part that we don’t know yet is how that’s going to play out,” he said.
McGrail, the Newmark manager, said in his market forecast last month that “concessions” of 20 to 30 percent are being offered in some Boston buildings where leases are up. Those kinds of changes in the office market dynamics make it difficult to predict vacancy trends, Ariniello said, as lowered rents “could create opportunities for firms that could not afford to be in Boston before.” In October, the city issued a report on strategies to revive downtown in the wake of the pandemic, including consideration of direct rent subsidies to organizations to move into vacant downtown space as well as possible tax incentives to building owners who lease to small businesses.
Of course, building owners who make a dent in high vacancy rates by significantly lowering rents will face a squeeze on their operating margins, and decreased revenue generation from buildings will factor directly into property assessments.
Property tax accounts for three-quarters of the revenue funding Boston’s $4 billion annual budget, and commercial property carries the major load of that, accounting for roughly 60 percent of the tax levy compared to 40 percent from residential taxpayers. Ariniello said that heavy reliance on property tax has insulated Boston from the sudden impact of the pandemic felt by cities with local income or sales taxes.
The effect of sustained commercial office vacancies on property values in Boston is likely to be at least a couple of years away. That’s because the city’s assessing system is, in Ariniello’s words, “backwards looking.” The assessments and tax bills going out this month are based on market activity and the revenue-generating capacity of buildings in 2021, a period when most space was leased even if not fully occupied.
But even when assessments catch up with the depressed state of the office real estate market, it will not mean a sudden hit to municipal revenue and squeeze on city services, Ariniello said. The city can maintain or increase the total amount it collects in property taxes each year by raising the tax rate – the amount of tax owed per $1,000 of value – if assessed values fall, he said.
If Class B office values fall sharply, those buildings would still see a drop in their tax bills under a higher tax rate. Maintaining the same level of tax revenue for city coffers, however, would mean pushing more of the commercial tax burden onto Class A buildings, even if their assessed values haven’t gone up. “There is a rebalancing,” Ariniello said of such a scenario. The other option would be to shift more of the load onto residential taxpayers, something elected officials would probably only do reluctantly, given that those residents form the core of the city’s most reliable voters.
Boston could face a fiscal squeeze under the Proposition 2½ state tax-cap law, but it would take a huge hit to property values to trigger that. Under Proposition 2½, a city or town’s total levy – the amount it collects from all property taxes – cannot exceed 2.5 percent of the total value of those assets. Boston’s current tax revenue represents about 1.4 percent of overall property value “and as such it is unlikely that the levy ceiling will come into play in the near future,” said Ashley Groffenberger, the city’s chief financial officer, in a statement.
The picture for the office market in Boston is in many ways a tale of two clashing city trends. The dire situation that may soon face some Boston building owners is playing out as millions of square feet of space in gleaming new office towers continue to come on line. In a pattern described in the real estate world as a “flight to quality,” these new buildings are filling up even as Class B space goes wanting.
A prime example is the new 600-foot skyscraper at One Congress Street, between North Station and Government Center. With 1 million square feet of space, it is “being delivered fully leased,” said Tom O’Brien, chief executive of HYM Investments, the building’s developer.
Promotional materials say it is “more than an office building, it is an oasis in the center of the city.” The building will feature an outdoor roof garden, 30,000 square feet of “fitness, wellness, food, and beverage offerings,” as well as a bicycle storage and underground parking.
O’Brien said the phrase going around among leaders in the business community is “we have to earn the commute” with amenities and perks that make employees feel “I want to be in the office.”
When it comes to the Class B office space where the vacancy problem is centered, Boston has already seen some of the repurposing of office space experts say will be necessary. The city has benefited enormously from the region being a major global hub of life sciences, with millions of square feet of vacant office space that has undergone conversion to lab space since the pandemic’s onset. But the pace of such conversations is not expected to continue in 2023, said McGrail, the Newmark manager, in his market forecast last month.
“I think we have to be very mindful of what that means for the market,” McGrail said.
Along with raising the idea of rent subsidies or tax incentives for building owners, the city report issued in October on strategies for downtown revitalization touted the conversion of excess office space to residential units as a promising idea. Earlier this month, the Boston Planning and Development Agency approved a $100,000 contract to have HR&A Advisors, a New York real estate consulting firm, carry out an analysis of the opportunities for conversion of office space to residential and other uses.
The idea is appealing, especially given the continued high demand for housing in Greater Boston, but residential conversions are unlikely to make a major dent in the problem. There are lots of challenges involved, given the floorplate of buildings, zoning issues governing residential construction, and the costs that would be involved. In an analysis by the design firm Gensler, which looked at 300 buildings across several markets in North America, just 30 percent of them were deemed suitable for exploring residential conversation. In Boston, that figure was even lower, with just 12 percent of the downtown buildings the report looked at – 10 out of 84 properties – rated as viable candidates for residential conversion.
“That repurposing is not going to be easy,” said Van Nieuwerburgh, the Columbia business school professor. “A lot of office space is not well-suited to other uses or very expensive to convert.”
“I don’t think we’ve reached the bottom yet,” said Myers, the Colliers research director, of the office vacancy crisis. “If you’re a Class B landlord, there’s no quick solution.”
Boston’s tax structure may cushion it from the worst of the “urban doom loop” Van Nieuwerburgh warns of. But like many US cities, it is undoubtedly facing some serious headwinds.“It’s a bad situation, needless to say,” said Small, the NAIOP chief executive. “All these things are starting to bubble up, and 2023 is going to be a very tough year for the office sector.”