Real Estate “Doom Loops”


Brian D. Milovich

Managing Principal, Calvera Partners

A doom loop sounds pretty ominous. Recently, it’s been used by the Wall Street Journal to describe issues in San Francisco as well as the banking industry. For cities like San Francisco, the WSJ article says a doom loop happens when “tax revenue falls, services suffer, businesses close and disorder moves in. Residents leave, commuters and shoppers stay away and the cycle is self-reinforcing.” Regarding banking, the WSJ describes it as “where losses on loans trigger banks to cut lending, which leads to further drops in property prices and yet more losses.” Are certain markets stuck in a doom loop and is commercial real estate in a broader sense headed in that direction?

Personally, I don’t believe San Francisco is spiraling beyond repair. While it will likely experience more short-term pain, the natural benefits of the Bay Area will never go out of style—unique architecture, the Pacific Ocean, wine country, elite universities, the Golden Gate Bridge, access to skiing in Lake Tahoe, temperate climate, and much more. Places like Detroit, which is said to have entered its own urban doom loop in the 1970s, don’t have the natural benefits to buttress it in times of severe stress. People want to be in San Francisco, but the reason to come back isn’t there yet.

The recent exodus of people and business from San Francisco and rise in retail theft and disorder is to blame for the high-profile closure of Nordstrom and the distress of the Westfield shopping center it once occupied. It’s difficult to watch previously vibrant places throw in the towel, but it’s worse to see politicians try to spin this as an “opportunity” to “reinvent” the space in the “new normal” of the “post-Covid” world we now live in. If public policy and those entrusted to make San Francisco actually work continue to fail, the doom loop could intensify. To me, though, it’s just a matter of time before the pendulum swings back to something just left of common sense (it is San Francisco after all) and market forces push San Francisco on an upward trajectory again. I find it difficult to be optimistic over the next few years, but long-term, as there are structural issues to overcome, it has to come back in some form.

San Francisco and a handful of similarly ailing cities seem to be one-off occurrences. A doom loop related to the broader real estate market is a different and much larger issue. Values are down 20-30% in apartments and even more so for office buildings. Aside from a handful of noteworthy distressed apartment operators like Veritas in San Francisco and Tides in the southwest, the distress hasn’t been widespread just yet. A recent report in the Wall Street Journal noted that there’s an 11% difference in pricing between buyers and sellers of apartments, the largest among the major real estate asset classes, leading to the greatest drop in transactions in decades. Deals aren’t getting done and owners are trying to hang on. If they’re hanging on, they’re finding a way to make their debt payments and are helping to stave off an apartment doom loop.

Today, we are seeing apartment deals where there’s no equity left for the seller. We like some of them, but the lender would have to sell it to us directly or it would have to be a short sale. Those deals are not transacting because the debt service continues to be paid to avoid a lender takeover. Once time runs out on these deals, lenders will end up taking losses, and the doom cycle could start. It’s not like real estate lending is robust at the moment anyway. The agencies (Fannie Mae, Freddie Mac) are really the only game in town for apartments as they have the best rates and terms. Regional banks, if they’re still lending, are not competitive. Like San Francisco with its natural attributes, the apartment market in particular has its own buttress—significant dry powder. There is a lot of investment capital on the sidelines. This is why deals are still getting done today at a 5% cap rate when interest rates are at 6%, creating negative leverage. There’s a huge wave of money that needs a home, and when the levee breaks on the cap rate versus interest rate dynamic, excess capital will keep the multifamily market afloat from the dreaded doom loop.

More distress is to come in certain metro areas and in the overall apartment market. How deep the distress becomes remains to be seen as there has already been a substantial reset in pricing, both from interest rate increases and lackluster urban recoveries. What we would like to see is a return to a rational market where positive leverage is normal and rent assumptions more closely mirror inflation and historical averages. Also, a market where there’s a real return on investment for quality renovations and where one can find cost-saving operating efficiencies instead of another ancillary fee for tenants. The market and some metros are in transition. More short-term pain is coming, and we’re ready for it.


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