Why do commercial spaces sit vacant?

We need land value tax bad [1]

In Los Angeles I’ve watched business after business close because their rent was increased by their commercial landlord only for the property to sit vacant in some cases (no exaggeration) for over 5 years!

Thats absurd. Also as a business owner who would like some space to work out of your only options are endless swaths of vacant industrial buildings that are tens of thousands in rent a month. I don’t quite get how anyone runs a brick and mortar or has space to do anything profitable.

[1] https://en.wikipedia.org/wiki/Land_value_tax

Interesting, but It doesn't answer why a bank would hold a completely vacant building for 15 years.

I think we need Vacancy taxes that go up based on the percentage of time vacant over different spans of time. Anything that makes owning an empty building a bad investment in all circumstances. This needs to apply to all units in a multitenant building.

  why a bank would hold a completely vacant building for 15 years.

A problem is that the externalities of leaving a space vacant are not priced in. Having a bunch of storefront vacant in an area makes it much less appealing and devalues all the other properties surrounding it. It does seem like a vacant storefront tax, which is briefly mentioned at the end of the article, could address this, if partially.

This whole extend and pretend deal seems like it's simply accumulating risk hoping this will pass, while risking an even bigger, potentially systemic crash. Though I honestly don't know that much about the commercial finance world.

TFA seems to claim that the benefits of "nice buildings" outweigh the externalities of desolate, character-less street levels in cities. It doesn't seem very on brand for Strong Towns.

This phenomenon is going on in the downtown of my city - decreased foot traffic leads to tenants leaving, and the cycle continues. It's a miserable place to live or work that basically becomes a ghost town at 5pm. They're trying to do some office-to-residential conversions, but they're not very desirable because the entire neighborhood feels hollow and abandoned.

Instead of delaying these defaults and accumulating systemic risk until there's a massive correction, someone should be enforcing accounting that marks to market the actual rental value. That would force banks to be honest about the real level of risk on their balance sheets.

It always bothered me that certain things are not marked to market. It's pretty much the point of financializing the economy, that you can then get a current value for things, instead of being able to pretend everything is fine.

The problem is that if you don't update values continuously, you are surprised when you finally are forced to. Some stock on the public market that isn't doing well goes from 100 to 90, 80, 70... etc, and people thinking about the stock have to make decisions accordingly.

A private loan against that business can sit at 100 until the company decides it can't pay, and suddenly the loan is worth 20.

> If [a vacant storefront tax] “worked,” the mechanism would be to force a lot of commercial property to default, which could put a lot of new space on the market at lower prices, which should lower the commercial rent. But it would also hurt the banks a lot, which has a history of leading to bad consequences and subsequent bailouts.

Sounds like the right trade-off to me. Let the banks get hurt for the pain that's coming to them for making a loan on an asset that declined in value, let's see if it actually causes bank bankruptcy, then let's consider bailouts. Because letting balance sheets express a lie about financial health is preferable somehow? Letting pressure continue to build until commercial property owners can't cover interest payments is preferable?

Ideally, commercial development would be done by publicly-owned companies. Instead of renting, sell the storefront for a pittance to a mom-and-pop owner operator, conditioned on occupancy and using it for primary income. If occupancy is forfeited, then sell it to a new mom-and-pop.

Selling instead of renting means there are no rent increases. You go back to having local stores that have been open for 40+ years that have a real relationship with the surrounding community. You make it possible for young chefs to get a restaurant space to prove their mettle without needing to cozy up to some wealthy financier who then sucks away most of the income. You make it possible for young people to start new independent businesses without a mortgage on their future, which helps them invest further in their surrounding community. Being able to buy cheap storefront space is what made the American Dream possible for so many immigrants to America and built the largest middle class in the world.

Something that's not addressed is how this situation plays out for 5-over-1 development[1] that's becoming the norm (or other mixed-use buildings).

Basically, the buildings cashflow solely on the residential, but the commercial space is/was valued optimistically (especially leading up to the 2020 pandemic). So a building's owner isn't in a financial bind, and if they were to lower rent on the commercial space, even if they didn't lose the building, it would be much harder to refinance the next time their loan matured. (Commercial loans are frequently "balloon" loans that have payments like they're amortizing over 30 years, but they mature before then, meaning the borrower either has to pay the remaining amount of the loan, or refinance.)

Possible Solution:

I've been thinking about a cumulative vacancy tax that increases every year a space is vacant (and decreases for every year it's occupied). So a building owner or loan underwriter could project when a vacancy would become more costly than lowering rent.

You could charge the tax on the assessed value of the vacant space. Increase it by 100 basis points for every year that a space is vacant. Decrease it by 200 basis points for every year that it's rented.

1: https://en.wikipedia.org/wiki/5-over-1

If you can pretend that 50% occupancy @ $500k per year total rent is a temporary market slump, why can't you also pretend that 100% occupancy at $700k in rent is also a temporary market slump?

Living in SoCal, I almost always prefer to order online. Most local businesses are losing to their e-commerce competitors; no wonder commercial spaces are empty.

I have a side business of a small e-commerce shop. I would consider having physical space just for the sake of luxury, but now I would rather spend that monthly rent on marketing online rather than paying for physical space.

IMHO, that's what is happening. Bank problems or anything else are secondary; if it were profitable to be at the physical location for the businesses, other factors would vanish.

In the current world isn’t the “downtown parking lot” situation more common? Where the value of the asset is increasing so quickly year over year, that locking in a contract right now for x years mean forfeiting the increases of future years - meaning the value of your asset is more when vacant than when rented/built on? IE why sell my parking lot this year for $5M when I’m 2 years it will be worth $7M, so I’m better off waiting and taking no income for the next two years as opposed to taking $5M and investing it.

Okay, the problem is ultimately that banks are constrained in the Loan-To-Value ratio they can have, but the value is something they can arbitrarily determine. They're incentivised to make the loan, and the person buying the property is also incentivised to do this, so they use the lever they have: they make up the value such that the loan can be made.

Perhaps if we split off commercial lending arms, allowed them unbounded LTVs, and then allowed them to fail we would get better performance?

It does seem like a pretty complicated problem. We want banks to be reliable, we don't have a pricing mechanism because the market is illiquid, and we have incentives to keep the Potemkin story alive.

So the problem here is the banks wrote their loans stupidly and both the bank and the property owner's willing and able to burn money to keep those chickens from coming home to roost, which has an enormous social cost on small business owners, citizens, and other businesses in the area, but the article concludes we can't really do anything about it because it might make the banks sad and cause the renegotiation of a bunch of those shitty contracts.

Since when did "taking a loss" get written out of the definition of "investing"?

Startup Idea: My company will lease your space for whatever price you want. Then we sub-lease your building at the market rate. We charge the different between the market rate for your building and what you want to charge + a small fee. That way your property retains it's "original" value, but actually gets rented out.

Everyone (especially us) wins!

Pricing something based on what you project to make over 20 years seems like an insane way to go about it. Nobody can predict that far in the future.

It's a no-lose scenario for banks though, which is why it's done that way I guess.

> Intuition fails because normal people think of a building as a building, when in the majority of cases, a building is not a building but a financial product. Behavior that makes no sense for a building can make perfect sense for a financial product.

And it is precisely why a lot of people hate capitalism.

Adam Smith himself would would disapprove: "As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed, and demand a rent even for its natural produce."

This doesn't make sense to me, why is lowering rent by 30% any more "proof" that the building is not worth what's stated on the bill than having a 30% vacancy rate at the expected value? Aren't both subject to the same "market conditions" argument?

I've seen in here a couple people saying that Land Tax is the answer. But...

Let's say I have a building that's sitting vacant. Under the current system, I pay property tax, which is based on the land plus the improvements (the building). So it costs me to hold the building vacant.

If we switch to a land tax, then that would be taxed on the value of the land only (though presumably at a higher rate). But if moving to a land tax is revenue neutral, then the tax on vacant land would be higher than it was before, and the tax on improved land would be lower.

The net effect of a land tax, then, would be to lower the tax on this unoccupied building. How is that supposed to fix the situation?

Why can you bullshit about an empty building but not a temporarily low rent building? Why doesn't this just lead to "Month-to-month and Pretend"?

Unmentioned in this article is the spread of small business pretend as a lifestyle, where someone signs a lease for the space, pays the rent, and never opens it or only after years of futzing around. They can do this because they have some other source of income, and it is just another aspect of wealth inequality that pretenders can outbid sincere small business operators. In my neighborhood we had a prominent corner store that was apparently vacant but actually had been leased by a restaurant that then spent 7 years intermittently remodeling the interior. Of course all the local NIMBYs spent the entire 7 years shouting about developers, but it wasn't their fault really.

My day job is a Director level role at a large commercial real estate firm. Our primary segments are brokerage, management, and development management. I've been doing this for 11 years.

>The story starts with a building operator and a bank deciding what a building is worth. To figure this out, the operator is going to make a financial model that projects the income that a building will generate.

We're going by existing leases at the property, and take into account their expirations and rent escalations. Mostly, we're looking at current income. If a building is valued at $20M because of a $1,000,000 NOI at a 5% cap, that's because it literally has $1,000,000 of yearly income NOW and some seriously high grade tenants to justify that cap. Also, if there are no tenants in the building, we value it by things like construction value. If we're talking about new developments, we usually pre-lease and borrow based on the signed leases.

>You may wonder how the cap rate is determined. The simple answer is the owner and the bank negotiate and agree on a number.

This is disingenuous. We don't pull a cap rate out of thin air. We go by market caps on comparable properties and also factor in the credit of the existing tenants and their lease terms. There is a tiny bit of back and forth on the cap if the buyer and the bank disagree but this a matter of tenths of a percent.

All of that said, I have never known a property owner who refused to lower rents in a game of chicken with the bank and most would certainly rather fill a space with someone than keep rents elevated. If a space is empty, it's generating zero income, your NOI is therefore lower, and the building value has already decreased. The bank isn't pretending it's worth more than it is because you're advertising a certain rate. They're just giving you more time to lease the space so it doesn't have to go into receivership, which is a loss for everyone.

Beyond that, most leases are signed at or below asking rent unless the area is extremely high demand. They may not be advertising a rate drop, but anyone in this business knows that asking rents are a point to be negotiated during the leasing process.

One "Simple Fix" for cities, albeit with limited scope: Force your Planning Commission, Zoning Board, etc. to keep track of the vacancy rates for commercial space. Then use their powers to strongly discourage the construction of yet more vacant commercial space. And/or renovation of such space to other uses.

EDIT:

- Please do not assume some trivial straw-man implementation of this idea. That includes City organization being hopelessly corrupt or incompetent.

> a building is not a building but a financial product.

Are we cooked chat?