Why do commercial spaces sit vacant? (2025)
Why do commercial spaces sit vacant? (2025)
By Andrew Burleson | Free Range City
In a recent mailbag session, Matthew Yglesias tackled a question regarding why certain commercial properties remain empty for years on end. While Matthew's initial response started strong, it eventually drifted off track.
That specific note became the most viral piece of content I've produced this year. Due to the volume of requests for clarification and expansion, I've decided to dive deeper into the mechanics of this phenomenon. While a detailed explanation might not go as viral as a pithy note, I believe it's a crucial concept for anyone interested in the future of our cities to bookmark.
The Core Question
The catalyst for this discussion was a query from a reader:
"Can you explain why it makes economic sense for landlords in high-priced metros to keep commercial real estate empty for years at a time? ... I understand there's a lot of social pressure on landlords to keep rents high or face the wrath of their neighbors, but how can that pressure still work after ten years of losses?"
The answer is both counterintuitive and straightforward: In many instances, reducing the rent on a property will trigger a bank foreclosure.
Because foreclosure is a catastrophic outcome for both the lender (the bank) and the borrower (the operator), both parties often prefer to extend and pretend. This means they leave the building vacant, hoping for a market shift rather than admitting the current valuation is wrong.
The Intuition Gap: Buildings vs. Financial Products
Most people assume that getting some rent is always better than getting no rent. However, this intuition fails because we view a building as a physical structure. In reality, most commercial real estate is not a building—it is a financial product.
When you treat a property as a financial instrument, behavior that seems irrational for a "building" becomes perfectly logical.
1. Commercial Loans Residential Mortgages
Our misunderstanding stems from the fact that most of us only have experience with residential real estate. Here is how the two differ:
Residential Property:
- Value: Primarily driven by the market (what a buyer is willing to pay).
- Qualification: Based on the buyer's personal ability to pay.
- Structure: Usually long-term amortized loans (designed to be paid off fully over time) thanks to federal programs.
Commercial (Income-Producing) Property:
- Value: Determined strictly by the income the building generates.
- Structure: Typically short-term "balloon notes" (not designed to be fully paid off via regular payments).
A Toy Example of Valuation
To illustrate how this leads to the extend and pretend trap, let's look at a hypothetical scenario.
Step 1: Projecting Income An operator creates a financial model. They forecast that the building will generate a net rent (after all expenses) of $1,000,000 per year.
Step 2: Applying the Cap Rate The operator assumes a Capitalization Rate (Cap Rate). This is the percentage of the total property value that the building generates as annual income.
If the agreed-upon cap rate is , the valuation is calculated as:
Note: Another way to view the cap rate is as the "payback period."
Crucial Insight: The physical building (its architecture, amenities, or location) is secondary. These factors only matter insofar as they influence the gross rent or operating costs. Ultimately, the bank is valuing the income stream, not the bricks and mortar.
The Loan Terms
Once the value is set at \20\text{M}$, the bank provides a loan. Because banks are highly regulated, they must maintain safety margins to limit risk.
| Term | Detail | Value in Example |
|---|---|---|
| LTV Ratio | Loan to Value (Max lending limit) | |
| Loan Term | Duration before full repayment/refi | |
| Interest Rate | Annual cost of capital | |
| Equity | Operator's cash contribution | \4,000,000$ |
| Loan Amount | Total borrowed from bank | \16,000,000$ |
The Operator's Obligations:
- Pay \640,000$ in interest annually.
- At the end of year five, either pay back the full \16\text{M}$ or refinance the loan.
The Operator's Checklist:
- Secure \4\text{M}$ in equity.
- Obtain \16\text{M}$ loan from bank.
- Acquire building for \20\text{M}$.
- Fill building with tenants to cover interest and profit.
- Refinance at the end of the 5-year term.
The Logic Flow of Vacancy
The Breaking Point
Now, imagine the operator has the building and is working to fill it. But then, the market changes. Suppose that 3 years...
# Simplified logic of the 'Extend and Pretend' trap
def check_foreclosure_risk(current_rent, cap_rate, loan_balance):
current_value = current_rent / cap_rate
if current_value < loan_balance:
return "Risk of Foreclosure: Do not lower rent!"
else:
return "Safe to adjust pricing."
# Example: Rent drops to $500k, Cap Rate stays 5%, Loan is $16M
print(check_foreclosure_risk(500000, 0.05, 16000000))
# Output: Risk of Foreclosure: Do not lower rent!