Last month in our social feed, I shared an interesting piece from Greater Greater Washington on the glut of vacant office space in Washington DC. In a city with explosively high housing prices, the article questions why some of the reportedly 14 million square feet of vacant space could not—or was not—being converted for residential use. If half of it was converted to 1,200 square foot units, that would be around 5,000 new units. According to the same site, that is more units than were permitted to be built in DC in all of 2016.

Some people on Facebook were rather dismissive of my take and the article in general. Come on, Chuck. The market will take care of this problem. Indeed, I think it will, but not how you might hope. The way commercial real estate is financed has some strange incentives that I think many are not grasping.

The value of a commercial property is based on the rent that can be obtained. As rents go up, the building is worth more. As they go down, the building is worth less.

When obtaining commercial financing—when getting a loan—the value of the building will be appraised based on the rents that can be obtained. If you can collect a lot of rent, the bank will loan you a lot of money. If you can’t collect much rent, the bank is not going to loan you very much.

This is all pretty straightforward, right?

Let’s say a commercial property developer acquires a $1 million office building. First, they must put 20% down—$200,000. Likely half of that down payment comes from gap financing from a local bank(s) and the other half comes from investor cash. That means they will borrow $800,000 from a major bank—and that loan will be a financial instrument that will ultimately get sold onto a secondary market and securitized into different packages that are then sold in bundles around the world. It's a very efficient capital allocation model.

To get that $800,000 loan, the developer is going to need to show collective rents that value the building at $1 million. For ease of calculation, let’s say they have seven different units in the building and collect $10,000 per year from each unit. That is $70,000 of revenue annually. That’s enough money to make their annual debt service of $52,000 on a 5% loan, and have some money left over for other things (maintenance, taxes, investor return, etc…).

Building Value: $1 million

Loan Amount (80%): $800,000

Annual Debt Service (5% interest): $52,000

Annual Rent Revenue (7 units x $10,000 per unit): $70,000

Now the developer owns the building and everything is going great until—oops—market glut. We’ve just built too many units in the market and, as things turn over, we’re not able to fill all the units at the $10,000 per year rate. In fact, ponder a situation where only four of the seven units are rented.

The developer has some options at this point. Option 1: Lower the rent to a level that fills the vacancies. Option 2: Convert the office space to some other use. Option 3: Stay put and hope that the vacancies are a momentary blip in the market and that new tenants will soon be secured at pre-vacancy rates.

Let’s take a close look at how the "marketplace"—which is how we’ve come to define our centralized, corporate/government financial system—works these things out.

Option 1: Lower the rent

With a sound grasp of free market economics, the developer understands that supply and demand equilibrate with price. If the units don’t fill at $10,000 per year, then the price has to be lower.