Get your free copy of Editor's Digest
FT editor Roula Khalaf picks her favourite stories in this weekly newsletter.
Signs of stress in the commercial real estate sector are now mounting. Investors have been spooked this month by the commercial real estate loan exposure of lenders such as Community Bank of New York in the U.S., Aosora Bank in Japan and Deutsche Pfandbriefbank in Germany. U.S. Treasury Secretary Janet Yellen also expressed concern last week about the impact of falling real estate valuations on the banking system.
Though interest rates are expected to fall this year, the sector remains in a tough spot. About $1.2 trillion in U.S. CRE debt is due over the next two years, according to the American Mortgage Bankers Association. Developers will still face rising refinancing costs, as commercial real estate values have already plummeted and interest rates are unlikely to return to previous lows anytime soon. Meanwhile, the rise in remote work is hurting demand. Office vacancy rates in U.S., European and Asian cities are well above pre-pandemic levels. Loan delinquencies and non-performing sales are expected to rise.
Regulators are right to monitor the continuing risk of fire sales and hidden exposures among private lenders. But widespread ripples through the global banking system seem unlikely. Capital buffers, oversight and lending transparency, while far from perfect, have all improved since the 2008 financial crisis. Some patience in contract negotiations and opportunistic investors seeking discounts will also provide a cushion. We are in for a long and painful adjustment, not a short-term, sharp shock.
Retail and office buildings in major urban centers will be hit especially hard if work-from-home patterns continue. McKinsey projections suggest that demand for office space will remain below pre-pandemic levels for decades, with the value of office space declining by at least 26% by 2030 across the world's major cities. Companies are already downsizing to better quality space and redesigning their offices. Vacant buildings may sit idle for long periods, and some may be abandoned completely. Economic activity in some urban centers, such as San Francisco, with its high concentration of technology workers, could be hollowed out.
City governments are not powerless. They can extract more value from buildings by helping them be reused. Converting offices into housing is one option, helping to fill the national housing shortage. Mixed-use space is another option; for example, One Wall Street in Lower Manhattan's Financial District has been redeveloped into apartments.
Allowing buildings to have flexible uses helps cities remodel, mitigates price declines and reduces the risk of asset stranding. It is also better for the environment by avoiding the demolition of entire buildings. But even if prices are reduced, it comes at a cost. The real estate industry also often cites complex planning systems, rigid zoning laws and building regulations as other factors that hinder urban redevelopment. This is an area where city authorities can play a facilitative role.
Planning rules and processes should be made more flexible to encourage and accelerate reuse efforts without sacrificing building standards. Local governments can also help by meeting with developers, architects and planners to identify what is possible and what additional infrastructure is needed. The City of London told the Financial Times this week it would be “open-minded” about helping developers meet the requirements. Imagination is also key: corporate auditoriums could become cinemas at night, and urban labs could support new research districts.
Many buildings will remain unrenovated — there are architectural impediments and demand will depend on the quality of the neighborhood — but affordable residential space and other commercial opportunities should be part of urban renewal plans.
If municipalities want to maintain urban dynamism, they must become more agile. The CRE market is being reset. Allowing more buildings to be reused will make the transition less painful for lenders, investors, and urban areas themselves.