Federal Reserve Chairman Jerome Powell's comments last week that a wave of bank failures were linked to a downturn in the commercial real estate sector sent shockwaves through the financial world, sending some investors fleeing and others seeking opportunities.
Typical commercial lease terms in the U.S. are three to five years, but the rise of remote work and changes to urban land use have put time on the clock for office and retail property owners and financial sector creditors.
According to data released by the Treasury Department's Financial Stability Oversight Council (FSOC), citing analytics firm CoStar, office vacancy rates had been declining steadily over the past decade but spiked in the wake of the pandemic, reaching a record high of 13.1% last year.
“As of the midpoint of the third quarter of 2023, the national office vacancy rate reached a record high of 13.2%, up 370 basis points from the end of 2019,” CoStar analyst Phil Mobley wrote in his third-quarter analysis.
“The recent recovery in office demand is shaking up the US market,” he added.
Shares in private equity firm KKR's Real Estate Finance Trust, a real estate investment firm that puts money into commercial mortgages, fell by a quarter in early February on news that the company would cut its dividend due to losses on office loans.
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Delinquency rates for commercial mortgage-backed securities have been trending upward in recent months but are still well below the highs recorded in the aftermath of the pandemic and the 2008 financial crisis.
According to the latest FSOC report, “The decline in demand for office properties may take time to stabilize as tenants make remote work decisions and adjust the amount of space they need. Additionally, a slow return to densely populated urban office centers may reduce the attractiveness of office properties located there, as well as nearby retail space.”
Chairman Powell delivered much the same message before the Senate Banking Committee last week, going so far as to declare that small and regional banks that lend to commercial real estate will also fail.
“This is something we'll be dealing with for years to come. There will be bank failures,” he said.
“This is not primarily a problem for the big banks. It's the smaller banks that are having these problems. We're working with them. We're working through it. My word of mouth is I think it's manageable,” Powell said.
Investors are heeding Powell's warnings about the financial industry but are viewing them with skepticism, arguing the losses are unlikely to trigger a traditional liquidity crisis like the one that caused Silicon Valley Bank and Signature Bank to collapse last year.
“I think what Chairman Powell said is a little bit oversimplified,” Daniel Alpert, managing partner at Westwood Capital, told The Hill. “There's going to be disruption, and I think how that gets resolved with government or outside capital assistance is going to be very different than what we saw with the three banks.” [last year] And the same thing that we've seen in every other crisis has certainly happened.”
Federal Reserve Chairman Jerome Powell attends a hearing of the House Financial Services Committee's semi-annual monetary policy report to Congress on Capitol Hill, Wednesday, March 6, 2024. (Allison Robert)
He added that the pressure on banks from their commercial property exposure would not “happen overnight”, describing the situation as a “slow-moving train wreck” and saying they would take their time to revalue assets.
Still, short sellers are moving quickly to profit from the miscalculation.
One investment plan laid out by The Hill for real estate investment trusts (REITs) aims to take advantage of REITs' bloated balance sheets before rising interest rates and stagnant rent growth drive down asset values.
The proposal states that the REIT's assets would be revalued “over a relatively short period of time.”
Whether real estate-related losses lead to bank failures and prompt new government intervention like the credit lines the Fed set up for the financial industry last year may not be the biggest economic problem arising from the office and retail real estate crunch.
Rather, the most salient macroeconomic issue facing policymakers from the rise of remote work may be its long-term impact on commercial construction and the way land is used in U.S. urban centers.
“You're not going to see a lot of commercial construction in the economy for the next 10 to 20 years,” Alpert said. “That's a big negative on a macro level.”
Commercial real estate loans for construction and land development have declined in recent months after surging during the pandemic recovery and appear to be nearing a cycle peak.
Total construction spending has also fallen slightly in recent months from post-pandemic highs, but recent large investments in manufacturing construction could help fill the gap left by office projects.
Experts told The Hill that work is also underway in many parts of the country to repurpose vacant office space and redesign downtown business districts to accommodate reduced demand for in-person work.
“There are some silver linings to this in terms of land-use change in the commercial real estate market,” said Alice Shay, an urban planner at Bureau Happold Cities in New York.
“COVID-19 has really changed our view of how cities work and where their center of gravity is. In New York City, suburban boroughs have really thrived as people working from home spend money locally.”
While fully remote work has declined in popularity since the pandemic made it necessary several years ago, hybrid work increasingly seems to be having a lasting impact.
About 28% of paid workdays in the U.S. were worked from home in February, down from more than 60% at the pandemic peak but still four times the pre-pandemic level, according to Stanford University's National Work Survey.
Notably, the researchers' data shows that remote work adoption appears to be stabilizing at current levels.
“The pandemic has led to a permanent increase in telecommuting,” the research team noted in multiple studies.
Among workers who can work remotely, 35% choose to do so all the time, according to a 2023 survey by polling firm Pew, up from 7% before the pandemic but down from a peak of 55% in 2020.
Worker productivity also appears to be normalizing as the trend shifts to remote work: After surging along with many other economic indicators during the post-pandemic recovery, productivity stabilized, then rose again and is now in line with long-term trends.