Dive Overview:
According to Conference Board economists, U.S. commercial real estate is likely to face greater disruption this year and next as roughly $1 trillion in debt comes due, hybrid work erodes demand for office space, and interest rates remain higher than expected. “The worst is yet to come, and there are no easy solutions,” Conference Board senior economist Kurt Lyman said of the pressures on commercial real estate during a May 22 webcast. “This is the first time in a generation, or even a once-in-a-lifetime event.” Unusually high levels of commercial real estate debt are coming due as office property values have fallen more than 35% from their peaks and “building owners are facing higher costs,” Lyman said. “It's a powerful and potentially damaging combination.”
Dive Insights:
According to Moody's Analytics, values of commercial office real estate could fall by 26% by the end of next year as many companies downsize their workspaces or relocate to cheaper properties to accommodate the work-from-home trend.
Moody's said in a March report that valuations of all CRE types are expected to fall 10% from peak to trough over the next 18 months, with the office sector being the hardest hit. Banks have the resources to deal with the potential disruption, even though CRE represents the largest portion of their liabilities.
Federal Reserve Chairman Jerome Powell said he expects commercial real estate losses to hit mostly smaller and mid-size banks and warned that efforts to ensure stability will need to continue for years.
“Some banks are going to suffer losses,” Powell said in testimony before the House Financial Services Committee in March, adding that bad loans were concentrated among small and mid-sized banks. “I think this is going to be a problem that we have to solve for the next few years.”
Federal Reserve, Treasury, bank and real estate executives have warned for months that markets could be in turmoil as property owners struggle to refinance at higher interest rates. The central bank, which aims to keep inflation at 2%, has kept its benchmark interest rate unchanged at a 23-year high since July.
The decline in demand for office space and the resulting defaults and bank stress will vary by region and by property type and class, Lyman said.
“It's the big metropolitan areas that are getting hit harder,” he said. “Maybe the big financial institutions are lending there, but it's not just them,” he added. “Smaller banks are getting hit hard, too.”
Lyman said many lenders are extending loan maturities rather than writing off loans. “The 'fake extension' phenomenon is common among smaller banks.”
He said the CRE rebalancing is a “slow and steady process that has the potential to become a vicious cycle,” leading to tighter standards in some lending categories, a pullback in business investment and less consumer borrowing.
Not all analysts are pessimistic about CRE's prospects.
“The CRE outlook for the second half of 2024 is broadly favorable, with multifamily continuing to perform well, as well as industrial and retail,” JPMorgan said in a mid-year report this month.
Still, JPMorgan said “challenges may lie ahead,” noting that “the high interest rate environment is expected to persist and office vacancy rates continue to rise.”
JPMorgan said wars in Ukraine and the Middle East, as well as the upcoming U.S. presidential election, could also destabilize the economy and undermine the stability of commercial real estate.
“The upcoming presidential election combined with a gridlocked Congress could impact consumer confidence and spending, ultimately leading to a continued high interest rate environment,” JPMorgan said.