Commercial real estate investment is at its lowest level since 2013, office buildings are selling at steep discounts, and commercial real estate construction, excluding apartments, has slowed significantly.
As long as multifamily housing doesn't go the same way as office space, lenders and the economy as a whole should be able to weather the real estate downturn, according to a leading commercial real estate economist.
“The real estate market is in a downturn, but it's not in a vicious cycle,” Richard Barkham, global chief economist at CBRE, the world's largest commercial real estate services and investment company, said at the National Association of Real Estate Editors' midyear report conference in Austin on June 19.
Due to the shift to remote work that accelerated during the pandemic, tenants now need only 60% to 70% of the office space they needed in 2019. More businesses are asking employees to return to the office, but typically only a few days a week, reducing the total amount of space needed.
“By 2025, we expect vacancy rates to hit 20 percent and we'll run out of space,” Barkham predicted.
How is that possible? As of the end of May, the national office vacancy rate was 17.5%, while the Denver metro area's vacancy rate was 23%, according to Commercial Edge.
With an abundance of available space and falling rents, tenants are shifting toward higher quality Class A space, which is primarily represented by buildings built after 2010. Newer buildings are still seeing positive net absorption rates, meaning space is filling, while older buildings continue to sit vacant.
Barkham said tough market conditions have led to a sharp slowdown in new office construction. At the end of May, 83.8 million square feet of office space was under construction, accounting for 1.2% of existing stock, according to a Commercial Edge report.
That figure includes about 2.12 million square feet in Denver, nearly a third of which is a single project at 1900 Lawrence St., a 720,000-square-foot building near the old Greyhound bus station that's scheduled to open soon.
Riverside Investment & Development, along with Convexity Properties and Canyon Partners Real Estate, is developing Denver's largest office project in the last 40 years. Burkham's rationale for building a 30-story tower in a saturated market is spot on: More premium space is needed to lure workers back to the office.
Barkham argues that once the current pipeline is completed, the strategy will shift to renovating older buildings. Another CBRE study found that only 10% of office space is “prime,” or the type of space that tenants want today.
“This game is going to transform the Class B space into something people want,” he said.
In the first five months of the year, the U.S. office market saw $10.2 billion in transactions at an average price of $165 per square foot, according to CommercialEdge. In the Denver metropolitan area, sales this year have totaled $99 million at an average price of $103 per square foot, the lowest of any major Western city.
More than $900 billion in commercial real estate debt will mature and need to be refinanced this year, falling to under $600 billion next year and to about $450 billion the year after that.
Large banks have been building up reserves to deal with potential losses, and while some smaller regional banks could fail, that is unlikely to spark a larger financial crisis.
For now, the banking system appears to be able to handle the slowdown in demand for office space and the resulting defaults, but the double whammy of an apartment construction glut could change that.
“If we were to see a similar decline in multifamily housing, that would be a different story,” Barkham said.
But how likely is that to happen? Rising interest rates are driving many would-be homebuyers to rent rather than own. According to CBRE, the typical new mortgage payment in the U.S. is $3,153 a month, compared with an effective monthly rent of $2,163.
This means more absorption — people moving into new apartments as soon as they come on the market. But in 2024 and 2025, more supply will come online, testing the market's ability to keep filling new apartments.
What is uncertain is how much demand will exist to meet the high levels of units being completed over the coming months and, if there is an oversupply, how much rents will fall and what impact that fall will have on landlord and developer finances and, ultimately, lenders' balance sheets.
Most economists say the U.S. continues to face a housing shortage. Caitlin Sugrue Walter, vice president of research at the National Multifamily Housing Council, said the U.S. needs to build 4.3 million apartments across a range of price points by 2035.
That total includes a shortfall of 600,000 homes that were stalled during the Great Recession, Walter said in his presentation at NAREE. Dallas, Houston, New York, Phoenix, Austin and Atlanta face the biggest shortfalls.
Developers added 438,500 new apartments last year, a 22.1% increase over 2022 and the highest completion rate since 1987, according to the U.S. Census Bureau.
Walter said apartment completions are at a high level, but permits and starts are down as developers struggle with rising interest rates, and he said a correction is looming.
Zillow found in a study released in late June that the U.S. housing shortage is worsening, even as a homebuilding boom began during the pandemic. Zillow estimates that there are 4.5 million U.S. households with people who are not related to them. These individuals and family units are not counted as separate households, making them prime candidates to absorb new home and apartment supply.
However, a contrarian study from the University of Kansas argues that the US has a surplus of 3.3 million homes between 2000 and 2020, most of which occurred during the housing boom of 2000 to 2010. The US's problem, the study authors argue, is not one of supply but one of high house prices.
“There's a common belief that there is a housing shortage in the United States. This is evident in the popular and academic literature, as well as the housing industry,” Kirk McClure, a public policy professor at the University of Kansas, said in a statement. “Yet the data shows that the majority of U.S. markets have an adequate housing supply. Unfortunately, there is not enough affordable housing, especially for low- and very-low-income families and individuals.”
If the NMHC, Zillow and other studies are correct, the current surge in apartment construction should be absorbed. If the KU study is correct, the new supply, skewed toward luxury apartments with higher rents, will be too much for what's already on the market.
That could leave apartment developers and their lenders, already struggling with the collapse of the office market, in an even more vulnerable position.
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