Commercial real estate has endured a tough year, with U.S. real estate investment trusts (REITs) falling more than 10% on average. Looking ahead to 2024, the sector still faces three undeniable challenges.
First, there is the risk of refinancing existing commercial real estate loans in the ongoing high interest rate environment.
According to a Goldman Sachs report published in April 2023, the U.S. commercial real estate sector has about US$1.1 trillion (EUR1.0 trillion) of debt coming due by the end of 2024. Meanwhile, Morgan Stanley projects that US$1.5 trillion of U.S. commercial real estate loans will come due over the next three years.
With interest rates increasing by more than 500 basis points compared to March 2022, many homeowners may struggle to refinance their debt and mortgages at significantly higher interest costs.
Moreover, if landlords find it difficult to refinance or repay their loans, there could be a knock-on effect for the banks holding the loans, creating widespread losses and systemic risks across the economy and potentially requiring governments to step in to support struggling sectors.
The second is the landlord's financial “staying power” and capital structure – for example, if a landlord holds real estate assets using cash or equity, their financial calculations will be stronger and less susceptible to the cost of capital than if they were debt-financing their real estate portfolio.
After all, if a landlord has debt on their balance sheet, leverage should be limited in a high interest rate environment.
According to Goldman Sachs, there is already growing caution in the real estate lending sector, with the average LTV on underlying loans falling from an average of 60% post-COVID to 51% in April 2023. Previously, when interest rates were at historic lows, many portfolios had LTVs in excess of 75-80%.
Meanwhile, rising interest rates have increased the cost of capital, forcing property owners looking to refinance to face higher repayments and making it harder for those with high leverage to secure financing.
Third, there is the persistently worsening economic situation and its associated impact on commercial real estate demand. Growth is likely to remain weak, with the IMF lowering its 2024 growth forecast for the United States to just 1.5%.
Slowing economic growth is raising concerns about workspace demand, while structural changes such as the work-from-home phenomenon are causing public and private sector employers to recalibrate their real estate needs.
Already cracks are beginning to show. U.S. office vacancy rates hit a 20-year high of 17.8%, up 1.5 percentage points from a year ago. The hardest-hit cities are New York, Los Angeles and San Francisco, with office vacancy rates of 22.2%, 35% and 22%, respectively. Los Angeles and San Francisco have the highest vacancy rates on record.
Falling demand is putting further pressure on the sector: Post-pandemic working practices appear to be here to stay, and a McKinsey report suggests that demand for commercial property in so-called superstar cities will be well below pre-pandemic levels.
Under a moderate scenario, the firm predicts that office demand in 2030 will be 13% lower than in 2019 across the nine major cities studied, with that figure jumping to 38% in the worst-affected cities.
Obviously, demand for assets will always fluctuate, and traditionally, high-quality trophy assets – investment properties in the top 2.5% by value – are considered more capable of retaining their value and drawing demand despite challenging macro environments.
But even some of the trophy assets could come under pressure in 2024.
In November, Cigna Holdings, the anchor company of a real estate group that partly owns New York's iconic Chrysler Building and other key assets, filed for bankruptcy under pressure from rising debt-servicing costs.
Opportunities to acquire discounted or distressed assets may emerge in 2024 as more debt-laden owners face financial difficulties. However, investors looking to deploy capital in the sector should pay close attention to longer-term demand trends.
Many commentators believe the interest rate cycle is turning, which could help ease the real estate industry's woes, but even if that happens, it will only begin to solve one of the many problems facing real estate investors.
Ultimately, commercial real estate will likely continue to be hurt by a confluence of macro and market factors, including weakening demand, a lack of capital, and further declines in asset prices.