A recent analysis from Fitch Ratings has darkened the clouds gathering over the U.S. commercial real estate market a little: Fitch predicts that the upcoming commercial real estate crash will destroy more property value than the financial crisis of 2008. Even more ominously, Fitch believes that any recovery from the commercial real estate crash will be slower and less lucrative than the 2008 recovery.
By any standard, the US commercial real estate market is in trouble, especially in the office and retail sectors. Commercial real estate vacancy rates in many of America's largest cities are approaching 20%, the highest they've been in 40 years. This is problematic for more reasons than a real estate insider might realize at first glance. First, a building with a 20% vacancy rate is unable to generate a profit, let alone cover basic expenses like a mortgage and insurance.
The bigger issue is that the value of a commercial property is tied to how much revenue it brings in. Commercial properties don't appreciate like residential properties, where factors like exterior curb appeal and a buyer's emotional attachment can drive the home's value above and beyond what it would normally be worth. Commercial property valuation is a fairly simple equation where a prospective buyer uses current rental rates and income as the main criteria.
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That means a commercial office building with a 20% vacancy rate, or an entire commercial real estate portfolio, is losing value every month. According to Fitch analysis, office building values have already fallen 35% in the current investment cycle — a steep decline, but lower than the 47% decline residential real estate experienced during the financial crisis.
However, Fitch does not expect a commercial real estate recovery similar to the one experienced by the housing market after the 2008 crisis. The main driver of Fitch's bearish analysis is the reality that millions of American workers have not returned to the office even after the pandemic. According to a Goldman Sachs survey conducted in late 2023, 20% to 25% of the American workforce is currently working from home. In this new environment, office buildings cannot recover and become profitable.
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The 2008 financial crisis was different from other crises because most of the assets at stake were single-family homes and condominiums. These are assets that every American needs to live a normal life. Despite the decline in values, it was only a matter of time before Americans bounced back and started buying homes again. Americans bought a lot of homes after the financial crisis, thanks to the Federal Reserve keeping interest rates very low.
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The COVID-19 pandemic has permanently changed that calculation. Not only has it forced millions of Americans to permanently shift from working in the office to working from home, but post-COVID-19 inflation has forced the Federal Reserve to raise interest rates to stabilise the economy. While these rate hikes may have made sense at the time, their impact on commercial office owners and lenders has been devastating.
Developers who took out cheap, short-term loans to acquire as much commercial property as possible now can't refinance their debt at the same interest rates. Even if they can, they're paying roughly double the interest rate they were paying before. When you have dozens, hundreds, or even thousands of properties in your portfolio and interest rates double, you're out of luck.
Add to this the fact that even if these half-vacant office buildings find new tenants, the new tenants will pay lower rent per square foot than their predecessors, and it's easy to see why Fitch is predicting a “prolonged” recovery, which is a polite way of saying that commercial rents may never return to pre-pandemic levels, and if they do, it will be a long time before they do.
Any recovery will likely not be strong enough to stem the tide of commercial debt maturing in the coming years. By one estimate, nearly $3 trillion in commercial debt will mature by 2027, with nearly $1 billion of that maturing in 2024.
Put it all together: real estate developers are drowning in debt because they can't fill rental properties, and mortgage lenders are saddled with trillions of dollars in bad assets.Looking at the problems this way, it's easy to see why everyone from Fitch analysts to the International Monetary Fund is sounding the alarm about the possibility that the coming commercial real estate collapse could be worse than the one in 2008.
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This article, “Why Fitch Thinks the Future Commercial Real Estate Market Collapse Could Be Worse Than 2008's,” originally appeared on Benzinga.com.
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