Continued sluggish demand for office space, growing refinancing needs, and rising interest rates have… [+] A symptomatic problem for the commercial real estate sector.
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The sharp decline in office building values has many eagerly awaiting a major sell-off in commercial real estate, which could hit city and state budgets and lead to the collapse of major banks. So far, borrowers and lenders have avoided the worst of the damage, but their delaying tactics could come to an end, with dire consequences.
These concerns were highlighted through economic analysis by New York University's Arpit Gupta and Columbia University's Stijn van Neuwerburg, who projected a “$664.1 billion loss in value” for U.S. office real estate in 2022.
Since then, they, other economists and market watchers have predicted a major drop in office values, with headlines filled with dire predictions such as “debt flood,” “severe crash” and “$1.5 trillion crisis.”
While commercial real estate values have taken a serious hit, the predicted collapse or “apocalypse” has not yet occurred. As I wrote in a September 2022 Forbes article, “The commercial real estate apocalypse hasn’t come yet, but we all need to keep an eye on the dangers.”
Some argue the fears are overblown because the CRE market hasn't collapsed entirely: There will certainly be pain as banks restructure loans, with second-tier office buildings taking the biggest hit, but some analysts are downplaying the possibility of a severe hit.
In April 2023, CNBC's Tim Mullaney published a thoughtful analysis of “the coming commercial real estate collapse that may never happen.” He emphasized that many lenders appear to be weathering the crisis as tenants continue to pay rent and banks are not defaulting on CRE loan payments.
In June, The Washington Post's Natasha Sarin wrote an article titled “Why the Commercial Real Estate Crisis Isn't As Bad as It Sounds,” in which she pointed out that the CRE sector isn't just offices (it also includes apartments and warehouses, both of which are doing well) and advocated for bank lenders to “bolster their capital levels to prepare for potential losses before it's too late.”
Fast forward to 2024 and concerns about commercial property are resurfacing. In her excellent Financial Times column, Gillian Tett points out that “very little pain has been felt so far” in the sector. But bills still come due and she argues that “it's time for honesty” about the sector's problems.
While mortgages are often 30-year loans, CRE loans typically have shorter maturities (10 years or less) and require full refinancing when the maturity date comes. Many commercial loans were written during a recent period of historically low interest rates. As such, commercial loans are now facing a double whammy: continued work-from-home practices have reduced demand for office space, driving down asset values, and pushing up interest rates significantly when building owners refinance.
At the same time, banks do not want to declare loans as bad because it would negatively impact their balance sheets. So they have been refinancing and restructuring on more favorable terms than some expected and perhaps even than economic fundamentals justified. Some observers have cynically called this “fake extension.”
Tett cites a scathing analysis last year by the Newmark Group, a major real estate consulting firm that believed CRE lending was at risk because it was too concentrated in small and regional banks, which tend to hold more CRE loans and are often less well capitalized than the larger money-center banks.
More recent data also shows that CRE's problems continue. CommercialEdge, which monitors rental demand and prices for office space across the country, recently found that average office rents fell 1.2% year over year. That's not a bad number, but when combined with declining capital values for office properties facing declining demand and rising interest rates, it's not a good picture.
CommercialEdge also reported on office building sales, noting that “discount office sales are becoming more common.” Of course, there are big regional differences: Commercial rents in the Boston market increased 21.5% year-over-year, while rents in Chicago and Seattle fell by more than 2%.
This reflects vacancy rates: Boston's vacancy rate is 12.2%, compared with the national average of 17.9%. Tech cities like Seattle (22.5%) and San Francisco (24%) have higher vacancy rates as companies adopt more friendly policies toward remote work.
A new research note from Goldman Sachs highlights the severity of the problem. CRE loan modifications and extensions (“spurious extensions”) are pushing loan renewals out until 2024. Investopedia reports that CRE loans maturing “through the end of 2024” are “41% higher than a year ago.” “Office mortgages are expiring,” Goldman's research note concludes.
So the warning lights for office lending are flashing red. There are huge opportunities for buyers to buy space at deep discounts, especially in second- and third-tier space. But if banks are reluctant to lend, there could be too much office space available to absorb.
This has worrying implications for the entire financial sector, and for city and state governments that rely on real estate taxes and office space-generating economic activity. We will look more into these two risks in our next blog. But the end of CRE’s “extend and pretend” strategy could have dire economic implications.