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The commercial real estate market contributed $2.5 trillion to the US economy in 2023 and it supported over 15 million jobs, comprising roughly 10% of overall GDP and employment. However, it is currently experiencing a significant downturn. Consequently, various small businesses located near office buildings have been forced to shut their doors, banks are dealing with losses on commercial mortgages, credit conditions are tightening, and certain firms are laying off workers. These problems are a result of the commercial real estate industry suffering from work-from-home arrangements, soaring financing costs, higher operating expenses, counter urbanization and declining occupancy rates, with various office buildings sitting empty. The growing problems with office buildings and other types of properties are clearly creating struggles for the economy. With job creation, community development, and infrastructure at stake, it is vital for investors to understand the current plight of this large and important industry.
Mortgages Become a Headwind
After hitting an all-time low in 2021, financing costs for commercial real estate (CRE) mortgages soared with interest rates for initial fixed-income periods climbing approximately four percentage points. This has brought rates to the following levels as of late July:
- 6.92% for five-year fixed
- 6.87% for seven-year fixed
- 6.78% for ten-year fixed
These rates result, in part, from the Fed’s restrictive monetary policy and financing becoming harder to secure. Moreover, much uncertainty exists regarding the Fed’s interest rate hikes and the collapse of Silicon Valley Bank and Signature Bank, which collectively led to concerns regarding banking risks. In response, many financial institutions have made it more difficult to acquire loans. According to the Federal Reserve Senior Loan Officer Opinion Survey on Bank Lending Practices, “Banks reported tighter standards and weaker demand for all commercial real estate loan categories” in the first quarter of 2024. More than 50% of survey respondents reported stricter requirements for all types of financing. This includes the spread of loan rates over the cost of funds, maximum loan sizes, loan-to-value ratios, debt service coverage ratios, and interest-only payment periods.
On a positive note, in response to regional bank failures in early 2023, the Fed used its Bank Term Funding Program to increase liquidity. By temporarily increasing its balance sheet, the Fed further improved the financing environment, but credit is still tight by historical standards.
Meanwhile, an estimated $1.2 trillion of CRE debt is expected to roll over next year. Conditions are set to worsen, especially if the Fed pressures the economy for longer than anticipated. The reality is that the sector needs rates to fall because many of the loans that are coming due are somewhere in the three and a half to four percent coupon range while today’s financing costs are nearly 7%.
Escalating Operating Expenses
Operating expenses have increased broadly. For one, the commercial property insurance market has experienced escalating premiums since 2017. After surging 14.2% year over year (y/y) in the third quarter of 2020, premium gains seemed to moderate, entering the single digits, only to jump in the first quarter of 2023 by 20.4% y/y, the highest hike in 20 years. It is possible that insurance carriers have increased policyholders’ premiums to make up for a decline in the volume of policies they sell, with owners of vacant buildings less likely to renew coverage.
Climate change is another factor. Deloitte has found that premiums for buildings in 10 states with the highest expected annual losses from severe weather climbed 31% y/y and 108% during the past five years. Premiums in other states during those periods increased 25% and 96%. By 2040, premiums in high-risk states are expected to be 24% above the national average.
Furthermore, labor costs are rising, with trends steepening after the pandemic in 2020, according to the Employment Cost Index for all civilians, which illustrates that compensation increases have not simmered down to pre-Covid-19 levels.
The Troublesome Side of Remote Work
Meanwhile, occupancy rates as determined by leasing contracts have declined from approximately 87% in the first quarter of 2019 to approximately 80% as of the second quarter of this year, according to Cushman Wakefield’s U.S. Office Marketbeat report. Kastle’s office visitation report, based on key card data, depicts an even worse picture—companies aren’t fully utilizing their existing space due to an increase in work-from-home arrangements. Prior to the pandemic, the organization’s 10-city average occupancy rate was close to 100%, but it is now down to 56%. Clearly, flexible work arrangements have increased vacancy rates, creating a slew of problems.
Demographics, Demand and Delinquency
Demand for office and retail space is on a steady decline, causing significant consequences as illustrated by New York City. With weak demand, the value of all NYC office properties dropped more than 40% in 2020 and isn’t expected to strengthen in the foreseeable future. At least one estimate says average office values in 2029 could be 39% lower than in 2019. Pre-Covid-19, around 250 million square feet of new office leases were signed per year. This fell to 100 million in the first half of 2022.
Commercial real estate loans also illustrate issues with office buildings and other types of properties used by businesses. In many instances, banks are opting not to foreclose on office buildings when owners default on their debt because lenders do not have enough experience managing such spaces. So, they are instead entering into special servicing agreements. In 2020, less than 1% of single asset, single borrower office loans securitized through commercial mortgage-backed securities (CMBS) had entered into special servicing arrangements and less than approximately 3.5% of conduit loans, or loans for multiple properties, were in special servicing. This has increased to approximately 10%, according to Moody’s. In a related matter, more than $38 billion of US office building debt faces loan defaults, foreclosures, or other forms of distress, causing some banks to experience losses or at least increase special servicing for bad debt.
Toxic Debt Surfaces in Earnings Calls
Wells Fargo executives, in a recent second-quarter earnings call, noted that fundamentals in the institutional-owned office market have continued to deteriorate with lower appraisals reflecting the weak leasing market in many metropolitan areas. Wells Fargo CFO Michael Santomassimo said the bank had anticipated net loan charge-offs increasing by 7 basis points (bps) of overall loans in the first quarter to 57 bps in the recent quarter. Commercial property net loan charge-offs increased by $127 million during the quarter but only reached 35 bps of average loans. Santomassimo announced, “While losses in the commercial real estate office portfolio increased in the second quarter after declining last quarter, they were in-line with our expectations.” The company has reduced its headcount for 16 consecutive quarters. Likewise, CFO John Stern of US Bancorp reported that, “Our second-quarter net charge-off ratio of 58 bps increased 5 bps from the first quarter in line with our expectations, and we continue to expect our net charge-off ratio to approach 60 basis points in the second half of this year.” Blackstone Mortgage Trust, a real estate financing REIT, is also feeling the pain. Due to increasing defaults, it has cut its dividend by 24%. Other REITs such as KKR Real Estate Finance Trust Inc. and Ares Commercial Real Estate Corp. have taken similar actions.
The Aggregate Cost of Defaults
According to a working paper by the National Bureau of Economic Research, banks could reportedly face $160 billion in losses on real estate debt if default rates reach 20%. So far, small regional banks that have a larger percentage of their debt holdings in mortgages have had the most dramatic losses, causing their shares to underperform the overall market.
Risk Premium Climbs
In another sign of increased risk, cap rates, or the required return that an investor perceives when evaluating a potential real estate investment, have climbed. According to commercial real estate and services company CBRE, retail and office cap rates earlier this year rose above industrial cap rates for the only time this century and experienced the most significant increases out of all CRE segments. Among all CMBS, the likely causes are online retailing taking market share from traditional stores, Covid-19, concurrent technological advancements, and increases in remote work.
Decline in Office Demand Hurts Urban Revenue
CRE issues present serious implications for businesses near urban office centers. With technology allowing employees to work from home, counter urbanization is running its course, causing populations in many cities to decline. According to the US Census Bureau, the populations of New York City, San Francisco, Los Angeles and other major gateways have dropped following the Covid-19 pandemic. With individuals moving out of cities, so does their spending, reducing tax bases.
Implications for the Labor Market
With CRE owners facing persistently high operating costs, lofty interest rates and weak demand, office-loan defaults are increasing. Since banks and other financial institutions loan large sums of money to real estate developers and office building owners, financial institutions can potentially face additional losses if those borrowers default on their obligations. This could lead to widespread job losses in the financial sector. Large banks have already handed out more than 20,000 pink slips this past year, and this number is projected to grow, which could lead to a net loss of jobs. Big financial firms such as Bank of America, Morgan Stanley, Wells Fargo, and Goldman Sachs have planned layoffs amidst market uncertainty, according to CNBC.
Regional banks are taking an even greater hit because they have more commercial real estate exposure, relatively speaking. According to Goldman Sachs, regional banks provide about 80% of CRE loans. Furthermore, JP Morgan suggests that compared to money centers, small banks hold 4.4 times more exposure to US CRE debt. Therefore, these small and medium-size financial institutions are likely to be the most impacted by the tighter lending standards and profitability requirements they have established for CRE. Their financing abilities could be stunted, leading to layoffs. Lenders like KeyCorp, Truist, and Citizens Financial are scaling back headcounts after recording double-digit declines in profit. PNC and Citizens are also planning to decrease their workforces, with Citizens’ CEO Bruce Van Saun stating, “When deposits are more dear and they’re more costly, then you say, well, I really don’t want to be funding that.” These various challenges have led to the underperformance of regional banks since 2022.
Layoffs have been primarily centered at financial institutions, but if CRE continues to struggle, jobs could be lost in related industries. At risk jobs include developers, construction workers, architects, engineers, real estate agents, property managers and more. Small businesses located near vacant office buildings are also set to decline. With less foot traffic in urban centers, local entrepreneurs within close proximity to office buildings may be forced to shut their doors on account of a lack of customers.
Promising Factors
Despite the many aforementioned consequences, there is a glimmer of hope with a record number of office buildings expected to be converted into apartments this year. Local governments are playing a large role in this initiative, offering incentives to fill these spaces. Nevertheless, zoning and building requirements have complicated these efforts. Some cities discourage conversions in neighborhoods that lack supermarkets, schools and other amenities that apartment dwellers demand. Additionally, office building designs aren’t conducive to adding bathrooms to each new apartment. Many office buildings, furthermore, only have windows on two walls, while most apartment buildings are constructed with layouts like the letters L or O to provide more windows and better ventilation. Zoning restrictions, however, are changing. New York City Mayor Eric Adams has proposed “City of Yes Housing Opportunity,” allowing office buildings constructed before 1990 to be converted to housing. In turn, many large cities are following suit. In January of this year, apartment conversions under construction had quadrupled relative to the first month of 2021, according to data from RentCafe. Washington, D.C., appears to be leading with 5,280 apartment units being built from various empty office buildings. While providing much needed urban housing and construction jobs, this trend is also helping to ease the glut of office buildings. The increase in urban housing is also appealing because prices of suburban homes have soared, making houses unaffordable to many individuals.
The Future of the CRE Market
The outlook of CRE is largely dependent on whether the Fed maintains its current restrictive policy or begins to lower the benchmark earlier than expected. As of July 18, 2024, the mid-point rate was 5.38%. The Fed noted that they would lower rates once they feel more confident that inflation will cool to 2%. In June, the Consumer Price Index declined by 0.1% month over month and the Producer Price Index advanced by a mere 0.2%, which increased optimism that the central bank may start reducing rates. The upcoming presidential election is likely to complicate the timing of the initial step-down, however, because the Fed doesn’t want to risk the perception of the committee favoring either political party. Investors have placed the likelihood of a September rate hike at 90%. A delay in accommodation could sustain the pain in that the combination of high interest rates and weak demand will lead to an even greater number of office-loan defaults. Long-term interest rates, however, may continue to stay high even after the Fed delivers reductions. In the past, when the Fed lowered rates, deflation forces were prevalent, which contributed to long-term yields declining. Now, however, the trends of corporations onshoring or near shoring various functions and federal deficit spending are likely to support inflation pressures, causing long-term interest rates to stay elevated despite a slipping short end.
Office Occupancy Expected to Increase Slowly
Occupancy in most urban buildings isn’t projected to improve into 2025 and won’t reach pre-Covid-19 levels prior to 2028, according to a CBRE forecast. With office vacancy rates stagnant and below pre-Covid levels, commercial refinancing of real estate debt due to expiring mortgages is predicted to increase to $15 trillion next year, creating additional pressure for building owners as financing costs increase. Additionally, bank exposure to real estate defaults may lead to financial pressure, which can result in financial institutions continuing to implement tighter lending standards. This would reduce credit availability and potentially lead to more job market weakness.
Consequences for Investors
The most recent result of the Federal Reserve’s CRE financial soundness indicator, which covers 2023, shows the largest y/y percent drop in commercial real estate prices since 2009. The downturn of CRE has created several consequences for investors, as follows:
- According to the Federal Reserve Bank of Boston, investors are succumbing to the decline in revenue and earnings resulting from the climbing number of defaults. Vacancies and lower rents cause a decline in the income that these properties generate for their owners and investors. Property owners typically experience a large loss of income once their office leases expire, forcing them to default.
- The requirement for increasing toxic asset reserves has remained at 2% for 2024, weighing on investor earnings. According to the FDIC, in order to prevent sharp swings in assessment rates and maintain the Deposit Insurance Fund at a level that can withstand substantial losses, the Designated Reserve Ratio must be maintained at 2%.
- The poor performance of the regional bank index is hurting investor sentiment. This holds especially true following the failures of regional banks Silicon Valley Bank and Signature Bank. Investor sentiment is the lowest since the pandemic in 2020.
- Investors might choose to diversify their real estate investment strategies. They might choose to move away from investing in office spaces and instead focus on areas that might have growing demand in response to the pandemic. They may choose to invest in trends like housing, flexible workspace providers, data/logistical centers, etc.
- Market volatility within the commercial real estate sector is skyrocketing. Unless the Fed provides relief, sector performance is unlikely to improve. Insurance premiums, delinquency rates, and office-loan defaults are all experiencing record-high levels. This may lead to more stringent loan conditions and higher borrowing costs, which can negatively impact investors’ abilities to acquire and refinance properties, further decreasing demand from buyers for buildings.
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Thank you to our economic group interns Jennifer McKay and Jonty Hammer for helping this summer.