US commercial real estate imperiled by shift

US commercial real estate imperiled by shift

A home stands behind a real estate sign in a new development in York County, South Carolina, US, February 29, 2020. [Photo/Agencies]

With the US still trying to get its arms around some recent bank defaults, the next shoe to drop could be the commercial real estate market.

Perhaps the biggest blow to the sector, particularly in large cities, was the shift to remote work amid the COVID-19 pandemic, which started in the US in early 2020.

While workers have gradually returned to offices, it appears that remote work in some form will become permanent, and how high that percentage is will have a huge impact on the viability of commercial real estate (CRE).

Then there is the issue of higher interest rates, with the accompanying prospect of loan defaults, while landlords have seen a significant drop in revenue from office leases. And most of the banks making CRE loans are smaller, regional institutions, which already have faced depositor withdrawals.

The White House said on April 18 that it is closely tracking the commercial real estate (CRE) sector after recent strains in banking, given that many smaller and midsized banks have “non-trivial” holdings in the office market.

Jared Bernstein, a member of the White House Council of Economic Advisers (CEA), told a Senate Banking Committee hearing that CRE occupancy rates were well below their pre-pandemic level.

“The issue is very much on our watch list,” Bernstein said during a hearing earlier in April on his nomination to head CEA, when asked by Democratic US Senator Mark Warner about the effect of the collapse of Silicon Valley Bank (SVB) on the sector.

Warner noted that close to $6 trillion in outstanding commercial debt was related to the real estate market, and that a “massive dislocation” was under way.

Another problem for the industry is that about a third of the $4.5 trillion in CRE debt comes due before the end of 2025, according to Morgan Stanley analysts.

CRE loans account for about 40 percent of smaller banks’ total lending, against about 13 percent for the largest lenders, the Financial Times reported.

Wells Fargo reported recently that its nonperforming CRE loans had soared nearly 50 percent since December — to $1.5 billion.

The CRE sector is facing a “moment of truth”, Mohamed El-Erian, the chief economic adviser at asset management giant Allianz, told Business Insider. He warned that higher interest rates are a major concern.

“The moment of truth will play out over several quarters as some $1 trillion of commercial real estate holdings needs to be refinanced,” El-Erian said.

Nearly $450 billion in commercial mortgages are due to mature this year, with final payments due in the coming months for many property owners, according to data from Trepp, a platform that tracks commercial real estate data, noted JPMorgan.

Jeffrey Fine, Goldman Sachs’ global head of real estate client solutions, recently said on a company podcast that the CRE market is in the middle of a “perfect storm” of higher rates, tight credit and rapidly maturing debt.

The market faces a “big rightsizing”, Fine said, and he expects a drop in valuations in older properties and office buildings.

“Over time there’s going to have to be a very organized public and private partnership to figure out a careful unwind of this current dynamic,” he added. “Otherwise, we have a very messy situation on our hands.”

“Higher interest rates call for higher demanded capitalization rates (the ratio of a property’s net operating income to its price), which will cause most real estate prices to fall,” said billionaire investor Howard Marks, reported Business Insider.

Marks, the co-founder of Oaktree Capital Management, warned in an April 17 memo of a slew of mortgage defaults that could increase stress on the US banking sector.

The US’ largest city, New York, faces the most trouble over CRE, according to an analysis by myelisting.com, a website that covers the CRE industry.

“Due to its enviable location and substantial demand for office space, the Big Apple has long been a commercial real estate powerhouse. The pandemic, however, has left the city’s office market in shambles.

“New York is the riskiest metro area in the nation for office property valuations, where there are a whopping $16 billion in CRE loans coming due in 2023, a 30 percent increase from 2022,” the website reported.

Meanwhile, a stark contrast between the booming industrial real estate sector and the reeling office market has emerged, according to myelisting.

The demand for industrial space such as warehouses and distribution centers remains strong in major cities, including New York. The need for fulfillment centers has expanded along with the demand for industrial space, as e-commerce has roared.

“While the residential rental market has bounced back, the retail and office markets have remained slack — largely due to the shift to remote work and online shopping,” the Federal Reserve Bank of New York said on April 13.

“One of the challenges, or one of the things that makes it not so clear, as you know, people are coming back to the office, they’re just not coming back five days a week,” said Jason Bram, economic research adviser for urban and regional studies at the New York Fed.

“New York City’s biggest corporate landlords had it great for years — benefiting from a booming economy in a city where companies clamored to set up offices and from low interest rates that buoyed the economics of an industry built on debt,” The New York Times reported on April 25.

But now, “floors of office buildings throughout Manhattan have been emptied by tenants who have shrunk their footprint and employees who work from home”.

The value of New York City office buildings could fall by $48.75 billion in the coming years, according to a study by Columbia University and NYU, the Times reported, which will be a blow to the city’s tax revenue.

Across the country in Los Angeles, the industrial sector in the US’ second-largest city saw a 7.2 percent year-over-year rent gain in 2022.

In the LA office market, however, vacancy rates have increased substantially, and property values have fallen. The city has about $16.9 billion in outstanding office loans, and is 14th in the US for office-loan risk.

In San Francisco, the office vacancy rate “is about 30 percent, or about 35 million square feet that is not currently being used”, Colin Yasukochi with commercial real estate firm CBRE told NBC News Bay Area. “And that’s the highest that we’ve ever seen in San Francisco.”

CBRE says that San Francisco has a large amount of tech tenants, who have viewed returning to work in person differently. The sector, centered in nearby Silicon Valley, also has had tens of thousands of layoffs at major companies in the past year, which created another dilemma for CRE.

A former San Francisco WeWork building has seen its property value slashed by about 66 percent, according to Trepp, which tracks CRE data.

The building at 25 Taylor Street was once almost entirely leased to WeWork, the formerly highflying co-work startup. The building was valued at $28.1 million in 2014, but was recently appraised at $9.5 million, according to Trepp.

While a few landlords in San Francisco have been slightly reducing rents, most in the newer, taller towers have not, NBC reported. Some buildings with the best views are actually raising their lease prices because of high demand from companies choosy about where they will keep their downsized office space.

“They want to be at the top of these tall buildings, and they want to be in the buildings along the waterfront with beautiful views because they’re trying to get their employees to come back to the office,” Yasukochi said.

Landlords in lower or older properties also are not trimming prices but instead are offering months of free rent or money to customize their office space for new tenants, NBC reported.

“They can’t materially retreat on rent without risk of defaulting on their building,” said Alexander Quinn, director of research with Jones Lang LaSalle Commercial Real Estate.

Christopher Ailman, chief investment officer of the $306 billion California State Teachers’ Retirement System, told the Financial Times that he estimated office values had fallen by about 20 percent and that he was preparing for heavy losses on the fund’s $52 billion real estate portfolio.

The International Monetary Fund’s recent financial stability report warned how a mix of declining property values, tighter financial conditions and illiquid markets could devastate borrowers looking to refinance loans, leading to sharply higher default rates.

“If you have maturing debt, you can’t carry the existing debt load and you’re not willing to put more money in, then it’s foreclosure,” said Tony Natsis, head of the real estate group at law firm Allen Matkins, the FT reported.

Reuters contributed to this story.

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About Caroline Vega 228 Articles
Caroline Vega combines over a decade of digital strategy expertise with a deep passion for journalism, originating from her academic roots at Louisiana State University. As an editor based in New Orleans, she directs the editorial narrative at Commercial Lending News, where she crafts compelling content on commercial lending. Her unique approach weaves her background in finance and digital marketing into stories that not only inform but also drive industry conversations forward.