Why we should worry about the US commercial property crisis

Why we should worry about the US commercial property crisis

WeWork’s financial plight represents a further blow for the troubled commercial real estate industry that is already grappling with surplus capacity after the coronavirus pandemic sparked a surge in working from home.

Even now that conditions have returned to normalcy, most workers continue to embrace a hybrid working model and are reluctant to return to working five days a week in large offices, particularly in large cities such as New York and San Francisco.

In New York, many of WeWork’s sites are located in lower-quality buildings, and its financial troubles may exacerbate the widening gulf between desirable modern buildings and more dated properties.

The problems in the US commercial property sector are likely to trigger crippling losses for US banks, which have been enthusiastic lenders to the country’s commercial property sector.

The Wall Street Journal calculates that banks roughly doubled their lending for commercial real estate between 2015 and 2022 to $US2.2 trillion. Many of these loans were written by small and medium-sized banks.

The WSJ estimates that banks’ total exposure to commercial real estate comes to a staggering $US3.6 trillion if indirect loans – including loans to financial companies that in turn lent against commercial properties, and their holdings of bonds backed by commercial property – are included.

And that means the US banking sector is set to suffer swingeing losses from the slump in commercial property values.

In a paper, Work From Home and the Office Real Estate Apocalypse, researchers from New York and Columbia Universities – Arpit Gupta, Vrinda Mittal and Stijn Van Nieuwerburgh – estimate that US commercial property values have fallen by around half a trillion dollars.

“We show remote work led to large drops in lease revenues, occupancy, lease renewal rates, and market rents in the commercial office sector”, they say.

“We revalue New York City office buildings, taking into account both the cash flow and discount rate implications of these shocks, and find a 44 per cent decline in long run value.”

They add that “for the US, we find a $US506.3 billion value destruction”.

The researchers say that higher-quality buildings are buffered against these trends due to a flight to quality, while lower-quality office is at risk of becoming a stranded asset. “These valuation changes have repercussions for local public finances and financial stability.”

As the researchers point out, banks hold more than 60 per cent of all commercial real estate debt. A large chunk of the loan portfolios of medium-sized banks consists of commercial real estate loans.

In addition, “the spatial concentration of office assets in urban central business districts also poses fiscal challenges for local governments, which rely heavily on property taxes levied on commercial real estate to provide public goods and services”.

Within the US commercial real estate industry, there are hopes that deep-pocketed foreign investors could arrest the downward spiral in property valuations.

Three months ago, New York City’s largest office landlord, SL Green Realty, sold a nearly 50 per cent stake in a prominent New York City office tower – located on prestigious Park Avenue – to Japan’s Mori Trust. The $US2 billion valuation was only a slight discount to its previous valuation.

The sale sparked a large rally in SL Green’s share price, which is now trading at $US41.33. All the same, the company’s share price is roughly half its level in early 2022, when it was trading at more than $US80.

What’s more, although such high-profile sales help to bolster confidence, the overall US commercial property market remains moribund, with sales in July down more than 70 per cent from a year earlier.

And most of the potential buyers of commercial real estate are bargain-hunters hoping to pick up properties from distressed sellers for a fraction of the price they traded for several years ago.

At the same time, soaring interest rates are causing cracks to appear in the US residential real estate market.

Since March 2022, the US Federal Reserve has raised rates 11 times, pushing its key rate from close to zero to the present range of 5.25 per cent to 5.5 per cent.

This huge increase in official interest rates has flowed through to other US borrowing costs, with the average 30-year fixed rate mortgage rate now close to 7.2 per cent, the highest level in two decades. This represents more than a doubling in mortgage rates from two years ago, when rates were below 3 per cent.

This massive jump in borrowing costs has prompted many homeowners to decide to stay put, rather than buy new homes and take on more expensive mortgages.

In turn, this has caused the US residential real estate market to seize up, with the volume of residential real estate sales plummeting.

Sales of previously owned homes are now down about 36 per cent from the beginning of 2022.

Still, the dearth of existing houses for sale is also helping to support house prices. The national median existing home sale price rose 1.9 per cent in July from a year earlier to $US406,700, according to the National Association of Realtors.

Given the short supply of existing residential properties, potential home buyers have turned their attention to buying newly built homes from builders.

The sharp rise in the sales of new homes has boosted the share prices of US publicly listed home builders, with shares of D.R. Horton and Lennar Corp climbing by close to 25 per cent so far this year, while PulteGroup and Toll Brothers have both risen more than 50 per cent.

Originally Appeared Here

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.