Afind an investor Describe the prospects for commercial real estate, and you’ll get a plethora of responses. “The office is like a dumpster fire,” said Daniel McNamara of investment fund Polpo. His view of the broader market, which includes stores and warehouses, is only slightly less grim: “It’s really a perfect storm.” Tom Capasse of investment firm Waterfall Asset Management compared San Francisco and Seattle Waiting for the tech bubble to burst is called “office hell.”
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A nasty combination of events produced this hellishly perfect dumpster fire storm. The lingering impact of covid-19 keeps shoppers away from malls and employees at home, weakening mall and office values; all real estate valuations are hit by rising interest rates, which push up landlords expenses. Those woes have been exacerbated by recent banking turmoil and recession fears of laid-off workers and layoffs by former employers.
The situation poses problems for two large American industries that are intertwined. It starts with real estate, where landlords are grappling with the idea that the office buildings they own — empty and unlikely to be reoccupied — might be worth half what they bought them for. The second is their financier. When asset manager Brookfield recently decided it was better to hand over the keys to two massive Los Angeles office towers than to refinance a $784 million loan it owed, it handed over the keys to Citigroup and Morgan Stanley, both big bank.
No commercial real estate sector looks insulated. “Even in the warehousing space, you’re seeing companies like Amazon admitting they’re overspending and overbuilding,” Mr McNamara said. But the real concern is office space, which accounts for about a quarter of all U.S. commercial real estate (and its debt), because “it’s not a cyclical problem.”
Vacancy rates are rising in all but the best offices. Landlords are offering generous incentives to lure timid tenants. In San Francisco, more than 29% of offices are empty, nearly eight times the pre-pandemic level. Asking rental prices in the city were down 15% in 2019 compared to 2019. Due in part to property taxes, these buildings can be expensive to operate, and even a small drop in rent or occupancy can turn the building into a loss maker.
Some landlords may not be able or willing to keep the properties. If they can’t roll over their loan, they probably can’t. About 15 percent of outstanding commercial real estate debt from lenders of all types in the U.S. is due this year, Kevin Fagan of research firm Moody’s Analytics reports. Of those, he thinks about 40% may have difficulty refinancing. If the value of the building in question is significantly less than the loan value, the landlord may not be willing. Mr Capasse pointed to examples of “bigger sponsors preemptively returning keys even a year before the loan was due”.
The commercial real estate industry owes $5.6 trillion in debt to investors and financial institutions by the end of 2022. Half of that went to banks, according to data provider Trepp. Brookfield and a fund of its size may need to repay large institutions, but the vast majority of assets are in lenders with less than $250 billion in assets — assets that were already under severe stress after the collapse of Silicon Valley banks.
The danger is that the banks end up with lots of offices that they have to sell at deep discounts. This will bring back memories of the 2007-09 global financial crisis. But there are reasons to think that history will not repeat itself. First, commercial real estate is worth half as much as residential real estate, which is where things went wrong last time. Second, easy lending has led banks to issue mortgages worth as much as 100% of what homes were worth before the financial crisis. Commercial real estate lenders, by contrast, offer borrowers up to 75 per cent of mortgages, meaning prices will have to fall further before banks face losses.
Even the worst-case scenario will have only limited impact. About a quarter of the $2.2 trillion in commercial real estate loans owed to small banks is in office loans. Imagine that landlords paid back half of those loans this year — a total of about $280 billion. If the banks could recoup half the loan’s value by selling assets at a deep discount, say a third of what they were worth three years ago, they would take a $140 billion loss. This is only 10% of the equity held by small banks. However, the blows will be unevenly distributed and may compromise certain institutions.
Office Apocalypse
There is still the question of what happens to buildings that no one wants to work in anymore. Many offices are already in need of renovation. Construction costs are high due to material and labor shortages and new laws around the world aimed at making buildings greener. Energy efficiency rules in England and Wales, for example, will ban one in 12 London buildings from being rented from 1 April unless landlords upgrade them.
Ryan Williams of real estate investment platform Cadre sees two paths. The first is “fundamental repricing, with banks taking back the keys and selling assets at deep discounts”. This may allow new buyers to adjust, upgrade or maintain buildings to accommodate lower occupancy rates.Second, local officials stepped in: “This does not meet the [many cities] Seeing an entire street of low-rise office buildings in dilapidation, the government may start offering incentives for renovation or renovation. ’ In some places, this adaptation is already happening. Look out the window economistIn offices in Washington, and on any given weekday, a handful of builders are busy converting the old Vanguard building (once the Peace Corps offices) into a shiny new condominium. ■
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