It’s now the middle of 2023, and for all practical purposes, it seems the COVID pandemic has ended. But simply because face masks are a rarity and restrictions have been lifted doesn’t mean lasting effects don’t persist. Naturally, the effects of the pandemic remain fresh in everyone’s mind. However, some things like the work-from-home economy and mentality now appear entrenched. Some employers are trying their best to lure workers back to the office. But the vast majority still insist on remote work leaving significant commercial office building vacancies. This is why many are certain that a commercial real estate collapse is unavoidable.
While a commercial real estate collapse would be catastrophic by itself, the ripple effects are what’s more worrisome. Real estate moguls and corporations have already lost millions as buildings sit with a significant number of empty offices. But these aren’t the only stakeholders affected. Next in line are the banks that are holding the loans on these buildings. Should landlords simply walk away due to commercial office building vacancies, many banks could be left in the red. And for urban centers that rely on the property taxes for such spaces, other problems could result. This includes insufficient revenues for schools, emergency services, transit and more. These are just a few of the reasons a commercial real estate collapse reflects a much bigger issue than many realize.
Taking Another Look at the Numbers
Since the pandemic began, many investors and real estate holders have been monitoring commercial office building vacancies. According to the latest figures, things have not improved, and in fact, look to have worsened. In New York City, one of the hardest hit areas, the current vacancy rate hovers around 22%. In essence, this means about 52 million square feet of office space remains available for lease. The oversupply of these spaces has resulted in a significant drop in value for these properties as well. Best estimates suggest that these same properties have lost about 44% of their value. These are big numbers and account for concerns about an impending commercial real estate collapse. With these types of valuations, it’s evident that many with commercial building loans will choose to walk rather than stay.
It’s worth considering that every downturn in any market has some potential upsides. With a commercial real estate collapse, the chance to acquire some cheap properties with residual value might exist. But here too, the outlook isn’t as favorable as one might think. Certainly, there are some newly constructed properties that remain in high demand. There are also some other Class A buildings that have good amenities and locales that support ongoing investments. But for cities like New York, roughly 70% of commercial properties lack such value. And even worse, only about 30% of all commercial buildings have conversion potential into alternative uses. The office building vacancies continue to be too sizable to make many of these properties worth the long-term risk.
The Impact on Major Cities
One of the repercussions of a commercial real estate collapse relates to city centers. This has been referred to as the urban doom loop as city revenues are intimately linked to commercial property taxes. In cities like New York, such taxes from commercial properties account for about 21% of all tax revenues. Thus, understanding that both commercial values and occupancies are shrinking, it is clear property tax revenues are as well. Should office building vacancies continue or worsen, many municipalities will struggle to maintain needed services. This includes things like police services, fire rescue, public transportation, and even education. Some major cities are already dealing with these situations currently.
When office building vacancies result in significant declines in tax revenues, urban centers progressively decline. At the present time, downtown areas are less populated because of remote work. But as municipal services diminish, fewer residents will want to live in downtown areas as well. Rising crime rates, increased homelessness, and worsening aesthetics will push residents into suburban destinations. And this will result in further declines in property tax revenues. This is the urban doom loop to which many refer, and it’s the commercial real estate collapse driving its potential. As a result, it is clear that major cities in the U.S have a vested interest in preventing such a collapse. And instead of being reactive in their approach, they should be investing in proactive solutions now.
Banks At Even Higher Risks
To understand the pressure banks will be under with a commercial real estate collapse, it’s worth examining current loans. In the U.S., roughly $1.5 trillion in commercial real estate debt will come due in 2025. These loans, which are primarily interest only loans, were initially created when interest rates were low. Today, however, interest rates are much higher, making refinancing of these loans very unattractive. At the same time, a new market appraisal of the same property will reflect significant declines in value. This means that banks will be less than enthusiastic about extending loans on current buildings. And it means landlords will similarly be less willing to persevere in such an unfavorable climate. Unless office building vacancies changes, this is what the situation will be in the next couple of years.
In the majority of cases, commercial building loans in places like New York City are structured as non-recourse loans. This means that corporations and real estate holding companies have the option to just walk away from a loan. They may have ample assets otherwise. But ultimately, it will be the banks holding these properties should a full commercial real estate collapse occur. Given the string of bank failures that recently occurred, this is concerning. In those cases, banks overextended themselves in making technology startup loans. It may well be that other banks may find themselves in the same position with a commercial real estate collapse. And if this affects enough banks, the country could even see another widespread financial crisis. This is how office building vacancies could have tremendous effects well beyond their own bubble.
Solutions Hard to Come By
Understanding the situation, it may be evident that simply solutions aren’t readily available. Zoning laws and office space dimensions make conversions challenging. Likewise, the revenue value of these alternative spaces is often much less than commercial real estate values. At the same time, immediate changes in the nation’s remote work mentality aren’t likely either. For most companies, it’s clear that Friday returns to the office are dead, and Monday returns are questionable at best. Regardless, cities, banks, and commercial landlords all have a strong invested interest in avoiding a full-blown commercial real estate collapse. Collaboration, innovation, and business savvy are needed to fix the current situation. Otherwise, a commercial real estate apocalypse may well occur, and we will all be affected by it in the process.