The commercial real estate market took a big hit during the pandemic, and it has yet to recover. Previous reports highlight the impact various pressures have had on office space, especially in urban settings. (Read one of them here in this Bold story.) Many had hoped that the prevailing commercial real estate trends immediately after COVID would be short-lived. But there remains a commercial real estate crisis with no clear end in sight. Notably, economic and social conditions that undermine a commercial real estate recovery persist. Likewise, holding costs and tolerance among lenders and investors are similarly unfavorable. Given this, it’s expected that this sector has yet to see the full fallout for changing societal shifts.
Perhaps, it’s not surprising that current commercial real estate trends appear unfavorable. From time to time, the real estate market waxes and wanes, which certainly can impact office space. But this time around, pressures on urban office spaces are significantly greater than in the past. And because of this, not only will property owners, investors, and lenders suffer the effects. The ripple effects of the ongoing commercial real estate crisis are likely to be substantial. And even municipalities may soon feel the pinch. One thing is clear: commercial real estate is far from recovering and may not see a return to pre-pandemic values for decades. The question is whether the commercial real estate crisis represents a situation of distress or one of opportunity.
“When you see delinquencies rising and foreclosures rising, that means we’re approaching the acceptance stage of the grieving process for office properties — and that’s healthy. But we’re not at the bottom yet.” – Rich Hill, CEO of Cohen & Steers investment firm
Distressing and Depressing Numbers
Prior to the pandemic, there was an abundance of office spaces for lease. Particularly in larger cities like New York and San Francisco, commercial real estate investing was lucrative. But as remote work became essential and subsequently preferred, these commercial real estate trends shifted. Valuations of previously high-end office buildings dropped precipitously as vacancies mounted. And with few buildings being sold as a result of shrinking demand, estimating current values have been difficult. That being said, some statistics still highlight the magnitude of the current commercial real estate crisis. And based on some recent though limited office building deals, valuations don’t appear particularly good.
Noting a paucity of office building sales, the few that have occurred have sold a small fractions of pre-pandemic values. The range thus far seems to suggest that some are selling at 10-25% of their worth five years prior. This coincides with other statistics supporting a commercial real estate crisis. For example, in May of this year, roughly 7% of commercial real estate buildings have delinquent loans. This has more than doubled since the same time a year ago. Similarly, 30 buildings in commercial-backed securities are known to be in foreclosure. This compares with only 12 in 2023. Given that estimates show a total of $737 billion of commercial real estate loans exist, these figures are concerning.
“There is a lot more trouble coming. If we think it’s bad now, it’s going to get a lot worse.” – Mark Silverman, Partner at Locke Lord law firm
Commercial Real Estate Trends Ahead
By this time, many had hoped that the current commercial real estate crisis would have started resolving. Some expected many companies to insist that their workers return to the office. This certainly hasn’t happened with roughly half remaining in remote or hybrid work situations. They also had hoped the rapid increase in interest rates would return to their low pandemic values. But this too seems unlikely based on recent statements by the Fed. These factors combined with inflationary increases in building costs suggest commercial real estate trends won’t improve soon. In fact, many expect things to get worse before they get better. This means that the commercial real estate crisis may well reach rock bottom sometime in the next year.
(Full time office work is still dead–read why in this Bold story.)
Strategies thus far have been to try and wait out the apparent commercial real estate crisis. One common practice, known as “extend and pretend,” renegotiates office building leases hoping vacancy rates will improve. But based on recent data, vacancy rates hover around 22% in major cities. Combined with the fact that many commercial real estate leases and loans are coming due, extend and pretend is likely to end. This is why foreclosures are on the rise as of late. These unfavorable commercial real estate trends are forcing owners and investors to explore alternatives. This includes changing commercial spaces to residential ones. But this is more costly and challenging that it might appear on paper. It’s only after valuations sink to a low enough level that these options become actually viable.
A Hard Pill to Swallow
For many investors, the ongoing commercial real estate crisis has been painful. For those who invested in lowly rated commercial real estate security bonds, essential 100% of their investment has been lost. This equates to roughly $150 million. Even those who were selective and invested in Triple-A securities have lost handsomely as well. Totals suggest about $40 million has been lost in this market with a 25% loss in investment value. While this is difficult to accept, this pales to the losses lenders and owners may experience. Foreclosures will continue to increase as the commercial real estate crisis worsens. And this could place smaller banks heavy in commercial lending at risk. Much of this will likely play out over the next couple of years as commercial real estate trends unfold.
Of course, owners, lenders, and investors aren’t the only ones dealing with the commercial real estate crisis. Cities, especially major ones with an abundance of commercial properties, rely on property tax revenues for operations. With declining valuations and foreclosures, property tax revenues fall as do municipal budgets. As a result, city services could be impacted directly with communities affected indirectly. At the same time, surrounding businesses like restaurants, bars, and shops will also continue to suffer. Once reliant on office buildings and their occupants, they too will feel the impact of current commercial real estate trends. The bottom line is that it looks like things will get worse before they get better. The commercial real estate crisis remains real, and remedies still look to be a ways off.
Forget what you think about workplace culture and read this Bold story.
