Whether you realized it or not, the nation has a serious problem when it comes to commercial real estate. Current U.S. real estate market news reports that there is roughly $1.5 trillion in commercial real estate debt. This debt is owed to a number of entities none the least of which are financial institutions. The problem that exists is one where various commercial properties are progressively falling in value. And in many instances, their new value is well below the amount owed on these properties. Several factors are to blame for this situation, but identifying which ones are most relevant is tough. But in order to consider solutions, it’s important to diagnose the issues before a full-blown commercial real estate crisis ensues.
The pandemic plays a large role in today’s current office space situation. Prior lockdowns followed by remote and hybrid work preferences left many vacancies in urban office buildings. Even now, a quarter of office buildings in most major cities is empty, making it hard for landlords to make payments. But according to U.S. real estate market news, the problems extend well beyond vacant commercial spaces. The issues extend to other business enterprises and to the cities harboring these buildings themselves. And macroeconomic effects as of late is adding salt to the wound. Understanding this, let’s explore these issues in greater depth to gain insights about the potential commercial real estate crisis currently.
(Remote or hybrid work postures have become a requirement for new hires–read more in this Bold story.)
“These [downtown office] buildings will go into a process that will make them no man’s land—untended, unwanted, unused.” – Susan Wachter, Professor of Real Estate and Finance, University of Pennsylvania’s Wharton School
Highly Leveraged and Underwater
The U.S. commercial real estate market today has been valuated at roughly $21 trillion. However, it’s important to note that only $7 trillion of this, or a third, involves actual office space. In addition, of this office space, only about a quarter of these are contributing to problematic debt. In this regard, it’s not likely that an immediate commercial real estate crisis will occur. However, this still indicates a sizable risk that the nation is facing. U.S. real estate market news reports that vacancy rates exceed 20% for office buildings currently. While this figure may not seem tremendous, it is once building valuations and owner leverage is considered.
Since the pandemic, demand for office space has declined significantly. In fact, almost all the large office buildings in Los Angeles now have a lower value that what is currently owed on them. In other words, these buildings are underwater. U.S. real estate market news reports that this is due to the rapid drop in value after the pandemic. Currently, office building owners in L.A. owe about $230 per square foot while the average value is about $154 per square foot. It is also important to note that the failed payment rate on office building loans has been recently declining year-on-year. This contrasts with the overall commercial real estate market, which has been stable. But if this continues, it could be enough to trigger a broader commercial real estate crisis.
Secondary Problems of Note
Remote work and office space vacancies are certainly the primary issues undermining commercial real estate values. However, there are major ripple effects that are just as concerning. Without urban foot traffic to and from downtown office spaces, other commercial businesses suffer as well. Restaurants for lunch and after-work dining are struggling in any city centers. Likewise, retail stores and shops are suffering the same fate. This means that some of these businesses may also be unable to pay existing loans or leases. Thus, as a secondary phenomenon, these situations will further contribute to a potential commercial real estate crisis. U.S. real estate market news is already reporting trends for these businesses to relocate to suburban areas. This represents another major piece of the commercial real estate crisis puzzle.
These are not the only ripple effects being felt in urban downtown areas. Municipalities themselves are also struggling as office spaces decline in value. Declining property values means lower tax revenues for cities, which undercuts public services and supports. Referred to as the urban doom loop, this triggers a vicious cycle for these areas. Lower tax revenues reduce city services, which in turn makes it even less attractive to be in downtown areas. Over time, these effects result in a progressive lowering of office building values as demand further declines. U.S. real estate market news suggests we are only seeing the earliest stages of this at present. And should it continue, it would indeed lead to an impending commercial real estate crisis.
(Is your city stuck in an urban doom loop? Read this Bold story and determine for yourself.)
Adding Insult to Injury
In addition to these more direct impacts affecting urban office space, the larger macroeconomic environment isn’t helping either. In the past year, interest rates have climbed significantly as the Fed tries to contain inflationary pressures. However, this has raised the cost of loans while making it harder for building owners to sell. Higher rates tighten credit options, both of which reduce the number of potential buyers. Combined with lower property values, the chance to unload vacant office spaces is tremendously reduced. These types of constraints as reported by U.S. real estate market news place owners as well as banks in tough positions. This too increases the risk for a commercial real estate crisis in the near term.
A Seller’s Perspective of the Situation
According to recent analyses, the amount of vacant office spaces in downtown major U.S. cities is approximately 25%. This is a substantial amount considering this is likely the typical margin of profit that many commercial real estate owners anticipate. But even with a 75% occupancy rate, landlords still aren’t coming close to breaking even. The vast majority of these landlords are underwater, meaning they owe more in commercial real estate loans than these buildings are worth. As a result, trying to sell these properties is a challenge and unlikely alone to be feasible office building solutions. But to avoid a full-blown commercial real estate crisis, this is likely to be a necessary evil.
In many urban areas, the actual office building loan-to-value ratio is about 1.5. From a building owner’s perspective, this means selling these properties would result in major losses. The other option would be to refinance the properties, but this too is an unfavorable option. With high interest rates, any refinancing opportunities would result in even higher payments. Plus, in the current climate with over-extended banks collapsing, credit tightening may not even allow such an opportunity. As a result, office building solutions from a seller’s perspective are limited and far less than ideal. The most likely course of action is to sell for a loss or wait out the commercial real estate crisis. Neither provide effective office building solutions at the present time in isolation.
Lenders’ Points of View
As is obvious given the number of underwater commercial real estate properties, lenders are in a very unfavorable position as well. Reportedly, lenders are carrying over $1.5 trillion in commercial real estate debt, and a third of this involves office spaces. Should building owners fail to make loan payments, lenders have a few options. They have the option to repossess the property. They could also foreclose on landlords who cannot stay up to date. Or they can offer loan extension to borrowers, hoping for things to turn around. Though it may not be one of the best office building solutions, the latter is the most probably option lenders will choose. In fact, this is the most likely course that could help minimize risks of a more severe commercial real estate crisis.
It’s worth examining lenders’ potential choices in the current situation to understand why they may choose to extend loans. Should banks decide to repossess office spaces in downtown areas, they are likely to lose the most. Banks are not in the business of managing properties, and they tend to do a poor job anyway. This means they will ultimately sell these properties after repossession as a highly discounted price. This is hardly ideal from a financial position. On the other hand, should they choose to foreclose on these properties, there are additional time and financial costs they will experience. Foreclosures also require depositor disclosures, which could create risks of bank runs. In contrast, offering landlords loan extension costs lenders the least and still offers hope for future returns. This may temporarily delay the commercial real estate crisis, but it is also ineffective when it comes to office building solutions.
Office Space Conversions
In an ideal situation, office building solutions would involve converting spaces to other uses. Some office buildings are revamping layouts to better accommodate hybrid work spaces and shared real estate offerings. But these remedies still do not utilize office space in an optimal way. Likewise, the demand for such space pales in comparison to pre-pandemic demand for commercial offices. Other options involve using spaces for gyms, labs, and biotech centers. However, with the urban doom loop cycle, less foot traffic in downtown areas is also reducing demand for these uses. While these offer reasonable strategies to prevent a commercial real estate crisis, they aren’t likely to be completely effective either.
In terms of office building solutions, the best option would be to convert these properties into residential units. Based on the lack of affordable housing in many city centers, this would be ideal. Likewise, this would help revitalize downtowns and break the vicious cycle of the urban doom loop. But many barriers stand in the way of residential conversions. For one, city zoning and code requirements prevent a simply switch from commercial to residential space. Significant costs would be incurred in the process for developers even if city planners and policymakers were on board. This would raise residential costs likely beyond market supply and demand pricing determinations. Once again, though a logical approach, this too is unlikely to avert a commercial real estate crisis.
The Potential for an Urban Overhaul
Based on the above analysis, it would seem sellers have few good options. Likewise, lenders appear stuck as well in a losing situation. Opportunities to convert office spaces to properties in greater demand also have their own set of issues. However, there is evidence that office building solutions exist and are beginning to emerge. In Washington D.C., Hines real estate investment group recently purchased a commercial building for $60 million. This is noteworthy because that price is about half of what it cost to develop the building. Such a discount invites new opportunities for renovation and revitalization of city centers. This likely reflects the first steps and the earliest office building solutions that might be effective.
The broader office building solutions will need to expand from these types of efforts to those that involve residential conversions. According to experts, it will require property values to fall even more (and possibly to even negative values). When operating costs exceed commercial lease incomes, this could happen. Indeed, this will define a serious commercial real estate crisis. It will also welcome office building solutions that allow complete urban overhauls. This may be a few months to years away. But this may ultimately be required before we find our way out of our current situation.
