(Editor’s note: Welcome to the New Real Estate Barons, a Bold mini-series examining some out-of-the-box angles of real estate. Check out the first installment, which focused on the rise of the Airbnb mogul; today’s installment digs into the problems facing commercial real estate and how solving those problems could mean success.)
The commercial real estate industry is in trouble. Recent trends are affecting demand as well as supply, particularly that of office and retail space. These trends not only involve economic ones but likewise those related to remote work preferences. As a result, the health of this sector is in question as hundreds of vacancies persist in urban areas. Some experts are event predicting that a looming commercial real estate crisis is right around the corner. But there is hope in preventing such a crisis, and business has a major role to play. Office space solutions could turn the situation around. In fact, this may represent a notable opportunity for some businesses to actual gain a market advantage.
Certainly, the demand for these office and retail space could suddenly shift. There are some indications that several companies are wanting employees to return to the office. This could affect the situation in a positive way. But banking and economic scenarios look much less hopeful in this regard. As valuations change and become less well defined, lending and credit shifts could further the commercial real estate crisis. Also, with changing oversight requirements on lending, financing and refinancing such spaces may decline even more. These are the telltale signs that indicate effective office space solutions are needed. And where there’s a need, a tremendous business opportunity often exists.
”Price growth is slowing and for some asset classes it’s starting to decline. Office properties have been more challenged than others for obvious reasons.” – Xander Snyder, Senior Commercial Real Estate Economist at First American
Downward Demand for Office Space
Ever since the pandemic, demand for office and retail space has drastically declined. The sudden shift to remote and hybrid work resulted in many commercial buildings having unoccupied spaces. In turn, this reduced the amount of foot traffic in urban areas affecting municipalities and other businesses alike. This so-called urban doom loop has persisted and continues to be an issue for many cities and companies. Attempts at office space solutions have been tried, but thus far, an effective has not surfaced. And to a great extent, retail spaces are also suffering such problems as e-commerce trends advance. These reflect major changes that are fueling a potential commercial real estate crisis.
In many cities, residential construction continues to grow as affordable housing remains limited in many areas. But this is not the case for commercial construction. Since demand has sharply fallen, supply has risen proportionately. And with greater supply, there is pressure to lower lease and rent rates, which undercuts real estate value. On the one hand, those who own commercial properties need a certain income to meet mortgage payments. But at the same time, potential tenants have many more options from which to choose. This is causing competition for occupancy based on price, which is why a future commercial real estate crisis might occur. Without a change in demand, these downward trends are likely to continue.
“More than 50% of the $2.9 trillion in commercial mortgages will need to be renegotiated in the next 24 months when new lending rates are likely to be up by 350 to 450 basis points.” – Lisa Shalett Morgan Stanley Wealth Management’s chief investment officer
Pandemic shifts definitely played a part in affecting demand and contributing to a potential commercial real estate crisis. But economic ones are also playing a major role. Given inflationary pressures, the Fed has progressively increased the interest rate over the last couple of years. From a benchmark of nearly zero, it now sits at 5%. This is noteworthy because it means commercial real estate rates of return fall concomitantly with these increases. And lower rates of return naturally mean lower valued properties. Without effective office space solutions, this type of situation is unsustainable for many commercial real estate entities.
Many economic experts predict that a recession will occur in the coming year. Others favor stagflation, a combination of slow growth and high inflationary pressures. In either case, the economic landscape for office and retail space is not favorable. Lower growth means that fewer firms will be looking to lease office and retail space, which further cuts demand. And higher interest rates mean commercial properties will be constrained in reducing prices. The key will be to devise office space solutions that could reattain higher occupancy rates. This would be one way to avoid a commercial real estate crisis while waiting for economic shifts.
To make matters even worse, the recent banking crisis isn’t helping the situation. Did you know most commercial real estate development loans are provided by small to mid-size banks? In fact, estimates suggest that 80% of these are from such banks. Given the recent bank failures of Silicon Valley Bank and Signature Bank, this could be problematic. Banks that are heavy in commercial lending will be at higher risk for foreclosures, which could trigger more bank failures. And tighter federal regulatory oversight of these banks is expected, making access to credit more difficult. These issues too will be an economic factor contributing to a commercial real estate crisis.
“I do think you will see banks pull back on commercial real estate commitments more rapidly in a world [where] they’re more focused on liquidity.” – Richard Ramsden, Researcher for Goldman Sachs.
Potential Office Space Solutions
Devising office space solutions to avoid an impending commercial real estate crisis will not be easy. Zoning and building requirements often impose barriers to space conversions to other alternative uses. Regardless, opportunities exist to utilize existing commercial office spaces for student dorms, academic classrooms, and religious centers. These destinations might also be developed into event spaces and social hubs that might be attractive in an urban area. Coworking settings and creating multifunctional locations for different activities might also be considered. These may require working with city planners and leaders to change existing restrictions. But if done effectively, such office space solutions could reap large rewards over time. These strategies might not only help avoid or limit the impact of a commercial real estate crisis. They might also pave the way for a new type of real estate baron for the future.