Checking The Commercial Real Estate Pulse

For the last few years, it seemed somewhat obvious that the commercial real estate industry was headed for a deep dive in the wrong direction. Today, the somewhat obvious seems more of a likely than unlikely outcome. 

During and after the COVID-19 pandemic, landlords have struggled to fill vacant buildings after forced remote work. Hybrid workers (half remote, half in-office) have become the best band-aid for that, but it is a band-aid nonetheless.

As reported by other sources, LPL Financial chief economist Quincy Krosby recalls that some commercial builders had borrowed money to fund projects but “just walked away and gave it back to their lender”.

In order to combat inflation, the Federal Reserve will begin raising rates in March of 2022. This tactic has increased commercial real estate loan costs to higher levels than the industry may be ready for. According to the National Association of Realtors, the nationwide vacancy rate in office space reached a new record of 12.9% during the first quarter of 2023. This is up from the 12% recorded a year ago.

In the same quarter, the sudden failures of various banks (like SVB) shocked the public (bankruptcy). The Federal Reserve then warned about credit tightening (a little late, don’t you think).

The predictions of a recession in 2023 have sparked fears that companies would struggle to pay their loans. According to recent analyst reports, the short sellers have been keeping an eye on REITs in an attempt to better understand the commercial real estate market’s potential future.

Where, When OR WILL Commercial Real Estate Crash?

Analysts say that the big drop in commercial real estate valuations will likely continue for a while. Krosby says that a CRE recession “will be staggered.” She says that banks prefer to extend non-performing loans rather than write them off. For now, that may work to smooth out the eventual fall.

That said, many metro areas are still experiencing increased office rents for commercial property despite the high vacancy rates. The situation is different in each city. A commercial real estate company JLL report shows that asking rents of office buildings rose by 0.3% in the United States between 2022’s final months and this year’s first quarter.

JLL reported that rents increased faster for buildings with more upscale features in better locations. Some markets, including Charlotte, Nashville, and Orange County, California, saw record transactions.

Commercial Real Estate Properties Continue to be Supported by Banks

Financing is easy to find according to St. Louis Federal Reserve Bank, which has been tracking this figure since 2004, commercial real estate loans reached an all-time record of $2.9 trillion in May 2023. Commercial real estate loan growth has risen by 10% last year.

The banks appear to be prepared for a possible economic slowdown. Federal Reserve said all 23 banks who underwent their annual stress tests showed that they could withstand a severe economic downturn. These institutions account for about 20 percent of downtown bank office loans and commercial property.

According to the Fed, the stress test predicted a rate of loss “roughly three times the level reached during 2008’s financial crisis.” According to the test results published by the Fed on June 28th, “large banks may have suffered heavy losses, but they could still continue lending.”

Office Space Real Estate Most Vulnerable To Recession

Many observers expect the economy to continue its downward trend, even without commercial real estate collapse.

CBRE, a commercial real estate and investment company, predicts the Fed’s interest rate increases to combat inflation will cause a recession this year. This will then lead to less leasing and real estate investments.

CBRE’s latest forecast stated that the drop would be “gradual and uneven”. The economy is expected to stabilize at the beginning of 2024, but its impact on the real estate market will last until the employment rate increases.

To dig a bit deeper, delinquent commercial property loans are being charged off by banks. Charge-offs are a good indicator of the direction the market is going in because they show that borrowers cannot afford to pay back their loans. CFRA Research estimates that the rate of delinquencies for the first quarter of 2023 will be 0.95%.

This is below the level before the pandemic of 1.01% for the first quarter of 2020. However, “these ratios will deteriorate even further with the weaker U.S. Economy in the second half of 2023,” stated Kenneth Leon in CFRA Research’s June 20th, 2018 report. The office market has been down since the pandemic.

Office Space In Flux As New Commercial Buyers Emerge

Some employees have returned to work in the wake of Covid. However, hybrid and remote working is here to stay. JPMorgan Chase, for example, requires employees to come back to the office in person. The same goes for Goldman. Other companies, such as Amazon and Apple, require them only to be present part-time (hybrid-remote).

In an April 2023 NAR report, the NAR stated that “the future is uncertain” for traditional office spaces. Property owners, therefore, are searching for innovative ways to reuse their empty office space.

According to the NAR, universities have expressed interest in renting office space as a way to bring students back to school, as opposed to offering classes online as readily as they have in recent years. That said, renovations can be tricky (zoning alone can become a nightmare), and the inflation rate has driven up prices.

Krosby argues that converting office space into housing doesn’t solve the problem because it depends on whether employees return to work and want to live near their workplace.

Some buyers are willing to buy despite the challenges, even if they do so at a discounted price. A recession can be lessened by even moderate demand. Dutch Mendenhall is the founder of RAD Diversified REIT. He says he has had sellers who said he was insane 12 months ago but now accept my offer. In six months, the time will be right to purchase office space. Clear your ledgers, study up on commercial real estate and buckle up; the shake-up is coming, and those who are prepared the best will win out (whether you are a buyer, seller, agent or broker).