Troubled waters in the commercial real estate market?

ARTICLE | July 10, 2023

In the aftermath of the pandemic that significantly reshaped the global economic landscape, the commercial real estate sector continues to grapple with enduring challenges. Some experts predict that the industry could experience an economic crash worse than the 2008 financial crisis, with office vacancy rates reaching a 20-year high, more than $3.1 trillion of commercial real estate loans outstanding (according to Goldman Sachs), and interest at the highest rates in more than a decade. However, despite the alarming predictions, there are also reasons to believe that the commercial real estate market can weather the storm and adapt to the changing times.

The commercial real estate dilemma

Anxiety surrounding the US commercial real estate (CRE) market and its potential impact on banking institutions and the larger financial ecosystem is growing. 

The primary concern rests with office real estate, which is currently grappling with vacancy rates unseen in decades. Plunging occupancies coupled with escalating interest rates are driving property valuations down. Exacerbating this situation is the reality that approximately a quarter of CRE loans will require refinancing in 2023, at heightened rates, according to Mortgage Bankers’ Association data. This is coinciding with a time when banks are curtailing lending activities.

The apprehension becomes even more pronounced when looking at smaller regional and community banks. These institutions typically rely on financing real estate deals as a key part of their operations, meaning a significant proportion of these loans reside on their balance sheets. However, as these banks grapple with decreasing deposits and consequent reductions in their lending capacities, the strain intensifies. Borrowers may face even more pressure as their access to funding could potentially evaporate, adding more tension in the commercial real estate sector. 

A typical down cycle or a potential challenge ahead?

However, not all experts share the same level of pessimism regarding the commercial real estate market. Some argue that these challenges are more of a typical down cycle. Factors such as the diversification of commercial real estate, with warehouse, industrial, retail, and hotel sectors performing well, could help cushion the impact of the struggling office market. After all, the entire $3.1 trillion of outstanding CRE loans are not all office buildings. 

Despite high office vacancy rates and the need to potentially refinance loans at higher interest rates, some analysts are confident the majority of debt coming due in the next two years may still be refinanced. According to some expert estimates, about three-fourths of commercial real estate debt generates enough income to pass banks’ refinancing standards without significant modifications. Banks have also remained resilient, with delinquencies remaining lower than pre-pandemic levels.

How is this different from the 2008 crisis? 

The 2008 financial crisis was largely precipitated by the bursting of the housing bubble and subprime mortgage lending, which resulted in a banking and financial crisis. The commercial real estate sector also suffered significantly during that period, with plummeting property values and soaring vacancy rates. 

In contrast, the current challenges in the CRE sector are primarily driven by shifts in work patterns due to the pandemic, leading to an unprecedented rise in office vacancies. In the current situation, it’s not an asset bubble that’s the cause of the problem but rather a drastic shift in demand. 

It’s also noteworthy that the risk associated with CRE loans is not solely borne by banks. A considerable portion of these loans is securitized and held by various asset managers and insurers. This distributed risk potentially cushions the overall impact on the financial system compared to the 2008 crisis, where banks were largely left holding the bag. 

Moreover, banks now operate with far better capital reserves, providing a much-needed buffer against potential defaults. So while defaults are certainly on the horizon, the systemic exposure is far from the pervasive risk seen with subprime lending in 2008. Given this, and considering lessons learned from the past, regulators, including the Federal Reserve, are likely to intervene promptly and decisively if they perceive the risk to be mounting to a systemic level. 

Regional variations and potential strategies

While there are undoubtedly challenges in the commercial real estate sector, the situation varies across different regions and property types. Commercial construction projects in Texas have prospered, accounting for 20% of the nation's commercial real estate spending in 2021. On the other hand, cities like New York and San Francisco have experienced significant declines in daily office workers since the start of the pandemic, impacting the local commercial real estate markets.

Industry players need to adapt and innovate to mitigate these challenges. Strategies to weather the storm could include repurposing vacant office spaces for alternative uses, exploring opportunities in thriving commercial sectors such as industrial and warehouse properties, and strategically managing refinancing efforts industry-wide.

Long-term investment opportunities may also exist in higher-quality and well-diversified Real Estate Investment Trusts (REITs), particularly those demonstrating greater resilience than their counterparts. Such trusts could provide a more stable investment platform during these uncertain times, further diversifying the industry’s response to the ongoing challenges. 

This article is intended to provide a brief overview of current commercial real estate challenges. It is not a substitute for speaking with one of our expert advisors. For more information, please contact our office.