The commercial real estate market was headed for a nosedive. It seemed so obvious.
Landlords had been struggling to fill buildings left vacant after Covid-19 forced remote work.
Some commercial builders who had taken out loans to finance projects “were just walking away, giving it back to the lender,” recalls Quincy Krosby, chief global strategist for LPL Financial.
The Federal Reserve’s inflation-fighting rate hikes, beginning in March 2022, boosted the cost of loans.
Office space hit a record-high vacancy rate of 12.9% in the first quarter of 2023, up from 12% a year earlier, according to the National Association of Realtors (NAR).
Predictions of a late 2023 recession have sparked concerns that businesses would be struggling to keep up with loan payments. In recent months, according to analyst reports, short sellers have been keeping a close eye on real estate investment trusts.
So where’s the crash?
The big plunge in commercial real estate valuations, analysts say, is more likely to be a long slide.
A CRE downturn “will be staggered,” says Krosby. Referring to banks’ preference for extending non-performing loans rather than writing them off, she says, “It’s the old ‘delay and pray.’”
Office Rents Still Rising In Many Metro Areas
Despite the vacancies, commercial real estate rents are continuing to rise, with the situation varying widely by city. According to a report by commercial real estate services company JLL, asking rents for office properties rose nationally by 0.3% between the final months of 2022 and the first quarter of this year.
But rents rose at a faster clip for fancier buildings in desirable locations, with some markets—including Charlotte, Nashville and Orange County, California—seeing record-breaking transactions, JLL said.
Banks Continue To Support Commercial Properties
Financing is not hard to come by, either. Loans for commercial real estate were at an all-time high of $2.9 trillion as of May 2023, according to the St. Louis Federal Reserve Bank, which has tracked that figure since 2004. In the past year alone, commercial real estate loans have jumped by about 10%.
Banks appear ready to handle a potential economic downturn. The Federal Reserve says all 23 banks that underwent its annual stress testing showed they could withstand a severe recession.
Those institutions hold about 20% of all banks’ office and downtown commercial real estate loans.
The stress test projected a loss rate of “roughly triple the levels reached during the 2008 financial crisis,” according to the Fed. The test results, published on June 28, revealed that “while large banks would experience heavy losses in the hypothetical scenario, they would still be able to continue lending.”
Recession Still Expected; Office Space Most Vulnerable
With or without a commercial real estate crash, many observers still expect a downturn.
Commercial real estate services and investment firm CBRE predicts that Fed interest rate hikes aimed at taming inflation will lead to a recession later this year, which will in turn result in less real estate investment and leasing.
“The drop will be gradual and bumpy,” said CBRE in its latest forecast. “The economy should stabilize by the start of 2024 but the downturn’s impact on real estate will linger until employment growth resumes.”
Banks are already beginning to charge off delinquent commercial real estate loans. The rate of charge-offs indicates the market’s direction because it means borrowers can’t afford the loans. For the first quarter of 2023, the delinquency rate is 0.95%, according to CFRA Research.
That’s below the pre-pandemic level of 1.01% in the first quarter of 2020, but “these ratios are expected to deteriorate further in the second half of 2023 with a weaker U.S. economy,” said Kenneth Leon, a research director at CFRA Research, in a June 20 report. “The office market has weakened since the pandemic.”
The Fate of Office Space Is Unclear as New Buyers Emerge
In the wake of Covid, some employees are returning to the office, but hybrid and remote work are here to stay. Companies such as JPMorgan Chase are directing employees to return to work in person, while others, like Amazon and Apple, are requiring them to be in the office only part of the time.
As a result, “the future of the traditional office space is unclear,” NAR said in an April 2023 report. So property owners are looking for creative ways to repurpose their vacant office space.
The NAR has noted that universities are showing an interest in leasing office space to attract students back to class.
Some office buildings are being turned into apartments or condominiums, though renovations are tricky and inflation has pushed up costs.
Converting office space to housing, Krosby says, doesn’t necessarily fix the problem because demand for those units hinges on employees returning to work, and wanting to live nearby.
Despite the difficulties, some buyers appear willing to step in—albeit at a discount. Even moderate demand could lessen the impact of a recession.
“I’ve had sellers come back to me that I made offers on that said I was crazy 12 months ago who are now entertaining my exact offer,” says Dutch Mendenhall, founder of RAD Diversified REIT. “Six months from now, it will start to be a real optimum time to buy office space.”