Empty buildings, tight credit, high interest rates set stage for commercial real estate collapse
Welcome to the great commercial real estate panic of 2024.
While some employers imposed return-to-work policies as coronavirus fears faded, many companies allowed workers to stay home or split their schedules, hollowing out downtown spaces across the nation. At the same time, in an effort to tame inflation the Federal Reserve raised interest rates to the highest point in decades, which makes it difficult to refinance distressed loans.
Billionaire CEOs predict massive losses and the potential collapse of the commercial real estate market if the trend continues, sparking fears of wider economic fallout at banks that hold a large share of debt in the wobbly market.
The office sector set a vacancy record of 19.8% in the first quarter of 2024, up from 19.6% in the previous quarter and historic peaks of 19.3% in 1986 and 1991, according to Moody’s, a financial services company. Tenants might not need as much space when leases expire, making large buildings less desirable.
“Another quarter of vacancy increase emphasizes the long-term ramifications of hybrid work models, despite positive employment and GDP trends in the current economic cycle,” Moody's analysts said in an April 1 report.
Federal and local officials say it is no time to despair. They’re pushing big plans to convert office space into much-needed housing and to make downtowns safer and more attractive.
But those ideas are complicated, and transformation takes time. In the meantime, owners face the lousy choice of selling properties at a loss or risking default if they cannot negotiate with lenders.
“Two years ago, interest rates started to rise pretty dramatically — that changed the borrowing environment for a wide range of property owners and potential owners. That also brought questions about what the appropriate valuations are for properties,” said Jamie Woodwell, the Mortgage Bankers Association head of commercial real estate research.
Some property holders are offloading sites at major discounts, including a 175,000-square-foot office building in the heart of the nation’s capital.
Located a half-mile from the White House, the building on Vermont Avenue recently sold for about $16 million. It last sold for $60 million in 2006. Its assessed value dropped from about $72 million in 2018 to less than $50 million this year.
The Beltway area is sometimes described as recession-proof, given the presence of the federal government and the money, contracts and jobs that flow from it. Yet a society-altering pandemic is another thing entirely.
Starwood Capital CEO Barry Sternlicht, speaking at a Miami conference this year, said the office space is “one asset class that never recovered” from the COVID-19 pandemic and is likely worth around $1.8 trillion, a decrease from $3 trillion before the crisis.
Prices for commercial real estate declined 5.3% in the final quarter of 2023 compared to the same quarter in 2022, according to The Trepp Price Property Index.
Among office-property transactions, the price per square foot declined by $112 per square foot in the District for all of 2023 compared to the prior year.
New York City saw a $151 decrease per square foot and Los Angeles saw a $43 drop. The change around Chicago was largely flat, with a slight price increase of $3 per square foot, according to Trepp.
A D.C. office building at 13th and I streets — less than a mile north of the Smithsonian museums on the National Mall — took a $64 million loss in a December transaction compared to its 2018 sale price. Another building on the 14th Street corridor went for about $18 million in January after a $62 million sale in 2017.
JLL, a real estate services company, said it is important to differentiate among commercial properties.
Newer buildings, or premium “trophy assets,” are seeing high demand, with low vacancy at 11.3% and rents 46% above the rest of the market. Yet older products, such as the Vermont Avenue property and other Class B buildings built before 2015, are seeing higher vacancy rates at around 19%.
Elsewhere in the country, an office building that sold for $43 million in 2018 just went for $8 million in Quincy, Massachusetts, near Boston, according to a Bisnow report.
Even as some property holders offload assets, bargain hunters are hopping into the turbulent market.
Ian Jacobs, a Warren Buffett protege and heir to the Reichmann real estate dynasty, is buying up major San Francisco properties that hollowed out after the pandemic, according to The Wall Street Journal. The idea is to grab up properties at basement prices and hope it pays off much later.
Placer.ai, a startup that analyzes foot traffic, found employee office visits as of February were 31.3% lower than in February 2020, though 18.6% higher than in February 2023, suggesting a mild rebound in key metro areas.
But for now, the tumult in the property market is sparking fears of a domino effect in the banking sector, particularly the small and regional banks that underwrite large numbers of loans for distressed commercial properties.
“Over the past year, national office space values are down more than 35%,” Lisa Shalett, chief investment officer for Morgan Stanley Wealth Management, wrote in a March 25 weekly investment note. “While this may be a slow-moving stressor for markets, it’s notable that regional banks own 60% to 80% of the linked loans coming due in the next two to three years.”
She said commercial mortgage-backed security markets could be the first places where this stress becomes visible, as delinquency rates rise to 4.7% from 2.9% last year.
The Mortgage Bankers Association says $929 billion, or 20% of the $4.7 trillion balance of commercial mortgages held by lenders and investors, will mature in 2024. That is a 28% increase from the $728 billion in loans that were scheduled to be paid in 2023.
Howard Lutnick, chairman and chief executive of the financial services firm Cantor Fitzgerald, predicted in January there would be $700 billion to $1 trillion in commercial real estate defaults over the next two years unless interest rates fall quickly, dubbing it a “very, very ugly market.”
The banking sector’s fragility was on full display during the 2023 collapse of Silicon Valley Bank. Earlier this year, New York Community Bancorp reported a shocking quarterly loss due to exposure in the scuffling commercial real estate sector, sparking a credit downgrade and brief nosedive in its shares on Wall Street.
Treasury Secretary Janet Yellen acknowledged the fragility of the commercial real estate market in her February testimony to the Senate Banking Committee.
“Valuations are falling. And so it's obvious that there's going to be stress and losses that are associated with this," she said. "I hope and believe that this will not end up being a systemic risk to the banking system. The exposure of the largest banks is quite low, but there may be smaller banks that are stressed by these developments."
In the District, worries about vacant office space are compounded by fears about rising crime, particularly carjackings, and city politicians are still mopping their brows after the Washington Capitals and Washington Wizards franchises nearly decamped from Capital One Arena downtown to Northern Virginia.
D.C. Mayor Muriel Bowser is championing a $400 million, five-year plan to revitalize downtown with a focus on public safety, deregulation and the conversion of empty office space into residential units, hoping to increase the number of downtown residents from 25,000 to 40,000.
The Biden administration launched a multiagency push in November to convert empty commercial spaces into housing, especially near transportation centers.
The idea sounds promising but it has limitations. For instance, many office spaces have deep storage and interior rooms that lack the natural light expected in residences.
“Shark Tank” star Kevin O’Leary says the commercial space may have no choice but to revamp itself because up to 40% of people who work in small businesses are not returning to the office.
But it won't be easy, given the need for zoning changes, and it might be better to tear the buildings down and rebuild them as data centers or climate-controlled storage facilities, he told Fox Business host Larry Kudlow.
“That’s where we have to do it, but who’s going to pay for it?” Mr. O’Leary said. “That’s what the question is because we’re talking about a trillion dollars in aggregate here.”
For more information, visit The Washington Times COVID-19 resource page.
ReliaQuest and Aon Collaborate to Empower Organizations to Proactively Manage Cyber Risk
Robust job growth points to continued economic strength
Advisor News
Annuity News
Health/Employee Benefits News
Life Insurance News