By ERIN FLYNN JAY and KIMBERLEY HAAS
As business models continue to change in the post-Covid economy, some market experts are predicting a commercial real estate crash while others are saying there could be a revival in investment opportunities.
Desmond Lachman, an American Enterprise Institute senior fellow, recently wrote that high vacancy rates have already caused commercial property prices to decline. At the same time, property owners need to roll over around $500 billion in maturing loans at higher interest rates.
Lachman said this spells trouble for the banking sector in general and the regional banks in particular. He predicted commercial real estate troubles could lead to the failure of 385 regional banks.
“With as much as 18% of their loan portfolio consisting of commercial real estate loans, the regional banks can ill-afford a wave of property loan defaults,” Lachman said.
Lachman said at the heart of the commercial property sector’s woes is the fundamental change in work and shopping habits triggered by the pandemic.
“Companies have found that they no longer need to have their workers work full time in the office while shoppers have found the greater convenience of shopping online than at the mall,” Lachman said. “There is every sign that there will be no reversal in these changed work and shopping habits anytime soon.”
What do current delinquency and vacancy rates look like?
According to the Mortgage Bankers Association’s most recent Loan Performance Survey, delinquency rates for mortgages backed by commercial properties increased during the fourth quarter of 2023.
Jamie Woodwell, MBA’s head of commercial real estate research, said delinquency rates jumped to 6.5% of balances for loans backed by office properties and to 6.1% for lodging-backed loans.
Retail property loan delinquencies remained at 5%, elevated from the onset of the pandemic but unchanged in Q4 2023, according to Woodwell.
Woodwell explained that although long-term interest rates have come down from their highs of last year, each parcel of property faces a different set of circumstances, “which will come into play as the market works through loans that mature this year.”
As expected, the office sector is being hit hard overall. In addition to the highest delinquency rates, a Q4 2023 preliminary trend report from Moody’s Analytics shows the national office vacancy rate rose to a record-breaking 19.6%.
The previous record of 19.3% was set twice. In 1986, following five years of inventory expansion, and then again in 1991, during the Savings and Loan Crisis.
Thomas LaSalvia, head of commercial real estate economics at Moody’s Analytics, said that overall much of the commercial real estate world was stuck in limbo during the last quarter of 2023.
LaSalvia said that moving forward market challenges will pose potential risks to associated commercial loans, especially if the underlying collateral faces greater uncertainty with its performance metrics.
“That is indeed concerning for mid-size to smaller financial institutes which have significant CRE exposures,” LaSalvia said. But so far, Moody’s Analytics does not believe this will become a source of systematic risk for the overall banking system.
As a matter of fact, LaSalvia sees 2024 as offering opportunities for those who approach the commercial real estate market with the right mindset.
“In 2024, we expect to see greater integration of live, work, and play communities to drive the formation of the space market’s new norm,” LaSalvia said. “Among many challenges, there will be abundant opportunities for market participants to invest in this new era, if they believe in the future of commercial real estate.”
Last month, CBRE released its 2024 Market Outlook, which reports that commercial real estate investment activity will likely begin to pick up in the second half of this year.
Although they expect significant levels of loan defaults in the office sector, and a small amount in multifamily, that won’t be enough to destabilize the banking sector or prevent a revival in real estate investment activity.
CBRE’s Global Chief Economist and Global Head of Research Richard Barkham said office vacancy will peak at 20% and he pointed out that even though that number is high, that doesn’t mean it is as problematic as it sounds.
“10 to 15% of office is obsolete and will have to be demolished or converted but note two-thirds of all U.S. office buildings were more than 90% leased; as of Q2 2023 only 7% are under 50% occupied,” Barkham said.
Barkham said the CBRE expects a cut in the Federal Funds Rate, maybe up to 100 bps by the end of 2024. That will allow for a soft landing for the U.S. economy.
Leasing in all sectors, even office, will trend up, Barkham said, as the fear of a recession recedes.
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