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Predicting market movements with any degree of accuracy is nearly impossible, yet there is one market that most agree is a bubble about to burst. That would be the commercial real estate (CRE) market. Plenty of predictions (here, here, here, and here) have called for the demise of this once fruitful market. I addressed this topic back in June, and since then, markets have continued to notch record highs and the economy has continued to chug along.
Many economists are perplexed by the resilience of the CRE market, and markets in general, over the past 15 months. Could it be that everyone is waiting for a crash that may never happen?
CRE
As a reminder, the commercial real estate (CRE) market is not just composed of office buildings; it includes retail, industrial, and multifamily residential projects. While office buildings dominate the headlines, the entire CRE market is much more than just one sector. The question that lingers is if the office market is so dire, why don’t we see a flood of forced sellers?
As expected, the percentage who worked from home spiked sharply with the onset of the pandemic, crossing 60% in 2020. Currently, ~25 work from home, and this percentage is expected to remain steady or slightly increase over the years, as most companies have adapted to a work-from-home or hybrid model. This percentage represents a fivefold increase from 2019 and is viewed as problematic for the long-term health of office real estate.
According to data from real-estate consulting firm Colliers, U.S. vacancy rates rose from ~11% in late 2019 to ~17% present day, which is higher than at any point in the 2008 global financial crisis. When any data point is compared with the 2008 financial crisis, it tends to grab headlines.
The irony is that forced sellers have been pretty nonexistent, with only ~3.5% of all U.S. office deals in 2023 involving a distressed seller. In fact, the most recent data shows this number has dropped to 2.7%.
The question is HOW? How can the market remain this strong in the face of all these headwinds? There are a few reasons:
Economy
One thing that nearly everyone got wrong was just how resilient the U.S. economy would be. It wasn’t too long ago that soaring inflation and high interest rates were going to be the culprits of the next recession. Well, none of that has taken hold yet. Plus, the worst of inflation seems to be behind us, and the Federal Reserve is finally talking about cutting interest rates. This strong U.S. economy allowed most tenants to continue paying their contractual rent obligation.
A standard commercial lease is roughly three to five years, which means many leases are set to expire in the next 12 to 24 months. With companies reducing the amount of space needed as they embrace the hybrid work-from-home philosophy, what is going to happen when a huge chunk of leases ends and there isn’t enough demand to refill them?
This is a legitimate concern but one the economy should be able to take in stride, as most companies are not abandoning office space, just reducing the amount needed.
Debt Maturities
Quite possibly the biggest reason for the calm is that lenders are eager to kick the can down the road. The last thing lenders want are forced sales from borrowers in a weak commercial real estate market, which could lead to a ripple effect of losses. According to Cred iQ, only one-fourth of the ~$35.8 billion of office loans that came due in 2023 were paid off in full. That means the remaining three-quarters were “extended” to a future date.
In addition, office loans are more complex today, which can further delay distressed sales. There are more parties (i.e., institutions) involved in the larger office space deals, which makes it harder to get all parties to agree to foreclosing on a certain property. Of course, you can kick the can down the road only so far until the problem has to be dealt with.
Timing is important, and while many foreclosures are, no doubt, to come, ensuring they occur in an orderly and spaced-out timeline is important.
Opportunistic Investors
In every market, there are those who seek opportunity. Many private equity firms are raising immense capital to buy up distressed debt at favorable terms.
This is important since many U.S. banks, which are already exposed to massive unrealized losses, have started to pull back from lending. Outside investors can help slow the pace of forced sales and provide cushion for the office building market.
Now, opportunistic investors are not acting out of the goodness of their hearts, so they will aim for the lowest price possible before pulling the trigger.
Interest Rates
The hope is, as the Federal Reserve starts cutting interest rates later this year and into next, the demand from outside investors will increase. The logic is as follows: If money can be borrowed at a lower rate, more investors will be willing to step in, purchase distressed assets, and boost their internal rate of return.
While this may help some, the Federal Reserve has been clear that they are not planning on aggressively cutting rates in 2024 or 2025. Whether that happens or not remains to be seen, but lower interest rates are unlikely to move the needle much.
The reality is some borrowers will experience a day of reckoning, and the losses will be painful. The best-case scenario is to limit the damage from occurring all at once, spacing it out over several years. The U.S. economy can handle a few bumps along the way, but the ripple effect could be long lasting if a large swath of loans defaults at the same time.
There is no way to predict how this will all play out, and while market volatility will likely pick up as these headlines gain more attention, the CRE market is not just office space—it is much more than that. Remember to always focus on the bigger picture and don’t let the headlines dictate your behavior!
Discuss your situation with a fee-only financial advisor.