This year has seen a near-constant stream of negative news from the U.S. commercial real estate sector. Multiple large properties are in default, office occupancy levels have fallen, and rising interest rates have made refinancing problematic.
Conditions appear unlikely to improve in the near term. Banks, for example, are pulling back from the sector, with nearly 80% of senior loan officers expecting a deterioration of credit conditions in commercial real estate, or CRE as it is often known.
We think there are significant headwinds in the sector, and see a real risk—indeed, a likelihood—of further price declines in some commercial assets. At the same time, we think the broader risk to the economy and financial markets overall is limited, due to some inherent characteristics of CRE markets.
Not all commercial real estate is the same
To begin, it’s important to recognize that there is not just one type of commercial real estate, but many, each of which has its own supply and demand characteristics. Industrial and warehouse properties, for instance, have seen very high demand and stable to rising lease rates on a national basis, according to global property firm JLL. Office space, on the other hand, is experiencing double-digit vacancy rates as remote work continues to be a key factor in attracting and retaining workers.
Commercial real estate is not a single market
Mortgage delinquency rates differ by property type
Line chart showing the 30+ day delinquency rate for mortgages by property type. The rate on office properties has exceed that for multi-family and industrial properties by an increasing amount since 2017. Office delinquency rates are now nearly eight times those of multi-family.
Source - RBC Wealth Management, Bloomberg; monthly data showing 30+ days delinquency, through 8/1/23
Even within a single asset type, there are differences between regions, and even from building to building. Upscale retail locations are, broadly speaking, outperforming midgrade malls, and higher growth in the American Southeast is cushioning CRE declines relative to some of the larger coastal urban areas.
Trouble at the office
For now, the core of the problem is large office towers located in central business districts. The economics of these properties often require high occupancy rates to support the high costs of upkeep and amenities. With occupancy rates declining since the start of the pandemic, many office towers have been caught in a vicious cycle of declining rental income that makes it too costly to upgrade properties, causing existing tenants to decamp, which in turn puts more pressure on rental revenues. Higher interest costs resulting from the Federal Reserve’s rate hike campaign have only added to the pain.
This situation is unlikely to change soon, in our view. Attempts to force employees into offices appear unlikely to succeed, and we believe corporations will continue to reduce floor space—and costs—while seeking to attract better talent with geographic flexibility. This will likely reduce total demand for office space, particularly in high-cost central business districts.
Adjustments are likely, and normal
It’s not unusual to see demand decline for particular assets, and markets have various adjustment mechanisms. The first is price. As mentioned, commercial rents are falling alongside occupancy in many urban central business districts. Buildings remain viable as office space so long as the income produced at these new rental rates is sufficient to cover their operating costs. Current owners may have to default because they took on too much debt, but new and better-capitalized owners can continue to manage the properties.
In some cases, however, the rental income will never be sufficient under realistic assumptions regarding new demand levels and rental rates. Markets adjust for this by reducing supply, a process that is underway; the total square footage of office space in the U.S. recently fell for the first time since JLL began tracking the data in 2000. This decline is partly due to redevelopment, as properties currently configured for corporate offices are repurposed for retail, housing, or hospitality in response to local economic factors. Such conversions may involve on-site renovation or teardown, but in either case the removal of office square footage brings the market closer to balance.
We see three characteristics of CRE that may make it easier for the broader economy—and financial markets—to absorb financial losses in the sector.
The first is scale. The entire U.S. commercial real estate market is estimated to be worth roughly $20 trillion, but only an estimated $3 trillion of that is office space, according to the National Association of Real Estate Investment Trusts. That’s large, but in the context of the roughly $160 trillion in estimated U.S. household assets, we see it as manageable.
Another key factor is that investor portfolios generally have low direct exposure to the sector. Even assuming a relatively hefty 10% allocation to CRE, a total wipeout of that holding would only negate roughly the last six months of equity gains, assuming that the balance of the portfolio were invested in the S&P 500. Painful, certainly, but not catastrophic, in our estimation.
Finally, we believe banking system exposure to CRE is quite manageable. The median allocation to CRE loans among the 20 largest U.S. banks is only 9.3%, with office properties accounting for less than 2% of loan books based on 2022 year-end filings. Banks are generally secured creditors, and thus face a loss only after asset values decline by at least 20%. Some projects will lose more than that, but we think the overall banking system exposure is reasonable, even if some individual banks may experience stress.
Not out of the woods (or the central business district)
By no means would we suggest that there is no risk of broader market fallout from commercial real estate declines. We see two likely vectors of transmission. One would be if investors who have borrowed against their CRE holdings are forced to raise additional funds as the collateral value of their commercial securities falls. The famous adage is “Sell what you can, not what you want to,” and we could see sales of CRE leading to other assets being sold and triggering contagion.
There is some risk of this, most notably from insurance companies, which tend to invest in large commercial projects and are subject to regulatory requirements around liquidity and asset-liability matching. But as noted above, CRE holdings generally make up only small portions of investor portfolios; few investors are 100% levered and unable to absorb markdowns.
The other major risk would be a policy mistake. Following the March turmoil in regional banks, U.S. regulators have proposed significant additional capital requirements for lenders. Ironically, this could represent a meaningful risk vector, as declining CRE values push current capital ratios lower. If banks try to get ahead of potential losses through aggressive sales that drive prices down, the result could be a negative spiral in asset prices. We see this as an unlikely scenario, but if it were to develop, we think regulators are sufficiently flexible and rational to extend capital raising timelines.
Different this time?
Global cities have faced terrorist attacks, natural disasters, and world wars, and to date they have always emerged stronger and more vibrant. Perhaps a transition to a hybrid work model will prove to be a bridge too far for urbanization, but we doubt this is the beginning of the end for cities.