Commercial Real Estate in Demise?

Pre-pandemic, healthy demand for office and retail spaces signaled a growing commercial real estate (CRE) market. Loans were readily available, often with favorable terms. But the COVID lockdowns shifted the landscape significantly with businesses shuttering and employees transitioning to remote work.

Two-plus years later, a Federal Reserve survey on salient risks – part of the Fed’s October Financial Stability Report – showed roughly 75 percent of respondents citing the potential for “large losses on CRE and residential real estate.”

For CRE, particularly, its “demise” has been a pervasive market narrative.

But remote work is just part of CRE’s risk picture. This, according to a recent Global Association of Risk Professionals (GARP) survey of experts worldwide. Results revealed remote work, interest rates and economic uncertainty as the top factors driving CRE risk, with very little separation between the three.

Clifford Rossi, director of the Smith Enterprise Risk Consortium and professor of the practice and executive-in-residence for the University of Maryland’s Robert H. Smith School of Business, gives related insights in this Q&A:

To what extent, and why, are remote work, interest rates and economic uncertainty evenly pressing on CRE?

Rossi: I agree these are the major factors pressing on CRE – not just in the United States, but broadly across global real estate markets and sectors. And beneath what we’re seeing is the result of overly aggressive fiscal and monetary policy post-2008. And this was exacerbated during the pandemic, leading to significantly overinflated values across equity, fixed income, and real estate among others for years.

This has not been normal, and few risk managers can remember what a normal interest rate environment looks like. We also witnessed the worst bear market for bonds in recent memory, and CRE is experiencing some pain because of these policies as well.

As for work-from-home (WFH), the trend certainly has affected CRE regarding office space in major metro areas, where vacancy rates have gone up and companies have either not renewed their leases or are shrinking their footprint as many workers continue to work from home.

With interest rates driven to their highest levels in many years due to central bank policies and the heavy use of indexed-based loan products in CRE, we’re seeing debt costs that exceed return on investment on CRE generally. (Over one-third of all commercial debt is floating rate and about 50% of commercial mortgage-backed security debt over the last two years is floating). I believe we’re seeing the 10-year UST (US Treasury) exceed the median cap rate for the first time since 2008. This means pressure on CRE valuations.

Globally, U.S. and China CRE seem most vulnerable. China’s massive excess capacity in the apartment sector is creating a big drag on their economy. It’s resulting from decades of overbuilding for decades in China -- things like the default by Evergrande, Country Garden cash problems and the like. Subsequently, there’s been a year-over-year decline of nearly 40% in new construction permits.

Real estate was king in China. Now, that bubble is bursting. And the negative wealth effects are starting to manifest with falling home prices. On cap rates – indicative of expected return on a property based on net operating income, or NOI (numerator) and asset value (denominator), uncertainty in NOI cash flows pose a risk to CRE investors, and this could drive cap rates higher as property values soften, reflecting that higher risk.

In the United States, the CRE sector, with about $500 billion refinancing over the next three years, there’s a fair amount of concern that CRE obligors will face refinancing at significantly higher rates if rates remain at elevated levels.

Higher rates also affect CRE loan refinancing, as lower debt service-coverage ratios weigh on borrowers from an underwriting standpoint.

Regarding economic uncertainty, it’s undoubtedly causing many firms to batten down the hatches. U.S. CRE originations are down precipitously in many segments – for example by nearly three quarters in healthcare, two-thirds in office and over 50% down in retail.

The WFH factor is fascinating. The [GARP] survey showed that the percentage of firms whose employees work remotely up to three days per week has grown from 10-15%, pre-COVID, to roughly 35-55% today. This applies to all regions except China, where remote work has grown only to 20%. The impact on CRE risk?

What impact has this trend had on CRE risk? A recent Fitch analysis showed office vacancy rates at 13.1%, up from 9.5% pre-pandemic rates. This reflects the shift to WFH during the pandemic and continues by the numbers just cited. So, there’s unquestionably more supply than demand for space. This is playing into net operating incomes and posing NOI cash flow uncertainty in the market.

Can you give a CRE performance snapshot beyond remote work and office vacancy?

Rossi: To see beyond the remote work syndrome, one must peel this ‘CRE onion’ back by market segment to get a more precise read on performance. For example, multifamily and apartments have been holding up comparatively well with vacancy rates flat at about 5% and there’s been a slight uptick in rents, which is good but needs to continue to get back to earlier levels. We also must look geographically. Notable shifts have occurred in the United States during and post-pandemic. Large metros such as San Francisco and New York City saw significant declines in net absorption rates while other areas, like Nashville, Phoenix and Atlanta, have seen sizable net increases in construction activity reflecting some of the demographic shifts from the pandemic.

Commercial banks hold the majority of U.S.-issued CRE loans, so it seems paramount for them to manage their CRE exposure. Do you agree? And is this complicated by banks with the greatest CRE exposure tending to be quite small?

Rossi: First, consider there’s about $3 trillion in commercial and mutual fund loans at U.S. banks as of Q1 2023. Commercial banks hold about 28% of all CRE loans. And for most banks, CRE accounts for about a quarter of their asset base. And to that point, CRE represents one of the largest exposures for banks with assets under $10 billion.

So, this is a long-winded way of saying all banks, but especially smaller ones, need to be managing their CRE risks carefully through this tumultuous economic environment. Smaller banks also have a concentration-risk issue by virtue of their smaller geographic footprint. So, it’s very important for these firms to be tracking market conditions, looking at leading, not lagging, indicators, and monitoring obligor and actual CRE concentration levels against portfolio policy.

For more real estate risk insights from Rossi, including his take on the residential sector, listen to GARP’s Real Estate Risk in Volatile Times podcast. Rossi also was part of a recent GARP-hosted expert panel for an “Emerging Risks in Global Real Estate” webinar.