Since the remote working boom, the commercial real estate market has been moving against building owners and their lenders. But it’s difficult to tell how bad the downsizing and closure of company offices in the United States will hurt them — and whether it will produce contagion impacts for banks and financial markets.
The global vacancy rate for commercial office space rose another 35 basis points to a new all-time high of 15.9% in the third quarter of 2023, according to Jones Lang LaSalle, with the largest increase recorded in North America. A CBRE study of global workplaces released last month found a 22% decline in average square foot per person; relatively low office-space utilization rates; and plans by 43% of the organizations to reduce their office space by more than 30% over the next three years.
The market’s imbalance can make office space more affordable for companies that want it — CBRE estimates that asking rents will fall by 3% to 4% in 2024. Existing renters are also getting record landlord concessions — tenant improvement allowances and, for top-tier buildings in 12 U.S. office markets, average free rent of about 10 months, according to CBRE.
More than half of the responding 400 European and U.S. corporate real estate executives in CBRE’s office occupier sentiment survey said tenants seek shorter lease terms for new or renewed space. Commercial real estate services provider Colliers said tenants will also seek smaller leases in 2024, with most under 10,000-square-feet.
All of these trends spell trouble for commercial real estate lenders, which in the U.S. means mostly banks (see chart).
High interest rates and declining rent income means borrowers are beginning to have trouble staying on time with loan payments. As of the end of last year’s third quarter, 5.1% of the balance of office property loans was delinquent, said the Mortgage Bankers Association, up from 4% the previous quarter. The delinquency rate for U.S. commercial mortgage-backed securities (CMBS) in the office sector rose to 3.48% in November 2023, up 64 basis points, according to Fitch Ratings, which projects U.S. CMBS office loan delinquencies will skyrocket to 8.1% in 2024 and 9.9% in 2025.
Meanwhile, nearly $150 billion of mortgages on U.S. office buildings are maturing by the end of 2024, and just over $300 billion of loans will mature by the end of 2026, according to a review by software provider Commercial Edge of its property databases in October 2023.
The borrowers that might have the most trouble refinancing have CRE loans on U.S. properties in large central business districts. Those properties are “highly vulnerable as the structural shift to hybrid working has reset valuations,” according to Fitch. Commercial real estate with tenant rollover or lower debt service coverage ratios, in particular, will run into difficulties, said Fitch. The rating agency forecasts “continued negative net operating income growth for office properties in 2024, with lower quality urban office properties most affected.”
“In scenarios where both the lender and borrower misjudged the underlying assumptions about cash flow – particularly as it relates to interest rates – there is little point in foreclosing on a borrower that has otherwise executed well."
Ross Yustein
Kleinberg Kaplan
Bankers have been working to get in front of the looming declines in CRE credit quality, an have so far been pretty successful, taking some loan charge-offs, selling some assets, and stress-testing their largest exposures.
Ross Yustein, chair of law firm Kleinberg Kaplan’s real estate department said the current level of distress in commercial real estate is not extreme, “but there are still risks that need to be addressed” by lender and borrower.
Projects that were underwritten based on market assumptions several years ago are problematic. They require either more equity from the borrower or an agreement by the lender to extend the loan or ease the terms.
“In scenarios where both the lender and borrower misjudged the underlying assumptions about cash flow – particularly as it relates to interest rates – there is little point in foreclosing on a borrower that has otherwise executed well,” said Yustein. “If the borrower is adept at managing the property, there might not be better options.”
On the other hand, if credit losses in CRE portfolios do reach severely stressed levels in the next few years (a decline in property prices of about 40%), the result could be high contagion, including “the failure of a moderate number of predominately smaller U.S. banks,” Fitch said.