Update 778: Commercial Real Estate:
Office Building Debt and the Economy
Defaults, foreclosures, and other forms of financial distress are on the rise for commercial real estate loans — over 20 percent of U.S. banks’ loan portfolios —and approaching record numbers. In 2021, 90 percent of commercial mortgage loans were paid off on time. Last year, the figure dropped to 35 percent. “Survive until ‘25” was the industry mantra a year ago, but the extended pause in Fed interest rates has made that strategy increasingly untenable.
In 2007-08, a crisis in the residential real estate market spread throughout the economy and the Great Recession followed. Today’s office vacancy rate vastly exceeds that observed in the fallout from the global financial crisis, and post-pandemic work practices could become permanent. What lies ahead for this vast, critical market, and what are the implications for the broader economy? See below…
Best,
Dana
America’s $20 trillion commercial real estate (CRE) market is the largest of its kind in the world. The market grew considerably when investing in CRE looked like a safe bet, fueled by low borrowing costs and lenders eager to get into the market. Now, as trillions of dollars in CRE debt are set to come due in the next few years, CRE borrowers and lenders alike are concerned about whether the debt can be paid off or even refinanced. In a high interest rate environment, refinancing CRE loans becomes more difficult, and with office vacancy rates near an all-time high, owners of CRE properties are not earning the revenue they need to pay off their debts.
The current state of CRE debt suggests that sectoral storm clouds are on the horizon. If the CRE market falters or collapses, the fallout will ripple across the economy. This update will lay out how CRE debt got to its current state, as well as what the future could hold in store.
Brief Introduction to Commercial Real Estate Loans
Commercial real estate refers to any property that produces an income for its owner, covering everything from office buildings to multi-family rental housing. The vast majority of CRE properties are owned by business entities like corporations and developers as opposed to individual borrowers. CRE property is usually purchased using loans in much the same way as residential real estate. These loans are provided by a variety of lenders, though banks provide a majority of the financing. CRE loans are generally secured by a lien against the property in question.
But CRE lending differs from loans made in the residential real estate market in some critical ways:
- CRE loans typically range from 5 to 20 years as opposed to the 30-year fixed mortgage standard for residential real estate, and the amortization period — the length of time it takes for the borrower to pay back both the principal of the loan and the accumulated interest — is often longer than the term of the loan.
- CRE loans are generally made with a lower loan-to-value (LTV) ratio than residential loans, that is, the loan amount is usually proportionally less compared to the value of the CRE property than it would be with a residential loan. Specifically, CRE loans generally have an LTV between 65 and 80 percent of the underlying property value, as opposed to the 95 percent and higher seen as standard for residential mortgages. The LTV ratio measures the amount of leverage relative to the asset value, indicating the equity available for the loan. As such, the higher the LTV, the higher the risk is to the lender and thus the higher interest rates they will charge.
- The rates on CRE loans tend to be 0.5 to 1 percent higher than the rates on 30-year fixed mortgages, though rates vary depending on the lender and the type of loan.
- The interest rates on most CRE loans are floating rates, thus actively going up as the Fed raises rates.
- CRE loans have no equivalent to private mortgage insurance, meaning that lenders take on more risk when they finance CRE properties than they do with residential properties.
The State of the CRE Debt Market
The current trouble in the CRE debt market has been a few years in the making. Before the pandemic, CRE appeared to be an investment with reliable returns. As such, lenders were more than happy to provide capital to CRE owners, especially as low interest rates kept borrowing costs low.
Expecting the good times to continue, CRE owners used their capital to expand, especially in apartment complexes and multi-family residential apartment blocks. Others decided to hold on to aging CRE properties rather than demolish them, expecting these properties to remain profitable. When the pandemic hit and CRE properties began to see vacancies, many borrowers obtained extensions from their lenders with an “extend and pretend” strategy, taking advantage of low interest rates. The hope was that lenders would get their money back when CRE owners’ properties became profitable again after the pandemic subsided.
Instead, the post-pandemic economy brought new challenges for the struggling industry. Office vacancies did not return to their pre-pandemic levels and in fact continued to rise, reaching a peak of 19.8 percent last month with few signs of letting up as companies reevaluated their use of office space and many turned partially or entirely to remote work. Additionally, the era of cheap lending came to an end when the Fed began raising interest rates in 2022. The resulting higher borrowing costs made investments in CRE more expensive, which further depressed demand for and the value of CRE properties.
These factors led to waning CRE profits, with the IMF reporting an 11 percent drop in CRE prices since March 2022. Many CRE owners would be inclined to refinance their debt, but that has become difficult with high interest rates. Additionally, the decline in CRE property valuations has made refinancing more difficult for borrowers without breaching the terms of their original loans.
Today, lenders hold a staggering amount of CRE debt: according to the Mortgage Bankers Association, there is $4.7 trillion in outstanding commercial mortgages. $2.2 trillion in this debt is maturing before 2028; an estimated $554.2 billion is coming due in 2024, $533 billion is coming due in 2025, and $561.5 billion is coming due in 2026.
Source: Bloomberg
Of the CRE debt coming due in 2024:
- $227.2 billion is held by banks
- $81.7 billion is in Commercial Mortgage-Backed Securities
- $68.9 billion is held by government-sponsored enterprises
- $46.7 billion is held by life insurers
- $69.7 billion is held by all other sources
As most of the CRE debt is held by banks, much of the discussion over the potential looming crisis has focused on the impact it could have on the financial sector. Much of the debt is held by large banks that can more easily bear the cost should CRE borrowers default on their loans, with JP Morgan Chase, Wells Fargo, and Bank of America holding $171 billion, $145 billion, and $76 billion in commercial property loans respectively. But the bigger concern is how the crisis could affect smaller regional lenders, which hold 70 percent of CRE debt maturing through 2025. Additionally, regional banks hold more CRE debt as an overall percentage of their lending portfolio (44 percent) than large banks (13 percent). As such, should a large number of CRE borrowers default, regional banks stand to lose considerably more than their larger national counterparts.
Naturally, a crisis in CRE debt would spell further trouble for a struggling CRE property market. While the multi-family and industrial space markets are also facing hard times, the office space market is experiencing the most pain. The national office market lost $664.1 billion in value from 2019 to 2022. Since 2022, office prices have continued to decline, and major US cities are feeling the hardest impact. As of Q3 2023, San Francisco had seen the value of its office space drop 58.7 percent. America’s three largest cities, New York, Los Angeles, and Chicago, saw their office space value decline by 53.9 percent, 54.5 percent, and 42.4 percent respectively.
What Will Happen Going Forward
The volume of CRE debt coming due in the next few years could have a withering effect on the economy, potentially derailing the post-pandemic recovery. CRE debt defaults could destabilize the financial sector. One reason to worry is that delinquency rates on commercial mortgage-backed securities are already on the rise: delinquencies were at 3.48 percent for office spaces in 2023, and are forecast to rise to 8.1 percent in 2024 and rise further to 9.9 percent in 2025. The delinquency rates on multifamily properties are also expected to rise, though they remain considerably lower than those for office spaces.
Unlike office spaces, multifamily property owners are still finding plenty of tenants due to the shortage of affordable housing, thus helping to alleviate their difficulties in paying off their debts. As mentioned before, a major source of concern is the impact this will have on regional banks. Some of them, such as the New York Community Bank, have already reported unanticipated losses on CRE loans. Fed Chair Jerome Powell himself has warned that there will be failures in small and medium-sized banks. If enough banks fail, it would send shockwaves through the rest of the financial sector and drag down the economy.
Should the debt crisis create further harm for the CRE market, it would also spell trouble for cities and municipalities that have struggled since the pandemic. Local property tax revenue from CRE, residential properties, and other sources account for 30 percent of the general revenue for local governments. Additionally, city economies tend to rely heavily on the economic activity generated by CRE properties such as office buildings, including spending on restaurants and retail stores by office workers which itself generates tax revenue.
The decline of the CRE market has already brought considerable losses in revenues for many American cities. For example, the decline in office values is expected to cost the District of Columbia $464 million in combined tax revenue from 2023 to 2026. Meanwhile, San Francisco faces an estimated $150 million to $200 million loss of revenue between 2023 and 2028 for the same reason. If tax revenues fall too much, it could potentially trigger an “urban doom loop” for many cities, where cities are forced to cut public services, making the downtown areas less appealing to investors, and further driving down demand for and use of CRE properties, further reducing tax revenues and so on.
Options for Borrowers
All of this begs the question as to what recourse lenders and borrowers have to stave off disaster. Many have fallen back on the “extend and pretend” strategy they used during the pandemic. The motto in the CRE market for much of 2023 was “survive until ‘25,” as CRE borrowers hoped that if they managed to hold out until the Fed cut interest rates, they could then refinance their loans with minimal pain. Instead, inflation has remained stubborn and the Fed has delayed lowering interest rates, making “extend and pretend” look far less viable. CRE owners could also sell their property to pay off their debts, but that is an action of last resort as current market valuations mean that many owners likely would not get enough money from selling to pay off their entire debt. For older properties that are unlikely to recoup their losses anyway, CRE owners are resorting to demolishing the properties and making use of the land that it is on for redevelopment into properties with more profit potential. Others are trying to adapt their office spaces to changes in the workforce to ensure that they do not remain entirely vacant.
The CRE debt crisis merits the exploration of policy solutions from lawmakers. To that end, many lawmakers have embraced the idea of converting CRE to residential real estate. The logic is that if office space is not being used, and there is a shortage of affordable housing that is particularly acute in America’s cities, then why not kill two birds with one stone and turn that office space into housing units? The Biden Administration itself jumped on that bandwagon in October 2023, when it released an action plan that included the leveraging of federal funds and working with state and local governments to encourage CRE conversions.
While CRE conversions might be feasible for some properties, some experts have pushed back on the idea by pointing out several pitfalls:
- Downtown areas often lack the amenities necessary to turn them into livable neighborhoods.
- Converting offices to housing units can be prohibitively expensive for some office buildings, especially older ones. One study in San Francisco found that conversions cost between $472,000 and $633,000 per unit.
- Even if all viable office space was converted to housing, it would not be enough to resolve the affordable housing shortage in many US cities. One study In New York City found that only about 3 percent of office buildings would be viable for conversion to residential housing.
That said, supporters of CRE conversions point out that the practice could prove feasible for specific urban areas depending on their individual circumstances, and that local governments should take advantage of the idea where possible.
As it stands, should the CRE debt market falter as it faces the so-called “refinancing cliff” over the next few years as loans come due, the fallout for the economy would be significant. If enough borrowers end up unable to refinance and default on their loans, it could pose a risk to the financial sector as large banks are forced to absorb the losses and small and medium-sized banks holding CRE debt are forced to close. If interest rates remain higher for even longer than expected, struggling lenders would be hit even harder. The resulting crisis would lead to a spreading credit crunch with banks raising lending standards, decreasing the available supply of credit for businesses and households. All of this would hinder economic growth, or tip the economy into recession. While a commercial real estate crash is not a certainty, the possibility is a clear and present danger.