Recent falls in commercial real estate valuations – owing in part to higher interest rates and a decrease in the amount of available credit – have led some to worry about the industry’s future. These concerns hold special import in light of the remote work revolution that took place during the COVID-19 pandemic, which has caused a reevaluation of how workplaces and businesses use physical locations. To examine these questions more closely, we spoke to UNC Kenan-Flagler Business School Finance Professor Jacob Sagi, who discussed the challenges facing CRE — and how to disentangle the trends that are shaking up the sector.
Is there a crisis in commercial real estate?
Jacob Sagi: The office sector faces a looming crisis, but it’s far from representative of what is going on in CRE at large. It is important to understand that CRE is not monolithic. According to a recent study by the National Association of Real Estate Investment Trusts, the stock of CRE in the United States is roughly $20 trillion-plus. Office properties make up about 15% of that. Remaining CRE property uses include residential (e.g., apartments), retail (e.g., malls and strip centers), industrial (e.g., fulfillment warehouses), hotels and a large array of “specialty” uses (medical facilities, senior care, data centers, cell towers, marinas, and the list goes on). The CRE property market is diversified in its use of space, and the demand profiles vary with location. For example, the demand for space, regardless of the use, is different in high-growth Sun Belt cities than, say, San Francisco (a market hit hard by both COVID-19 and the tech recession). In other words, it’s important not to fall into the trap of painting the large and diverse CRE national market with broad brushstrokes.
What are the challenges faced by the CRE market, and which markets are most challenged?
Jacob Sagi: We’re all aware that interest rates have skyrocketed and, with that, prices of investment assets like stocks and bonds have plummeted. To understand how the same economic pressure should apply to CRE properties, consider that the typical CRE mortgage for desirable property types might have commanded an interest rate of around 3.5% in April of 2021. Fast forward two years and the rate on the same loan (with the same loan-to-value ratio) would most likely be north of 6%. Using the CRE pricing of early 2022, today’s mortgage interest rates are more than what many properties can yield in net income. Given that interest rates are unlikely to sink back to their levels in 2019, let alone 2021, only two things could bring a rational buyer to pay such lofty prices given today’s much higher cost of financing:
- Convince the buyer that income yields will grow quickly and furiously to make up for being lower than mortgage rates.
- Bring the price down … a lot!
The good news is that, according to Green Street Advisors, nearly all CRE property types are forecast to experience some income growth. The bad news is that, with some notable exceptions (e.g., industrial warehouse and distribution centers), few property types are forecast to experience growth that exceeds inflation by more than a couple of percentage point. This means that, for most CRE properties to be attractive to current buyers, values will have to decline relative to 2021 levels, and substantially so in a few cases. Why haven’t prices declined already? It’s because most owners do not have to sell. As a result, we’ve seen sale transactions fall off a cliff in 2022 and 2023 Q1. To get a sense of the gap between the prices at which investors are willing to buy versus what owners want to be paid, consider that publicly traded portfolios of real estate, whose stocks are traded on a daily basis, are valued by the stock market at a nearly 25% discount, on average, relative to the value at which private-market owners would appraise them. History shows us that, at some point, reality sets in and private and public markets converge. The question is when, and what might be the impact.
No one can say “when” with any degree of certainty. To understand the impact of a reckoning on the CRE market, one can examine two cases for which future income growth is unlikely to justify owners’ current lofty prices for the average property: office and multifamily properties. Even though both are facing the risk of a significant decline in price, the consequences for owners and lenders are very different. Multifamily properties experienced such phenomenal increases in rents in the last two years that owners who purchased or refinanced prior to mid-2021 would experience little to no loss relative to their original purchase (and financing) basis. Moreover, the multifamily market has access to financing from government-sponsored agencies like Fannie Mae and Freddie Mac and will be able to find refinancing even if credit markets remain tight when their loans are due. In other words, the multifamily market, as a whole, can probably take any looming hits and move on.
The office market is not so fortunate. Between the beginning of 2017 and the end of 2022, downtown office markets in the U.S. collectively posted an anemic 3% increase in value per year. An owner and its lender will face significant risks if a large tenant does not renew their lease or downsizes, and work from home is seen to be a one of the drivers behind that. Vacancies in all but the best office spaces are hard to fill. To add to this pain, for many loans coming due for financing and revaluation in today’s tight credit markets, the owner must inject significant additional equity or the lender may have to restructure and/or write down some of the loan (or, in some cases, foreclose).
Summarizing: There are certainly challenges facing the CRE market as a whole, but it would be overreach to claim that this entire market is in crisis. Many segments are doing well, and some (if not most) are well positioned to withstand a correction. The office sector is an exception. It is in trouble, but it also represents a relatively small part of a large whole.
Can office properties be adapted to new uses?
Jacob Sagi: This is one of the most oft-asked questions in relation to problems with the office sector of CRE. Much has been written about it. The obvious contender for adaptive reuse is housing. After all, we heard so much about the housing crisis, so this could be a win-win, no?
The short answer is “Perhaps a little bit, but not much and not anytime soon.” There are two main challenges here: physical and financial. On the physical side, the majority of modern office stock in the U.S., built after 1950, has floorplates that are too large for conversion to residential use. The latter requires access to windows and that means that apartments could only be arranged around the perimeter of the floorplate. This leaves, in many cases, a giant undesirable or unusable empty space (save, perhaps, for the elevator shaft) in the middle of the floor plate. Not ideal.
Second, it’s expensive to do the conversion and meet standard residential building codes. Plumbing, HVAC, etc., would all have to be redone. To make economic sense, the building acquisition basis (what a developer would have to pay the office building owner) would amount to half or less of the value of most appraisals. That’s because office properties, historically, have been more expensive to construct and rented for more (per square foot) than multifamily. A 2022 Moody’s Analytics study recently concluded that only 3% of NYC office buildings would be viable for conversion into apartments. This might change if prices were to significantly come down and cities were to introduce conversion incentives and subsidies – both are underway, but still at levels far too modest to make a significant impact.
Can a crisis in the office sector of CRE spill over to the rest of the economy? Can it, for instance, cause a banking crisis?
Jacob Sagi: Locally, yes. Nationally, probably not. To drill into this, let’s consider a few facts and statistics. The most obvious channel through which real estate troubles can spill into the rest of the economy is the financial system. That happened in the late 1980s with the savings and loan crisis, and with the financial crisis of the mid-aughts. The mechanism is, by now, familiar: struggling real estate properties default on their loans en masse, clogging up financial institutions’ balance sheets, and those institutions start to fail or have to curtail further lending. The subsequent credit crunch leads to more widespread financial distress, which feeds back to financial institutions. As we well know, this may require government intervention to prevent an out-of-control spiral.
As I argued earlier, the troubles in CRE are primarily in the office sector. There are few signs that owners of non-office properties are generically at risk of handing keys to their lenders. There are, however, signs that some of the most deep-pocketed owners (e.g., Blackstone and Brookfield) are indeed ready to do so with office buildings. Can the office sector, on its own, take down the financial system? I doubt it. To see why, let’s parse the sources of CRE lending.
According to the Mortgage Bankers Association, CRE lending is spread across banks (40%), insurance companies (15%), specialized private and publicly traded funds (11%), and Wall Street investors in mortgage backed securities issued by government-sponsored agencies (20%) and investment banks (14%). Systemically important institutions do not appear to have substantial exposure to at-risk CRE loans, but it is true that small and regional banks lend more against CRE in proportion to their size.1 Given the recent failures of SVB and Signature Bank, it is this class of financial institution that merits most concern vis-a-vis its exposure to CRE. According to data obtained from Trepp, about $545 billion in CRE loans provided by banks will mature and require refinancing in 2023 and 2024.2 Of this, roughly 30% (or about $161 billion) correspond to office properties. Based on the fact that roughly 80% of bank lending to CRE is done through small and midsize banks, one might ballpark the potential size of “troubled CRE assets” on vulnerable institutions’ balance sheets at $130 billion.3 This represents less than 2% of their total balance sheet, according to a 2023 FDIC report. The banking system, as a whole, should be able to withstand such a stress. Banking institutions are much better capitalized now than they were during the previous crises.4 Moreover, the federal government has shown a willingness to back up depositors as well as provide liquidity against the drying up of short-term funding sources to vulnerable institutions.
That CRE, and the office sector in particular, is unlikely to cause a national financial crisis should not be taken as trivializing the pain or impact of the stress within that asset category. According to the FDIC’s Community Banking Research Program for the end of 2022, roughly 27% of small/community banks (typically with loan balance sheets of $2 billion or less) are “CRE specialists” with CRE loans comprising 30% or more of their balance sheets. Some of these institutions could fail or may have to curtail their overall lending, and this could hurt some communities – especially those that are underserved by larger banking institutions. In addition, stressed properties with growing vacancies will likely mean a declining haul in property tax (and, therefore, local services) and the risk of growing urban “deserts.” There will be pain, but it is likely to be felt locally, with some communities suffering more than others. If anything, instead of CRE causing a crisis and taking us into a recession, it may be that a recession, instigated primarily by other influences, will further exacerbate troubles in the office sector, amplifying the pain in some communities.
1 “Small and regional banks” generally coincide with those with less than $250B of assets (i.e., loans) on their balance sheets.
2 I’m grateful to Stephen Buschbom for sending me this data.
3 This is likely an overestimate because not all office loans are troubled. On the other hand, not all non-office CRE loans are “untroubled”.
4 See this opinion issued by JP Morgan and another by the International Monetary Fund.
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Commercial Real Estate Faces Challenges, Not a Crisis