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Challenges in the US Commercial Real Estate Sector: An In-depth Analysis
The Pandemic Redefined Office Spaces Completely.
The US Commercial Real Estate Sector
The commercial real estate (CRE) market is a critical component of the global economy, encompassing various sectors such as offices, retail, industrial, multi-family properties, hospitality, and special purpose properties. The performance of the CRE market is influenced by a range of economic factors, including government policies, central bank actions, and global financial trends. This is a comprehensive analysis of these factors and their impact on the CRE sector.
Commercial Real Estate Market: Office Sector
Vacancies in the office sector have led to a halt in new development, deeply discounted properties, and an increasing rate of defaults. Buildings in Los Angeles and San Francisco have sold this year for a fraction of their prior value, and lenders are altering their strategies and tightening terms for those seeking to enter the space. Brokers have reported that money is extremely tight, with the best terms coming in at half-down and with 9 to 12 percent interest rates. Companies considering leases are now evaluating the creditworthiness of landlords to prevent foreclosures from affecting long-term agreements. Office space vacancies remain at historic highs in San Francisco, and numbers across California continue to trail pre-pandemic figures. Vacancies in the 50 largest metropolitan areas are more than in 2008 and are approaching the highs of the 1990s, which occurred during the real estate crisis.
The pandemic has changed the downtown landscape as companies have realized they can operate with much smaller real estate footprints, which has lessened their costs while also draining downtowns of weekday workers. Hybrid work is here to stay, and it’s restructuring the office market. Many downtown towers in Los Angeles, Park Avenue, New York, and San Francisco may never return to their pre-pandemic occupancy levels.
Other Commercial Real Estate Sectors: Retail and Industrial
While the office space sector is suffering, experts see positive signs in other commercial sectors such as retail and industrial real estate. Retail is showing signs of optimism except in the San Francisco Bay Area, which has been plagued by high crime, open drug use, and homelessness. Industrial commercial real estate remains the hottest of all sectors, with vacancy rates reportedly "unsustainably low" at between 1 and 2%. Market forces are responding, and new project developments are coming online across the state.
The Banking System and Commercial Real Estate
The banking system is still experiencing difficulties despite the belief that the banking crisis is over. Anecdotes from inside the credit system and commercial real estate system suggest that the crisis is still ongoing. Banks are hoarding cash, building up their buffer, and de-risking to avoid being the next bank failure. Banks are also experiencing funding difficulties and deposit flights. The Federal Reserve reported another record high in its bailout program, the BTFP, surging by more than $6.5 billion last week alone, and it is now over $100 billion. This program is a sign of stress in the system, and it's obvious that the banking crisis is not over yet.
Refinancing & Foreclosure Risks
A significant portion of commercial real estate loans are structured as interest-only loans, with borrowers making interest payments during the life of the loan and the entire principal due at the end. As interest rates have increased and lenders have become more reluctant to refinance these loans, there is a growing risk of defaults and foreclosures in the commercial real estate market.
Fitch Ratings estimates that 35% of pooled securitized commercial mortgages coming due between April and December 2023 will not be able to refinance based on current interest rates and property incomes and values. This risk is particularly high for office property owners, with as much as 83% of outstanding securitized office loans potentially unable to refinance if interest rates remain at current levels.
A rise in defaults and foreclosures could have a ripple effect throughout the commercial real estate market, leading to distressed sales, declining property values, and potential losses for regional and community banks heavily exposed to the sector.
Impact of COVID-19 Pandemic on the CRE Market
The COVID-19 pandemic has had a significant impact on the commercial real estate market, particularly on office and retail spaces. The shift to remote work during the pandemic has caused a decline in demand for office spaces and subsequently lowered occupancy rates, an increase in vacancy rates, resulting in decreased income for landlords. In addition to the decline in demand for office spaces, retail properties have also been negatively impacted by the rise of e-commerce and reduced foot traffic due to social distancing measures.
Additionally, many landlords who financed their office buildings with floating-rate debt are facing skyrocketing borrowing costs, while those who used fixed rates are soon facing maturity on that debt and will have to finance at much higher rates. This has led to large losses for landlords, with some choosing to walk away from their properties and eat the one-time loss.
Commercial real estate investment trusts (REITs) have seen their share prices plummet as a result of these challenges. Hudson Pacific Properties, a company specializing in office and studio properties in Los Angeles, San Francisco, Silicon Valley, and Seattle, has experienced an 86% decline in its share price since February 2020. Other major office REITs, such as Boston Properties 67%, Kilroy Realty Corp 65%, Cousins Properties 50%, and Vornado Realty Trust 77%, have also experienced significant declines in their share prices.
Government Policies and Central Bank Actions & Federal Reserve's Interest Rate Hikes
The Federal Reserve's recent interest rate hikes have contributed to the stress in lending, and the federal government's role in impacting the slope of the yield curve is potentially concerning. Historically, declining yield curve slopes are followed by recessions and unemployment spikes. A declining yield curve slope indicates that short-term interest rates are higher than long-term interest rates, which can discourage banks from lending and lead to a slowdown in economic growth.
The US Federal Reserve and government policies have been significant enablers of wealth transfers from Main Street to Wall Street, leading to non-market based inequality. The Greenspan put and the subsequent policies of Ben Bernanke have created inflation in assets, benefiting those on Wall Street. The wages of the average American have not grown since the 1970s, and despite high interest rates, home prices remain unaffordable for many. Institutional capital is now competing with individuals for single-family homes, with one in every five houses sold being sold to a corporate investor. The Fed's policies have made owning a home unattainable for many Americans, leading to a situation where corporations are renting out the American dream.
Global Financial Trends and Future Challenges for the CRE Market
The global financial backdrop is becoming increasingly odd and indicative of shifts and changes in the global financial order. Debt and power are starting to come at odds with each other, creating catalysts that shift thoughts about the global financial order. Countries such as China, the Middle East, and North Africa are de-dollarizing due to concerns about the US weaponizing the dollar and mismanagement, which creates national and economic security issues for those countries. Taxes and the total amount of debt are also contributing to the decline of the US dollar.
The commercial real estate market may experience an echo of the Great Financial Crisis of 2008 due to changes in occupancy rates and rising interest rates. It is important to monitor the implications of these shifts on the various sectors of the CRE market. Additionally, the potential for a regional banking crisis is high, particularly if a coming recession exacerbates the situation. If this happens, it will be up to the Treasury and Fed to come to the rescue by firing up the money printer, monetizing debt, injecting liquidity into the markets, and saving the financial system once again.
For more analysis on these topics, check out these articles:
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