Forecasts Suggest a Structural Change for Commercial Real Estate

Economic headwinds, including high interest rates and the continued prevalence of remote work, have the potential to create widespread changes for commercial real estate in the near term as well as over the coming years.

Record-high vacancies

A significant portion of office buildings is at risk of becoming obsolete, resulting in potential losses for real estate investors and banks.

 In Market Insider, Scott Rechler, CEO of RXR Realty, explained that while top-tier office buildings are likely to thrive as people return to in-person work, lower-grade offices will struggle and might become competitively obsolete.

  The U.S. office vacancy rate recently reached a record high of 13.1% with lower-tier buildings facing challenges due to poor infrastructure, lighting, and air quality. Distressed office space is being acquired by banks, including Goldman Sachs, which could lead to further price drops over time.

 Rechler said the commercial real estate sector is under pressure as around $1.5 trillion of debt in the sector approaches maturity, potentially causing refinancing difficulties.

Federal Risk Review

The FDIC's 2023 Risk Review highlights potential risks in the commercial real estate market. Community banks, accounting for 28% of new and existing commercial real estate loans in Q1, face elevated exposure, given their smaller size, according to a report in Investopedia.

 Real estate research suggests persistent high office vacancies, impacting office REITs. Despite stabilized deposits, 30% of U.S. banks have a notable concentration of commercial real estate loans. Rising delinquency rates in commercial mortgage-backed securities, coupled with economic uncertainty, could stress loan portfolios and limit growth, especially as banks plan to tighten lending standards across categories this year.

Interest rates not helping

The commercial real estate market, particularly the office sector, is facing vulnerability due to high interest rates after a period of low-cost borrowing, according to a report in Fortune.

 Another factor is the decline in demand. Remote work is causing a significant economic challenge for the office sector. Capital Economics, an independent economic research business based in London, predicts a substantial drop of 35% in office values from peak to trough. Kiran Raichura from Capital Economics, predicted that such a decline is unlikely to recover by 2040.

 Raichura based his prediction on two primary reasons:

 1) The increase in interest rates over recent years affects all real estate sectors, leading to higher capitalization rates.

 2) The reduction in physical office space usage is causing increased vacancies and weaker rental growth.

 Raichura said that the forecasted decline has increased over time, influenced by factors like the banking crisis, availability and cost of debt finance, and investors' confidence. He emphasized that the demand for office space is undergoing a structural change; firms are reducing space even if maintaining their size, leading to a prolonged recovery period. Additionally, interest rates are expected to stay higher, influencing real estate cap rates and subsequently lower prices.

 While some office assets may never fully recover, others may adapt or change their use. Raichura said that the best-quality office spaces will eventually rebound and perform well in the future, but the hardest-hit assets may become obsolete or repurposed for other uses.