Don’t Look Up – Why A Commercial Real Estate Crash Might Be Streaking Toward Us


They’re everywhere, all around us. Many of us pass by them every day, not thinking about what’s up there—or what isn’t. It’s the hundreds if not thousands of landmark skyscrapers and gleaming midlevel high-rises that define the skylines of every major city center in America, as well as those of secondary markets and satellite suburban office centers.

Before the Covid-19 pandemic, they were full of knowledge workers in industries from technology to customer service. Now, too many of them are modern-day ghost towns. And ghost is the correct characterization when considering the dangers lurking inside those buildings.

The Vacancy Phenomenon

The financial press is just beginning to scratch the surface of what many institutional allocators have been whispering about for a few quarters now, often as afterthoughts. What about the vacancies?

In markets like San Francisco, the problem is most pronounced. According to a new CBRE report, nearly a third of offices in the City by the Bay, or 31.6%, remain vacant since the lockdowns from Covid and subsequent downsizing across the media and technology sectors. For example, by April 2023, Salesforce completely moved out of its East tower in San Francisco’s South of Market district, opting to attempt to sublease more than 700,000 square feet of commercial space across two locations.

According to data from Kastle Systems, a managed security provider, average office occupancies were less than 50% in the Los Angeles, Philadelphia, and New York metro areas through the middle of July, with Chicago coming in at just 53.4%. Unsurprisingly, major office tenants are responding accordingly.

Leases, Loans And Liquidity

To further understand the problem, knowing how commercial office leases work is key. Generally, a lease is for approximately a five-year term with options to extend, often with inflation or market rate adjustments. Under that assumption, 20% of leases come up for renewal every year.

With far less need for space, many companies are negotiating down their square footage. As reported in the Philadelphia Business Journal, the law firm Fox Rothschild is reducing around 40% of its office space with a new lease deal, and advertising agency Digitas is downsizing its space leased by nearly 50%.

Furthermore, leases aren’t the only contracts that come up for renewal periodically. The very loans owners use to finance those office towers generally come up for renewal every five to seven years or so. When they do, not only must they be qualified for again – based on rent coverage to payment ratios – but they also get repriced based on prevailing interest rates.

And we all know what’s happened with mortgage interest rates over the last year and a half. So, even if the owners of those sizable office buildings can qualify for their loan renewal, the monthly costs just doubled. And that’s happening with 15% to 20% of most office buildings in America every year for the next five years.

Additionally, CoStar reports up to $12.6 billion of office loans are in special servicing, meaning these troubled borrowers worked out repayment plans; however, those scenarios sometimes end with them returning a given property to the lender.

To recap, vacancies are up and maybe going higher, average rents are surely coming down due to simple supply and demand, and borrowing costs and debt servicing are exploding higher. The problem is evident and will likely worsen over the coming years.

The Value Dilemma

There used to be an adage in commercial real estate: “A building was worth 200 times the monthly rent revenue.” The calculations have become more complex today, factoring in operating costs, taxes, interest rates, and other elements. Building values now are often discussed in terms of capitalization rates or net operating income.

Whether you use the old, simplified methods or new complex calculations, the base factor is always the same – rents. And with the total rent on a building coming down, the fundamental value of that building is declining. And as with the beginning of any bear market, early sellers are starting to exit while they still have something to exit with.

A new Capital Economics study forecasted San Francisco commercial properties will decline in value by 40% to 45% between 2023 and 2025. That’s an estimate of what the buildings will be worth – gross, not the value of the equity, after the debt is factored. Savvy owners know what’s coming.

Rising borrowing costs, decreased revenue, dropping values, and faster-declining equity would logically lead many people to the same conclusion. It’s time to sell. And selling they are beginning to do. First placed on the market a year ago for $160 million, a 13-story building in downtown San Francisco was recently sold in a deal reported to be worth less than $46 million, just a fraction of the original asking price.

Inevitable Fallout And A Glimpse Into The Future

As more and more leases come due, mortgages reprice, and buildings hit the market, the markdowns will likely get more dramatic. The pain felt by developers, institutional investors, and office-focused real estate investment trusts is likely only beginning.

But with many buildings initially financed – or refinanced – with only 50% to 60% equity, what happens when the equity disappears altogether and even goes negative? To see that playbook, one need only look back to the housing bubble bust that started the global financial crisis 15 years ago. The banks get stuck with the building.

As the recent bank failures of Silicon Valley, Signature, and First Republic revealed, rising interest rates and corresponding declining bond portfolio values significantly weakened the balance sheets of many regional banks. These same regional banks hold much of those loans, and signs of distress are starting to surface. A report by Trepp revealed the delinquency rate for office-based commercial mortgage-backed securities had more than doubled to 4% in just the last six months. As was the case with the Great Recession, many of these banks aren’t prepared to handle the coming onslaught of office building foreclosures.

Not only will the banks that take over these buildings face the same declining rent rolls that caused their prior owners to turn over the keys, but they will either be forced to turn into operators or need to sell in an accelerating bear market. After all, who wants to buy a half-empty building in a sea of half-empty buildings? Add in lots of new climate regulations, and pressure from ESG upgrades required to fight climate change, and one can see how new buyers would hesitate to jump in.

The logical next question is: What will this do to the banking sector if this scenario unfolds? What about the intuitions that hold this private real estate, such as endowments, foundations, and public pension funds? These are the kinds of clients we represent, and they are growing concerned, as they should be.

The Federal Reserve may have provided a glimpse of what might come with its treatment of the Silicon Valley Bank failure. Just as the Fed ultimately bailed out tens of billions in depositors’ uninsured balances, the Fed or the government will likely respond with another troubled asset loan facility and bailout. But unlike most of the bailouts in the recent past, what happens if those office buildings never fill back up? The taxpayer will likely be left to foot the bill.

The potential fallout doesn’t stop there. Major cities rely on real estate taxes to support their budgets. Still more have revenue taxes on the shrinking number of businesses that still occupy those office buildings, and most have sales taxes on the commerce in and around them. San Francisco, arguably the most severely impacted major U.S. city, reportedly expects a $780 million budget deficit over the next two years.

Cities already dealing with office vacancies, housing challenges, school funding issues, and public safety concerns will have fewer resources in the coming years to address worsening conditions. This might drive even more businesses and residents out of these hollowing neighborhoods, thus furthering the death spiral. The conditions that challenged Detroit for a generation when the auto industry pulled out decades ago may be metastasizing across America’s major cities as we drive idly by, not knowing what lurks above—or ahead.

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