Risks from the current US commercial real estate market

Since the Covid-19 pandemic, the remote work trend continues to cause a sharp drop in office leasing demand, making commercial real estate (CRE) like a ticking time bomb for the financial market in 2024.

According to Green Street, the commercial real estate market is experiencing the worst 4 years of stagnation ever, with office vacancy area since 2019 surpassing both the dot-com bubble period and the global financial crisis.

In this article, Viet Hustler will delve into the analysis of the current situation regarding the current commercial real estate crisis, the impacts on market participants and whether this will lead to a new financial crisis?

Current state of the CRE crisis

1 - Office vacancy rates surge due to increasing hybrid work trends

The biggest challenge in the current real estate market is the Commercial Real Estate - CRE sector (accounting for >25%)…

….due to people not wanting to return to in-office work after Covid:

• Office vacancy rate in Q1/2024 continues to hit record highs nearing 20%.

• Some large companies like Amazon have forced employees to return to the office at least 3 days/week.

• Pre-Covid, office occupancy rate was over 90%, however this figure has dropped to about 50% currently.

  • Office towers in San Francisco are nearly empty, with vacancy rates up to 35.6%, more than 7 times pre-Covid levels.

WeWork - from valuation 47 billion USD to the brink of bankruptcy

When the shared office (coworking space) trend became popular at the end of the last decade, unicorn WeWork was once valued at up to 47 billion USD.

• However, after Covid-19, with the remote work trend, WeWork became increasingly unprofitable and had to file for Chapter 11 bankruptcy on 11/07 last year → Further increasing the number of vacant offices.

2 - Pressure from high interest rates: refinancing costs increase, real estate values decline

Prolonged high interest rates increase refinancing costs

After a long period of using cheap debt to invest in CRE, the Fed maintaining high interest rates since 2022 has made refinancing buildings more expensive.

• According to MBA, borrowers will have to repay 929 billion USD for CRE loans in 2024 (accounting for 1/5 of total debt) and 573 billion USD in 2025.

• Biden encourages developers to convert empty office buildings into apartments to mitigate the housing supply shortage.

  • However, this is quite expensive and not feasible for all buildings.

Rapid interest rate hikes reduce real estate values

Many office buildings in major US cities have lost more than half their value compared to pre-pandemic levels, due to:

High interest rates → Increased borrowing costs → Rental real estate less attractive → Reduced demand → Declining real estate values.

→ To avoid default, investors must dump these assets, but they can't sell due to low demand.

• According to Green Street, commercial real estate prices have fallen since the Fed raised rates: now down -21% from the peak at the beginning of 2022.

• A real estate fund managed by KKR investment group had to cut dividends after recording losses on office real estate loans in Philadelphia.

• A series of office buildings sold at a loss:

  • The 22-story tower at 350 California Street is being offered for sale at only 80% of its 2019 value.

  • The Xerox building in Washington DC was sold for 25 million USD in February, losing 83% compared to the 145 million USD price in 2011.

  • Most recently, AT&T's old building in St. Louis was just sold for 3.6 million USD, losing more than 98% compared to the 205 million USD price in 2006.

3 - Industrial real estate supply tends to be oversupplied

On the other hand, industrial real estate supply is also tending to be oversupplied as large retailers change inventory management strategies.

The just-in-case strategy (stockpiling inventory to reduce back order risk) has shifted to just-in-time (importing goods from suppliers and shipping directly to customers) after Covid ended.

• Consumer goods manufacturer Newell Brands, retail pharmacy chain Rite Aid, sports retailer Fanatics have all reduced their warehouse space.

• In Q3/2023, vacant warehouse space reached a record high with over 156 million square feet – three times the available space in Q4/2021.

Impact of CRE crisis on tax revenue and banking system

In addition to direct participants in the commercial real estate market, CRE crisis risks could also create:

• Public debt burden when government tax revenue is lost.

• Potential crisis in the banking system.

1. Government tax revenue

High vacancy rates lead to lower rents; real estate developers and owners will lose income.

• Consequently, the government may also lose tax revenue:

  • FYI: In New York, office real estate accounts for 21% of tax revenue.

2. CRE losses could create a small bank crisis

In the case where property owners and real estate developers face debt payments in a high interest rate environment, without revenue due to reduced demand.

=> They are likely to default: the banking system and credit institutions as lenders will suffer significant losses.

• Currently, there is approximately 6 trillion USD in CRE debt, of which banks hold up to 3 trillion USD, equivalent to 50% of total debt.

• According to JPMorgan's report, CRE loans account for 28.7% of assets at small banks, compared to only 6.5% at large banks.

Therefore, if a CRE crisis occurs, it could lead to a systemic crisis among small regional banks (regional banks):

• In 2024, the regional bank index has fallen about -13%=, while the overall banking sector is up ~3%.

• The crisis is gradually spreading everywhere: New York Community Bank (NYCB) of the US, Aozora of Japan and Deutsche Pfandbrief of Germany have warned of bad CRE debt.

→ Banks at risk of collapse → Less funding → Less lending capacity.

• Scott Rechler (Fed New York) estimates up to 1,000 small banks could disappear in the next 2 years.

  

• FYI: Banks plan to dump CRE

  • Other banks are changing accounting methods by renaming debt groups held to maturity (hold to maturity) to ready to sell (available for sale)

    → Easily sell debt in the future.

Will the US fall into a new financial crisis due to commercial real estate?

Risks from regional banks are raising questions about whether the current difficulties will turn into a new financial crisis.

1 - Risks are fragmented

• The securitization of CRE debt allows the transfer of lender risk to retail securities investors.

  • Read more about the 2008 financial crisis caused by subprime mortgages (subprime mortgage): hereYoY

→ Risks are evenly shared among banks and insurance companies, ensuring the resilience of the entire financial system.

• However, this real estate securitization activity may create systemic risk due to the interconnectedness of various institutions.

2 - The office ratio to total real estate value is not too large

• Commercial real estate accounts for only 25% of the total value:

  • According to Savills, the total real estate value (excluding agricultural land) at the end of 2022 was 66,000 billion USD, most of which is residential real estate.

• Commercial real estate includes many other segments such as retail, warehouses, and multifamily buildings (multifamily).

Thus: Offices likely account for only about 6% of the total US real estate value, equivalent to about 4,000 billion USD.

• During the 2007 - 2009 period, residential real estate declined by 1/3 in value. If a similar shock occurs, the damage to the entire real estate sector would be 16,000 billion USD.

→ Even if all office buildings lose all their value, the losses they cause would only be 1/4 of that figure, so fears of a 2008 scenario repeating may not come to pass.

CONCLUSION

The US real estate market is facing many challenges in the leasing office segment. The post-Covid remote work trend is transforming the work model of many businesses worldwide. Additionally, prolonged high interest rate pressure is causing office property values to decline, increasing refinancing costs for property owners.

In addition, according to Goldman Sachs, limited funding and the price gap between buyers and sellers are also making the commercial real estate market dismal.

• January transaction volume down -11% YoY. Office leasing activity down -25% YoY and industrial down -28% YoY

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• CRE debt of 1,000 billion USD maturing this year is like a ticking time bomb for mid-sized and small banks (estimated to provide up to 40% of the loans). Some analysts also forecast that these banks will face difficulties. However, overall, commercial real estate-related issues will not worsen to the level of becoming a crisis due to:

• The office ratio accounts for a relatively low portion of the total real estate market value.