The challenges of commercial real estate are coming to the surface

At the end of last year, expectations of central banks easing their policies led to a significant drop in long-term interest rates, which are determined by market forces. This decline was a boon for the listed real estate sector, sparking a recovery rally it desperately needed. However, the situation shifted at the beginning of 2024. Interest rates started climbing again because inflation turned out to be more stubborn than expected. This stubbornness implies that central banks might delay easing their policies, both in timing and intensity. This recent increase in long-term interest rates negatively impacted the listed real estate market. Unlike many tech stocks, which saw a strong start to the year, the listed real estate sector did not enjoy a similar kickoff.

Listed real estate stocks continue to move in tandem with long-term interest rates

Despite the recent pullback in interest rates, it is anticipated that central banks in both the US and Europe will begin to lower policy interest rates at some point in the near future. However, this does not signal a clear path forward for real estate. Except for an unforeseen catastrophic event, interest rates are expected to remain higher than the exceptionally low levels experienced over the past decade, and challenges persist, particularly for certain segments like commercial real estate (offices). This sub-segment of the real estate market is still in the middle of the storm, as already flagged in our article of November last year. In that article, we explored research by Stijn Van Nieuwerburgh, a professor at Columbia Business School. He predicted significant challenges ahead for US office spaces, banks with substantial commercial real estate debt on their balance sheets, and even city budgets that rely heavily on property taxes in the US.

The challenges facing the commercial real estate sector, particularly office buildings, stem from a mix of weak return-to-office numbers and elevated interest rates that hinder borrowers' ability to refinance. Professor Van Nieuwerburgh’s thesis is currently starting to play out, to a certain extent in the real world. It has taken time to figure out the current value of specific office properties, as market activity slowed with sellers reluctant to accept distressed prices. Yet, recent developments highlight the growing difficulties. For instance, debt secured by a Blackstone-owned Manhattan office building is being offered at a 50% discount. Similarly, a premier office tower in Los Angeles was sold for nearly half of what it was purchased for a decade ago. These instances align with Professor Van Nieuwerburgh’s model, which was discussed in our November article, suggesting that the value of US office spaces could decrease by 40-45% relative to their pre-COVID-19 valuations. In addition to these depreciating values, developers and owners of commercial properties, including offices, are now also facing increased refinancing costs.

 

As highlighted by Professor Stijn Van Nieuwerburgh, the downturn in commercial real estate is proving to be problematic for certain banks as well. This was recently exemplified by New York Community Bancorp and Japan’s Aozora Bank. Both institutions saw significant declines in their stock market valuations after announcing substantial losses connected to their investments in US commercial real estate. This situation prompted rating agencies, such as Moody’s, to consider downgrading New York Community Bancorp's credit rating to junk status. Banks are bracing for a wave of commercial real estate loan maturities, with estimates around $1 trillion due over the next two years. According to Professor Van Nieuwerburgh's research, it is the smaller US regional banks that face the most significant risks, rather than the larger systemic banks, which somewhat limits the risk of widespread contagion across the global banking sector. These smaller banks have greater exposure to the commercial real estate market and lack diversified sub-businesses that could buffer them against downturns in this sector. Some analysts, including billionaire investor Barry Sternlicht, predict as much as $1 trillion in losses for the office real estate sector alone.

Regulatory authorities are also expressing concern over potential losses in commercial real estate. Treasury Secretary Janet Yellen and the Federal Reserve have made recent statements emphasizing the risks commercial property poses to the banking sector, with the Fed incorporating commercial property risks into its annual banking stress tests more prominently. In Europe, the European Central Bank (ECB) has been cautioning banks that they may face additional capital requirements if they fail to adequately disclose their real estate-related risks. Recently, Deutsche Bank for example quadrupled its US real estate loss provisions.

While there are some differences between the US and Europe in office market dynamics, as discussed in our previous article— notably Europe's better return-to-office figures—this doesn't mean the European office market is without its challenges. The difficulties faced by Deutsche Pfandbriefbank, which has exposure to real estate risks in both the US and Germany, recently highlighted these issues. Data from CBRE, a global commercial real estate services and investment firm, indicates that prime office values in continental Europe are now, on average, approximately 30% below their peak values. Additionally, a Barclays survey revealed that over the past 12 months, the average weekly time spent in offices only increased from 3.4 days to 3.5 days. According to the same survey, employers have currently reduced their office space by about 10% and would cut back an additional 6% if given the opportunity to renegotiate leases immediately.

Not all is doom however for the office property market. Slowly, the transaction market is starting to open up, allowing investors to get comfortable again with valuations, and even offering attractive forward-looking returns for certain assets. Recent research from VTS, a commercial real estate technology company providing a platform for landlords and brokers to efficiently manage leasing activities, tenant interactions, and portfolio performance, indicated that the office is re-emerging as the primary place of business both in the US and Europe. Many companies are either mandating or encouraging employees to spend more time in the office, or they plan to do so. This shift is underscored by comments from the CEO of the French marketing firm Publicis, who pointed out the negative impact of excessive remote work on innovation. There is also an increased focus on converting obsolete or surplus office spaces into, for example, residential areas. However, as mentioned in our November article, this process is not without its challenges.

 

Link to previous article (see underlined text in the article):

https://www.econopolis.be/en/blog/posts/2023/november/the-growing-challenges-in-the-commercial-real-estate-sector-for-office-spaces/