Just How Big Is the CRE Gray Rhino? (Part I)

Commercial real estate valuations are down along with return-to-the-office occupancy rates. Interest rates are up. And loans are coming due. That means trouble.

Image via Microsoft Designer

It’s no secret that the Covid-19 pandemic dealt a big blow to commercial real estate, particularly downtown office space. Property values are down significantly and interest rates are up. That means trouble as roughly a trillion dollars worth of loans come due in 2024 and 2025 and as municipalities sustain a big blow to property tax revenues.

The story is playing out in the headlines each week: big, obvious, scary, and heading straight at us.

So how big and bad is the commercial real estate gray rhino, really?

Let’s break it down.

First: What are the numbers? How much debt is due and when?

Second: What kinds of commercial real estate are we talking about? How far have prices fallen –and how far and long are they likely to continue?

Third: Who is affected? Which banks hold the most CRE debt, how much is distressed or likely to become so, and how big is it compared to their overall financial position? Beyond the obvious challenge for banks, what are the domino effects on municipal finance, related industries? Who pays for the consequences?

Fourth: Who is doing what? Is that enough to solve the problem? If not, what other actions need to be taken? And what indicators will indicate that the problem is under control –or spinning out of control?

Today we’ll look at the first questions.

Here in Chicago, downtown office vacancies are over 25 percent, Crain’s reports. That is nearly double pre-Covid vacancies which were just 13.8%. The first quarter of 2024 set a new record high for the seventh quarter in a row and for the 12th time in the past 14 quarters. OUCH.

My city’s predicament is somewhat worse than nationwide, but not by much. Moody’s Analytics estimated in January that around one-fifth of US office space is vacant.

Office Rent and Vacancy Trends in 4Q 2023

Source: Moody’s Analytics CRE

The drop in office occupancies has been compounded by higher interest rates and the coming “maturity wall”: that is, roughly $1.2 trillion in commercial real estate borrowing coming due in 2024 and 2025 and needing to be refinanced. More than half, or roughly $659 billion, matures in 2024. Will banks and CRE owners be able to “extend and pretend”? Or will we see a spike in failures?

Some of the stories around the country are dramatic: investors like Blackstone, QSuper, Brookfield, PIMCO, and RXR, are simply walking away and handing the keys back to the banks in strategic defaults on commercial office space and hotels (particularly in Manhattan).

Canada’s biggest pension fund sold its 29 percent stake in a vacant 20-floor New York City building, 360 Park Avenue South, for $1. You read that right: ONE.DOLLAR. (Technically, however it included roughly $45 million in commitments to renovate the building alongside other investors. In 2021, the entire building sold for $300 million, making that stake worth close to $100 million; however, investors planned to pour in tens of millions more in renovations.)

Amazon announced that it would reduce its office space over the coming three to five years by letting leases expire or negotiating early exits. The company’s goal is to cut vacancies in its commercial space from 34% (18.2 million sf globally) to 10%.

Similarly, Bank of America will leave the 317,000 square feet it occupies over 13 floors in its Charlotte, North Carolina office tower more than a year before the lease is up.

These individual exits by big names are emotionally resonant and do not necessarily represent the rest of the market.

Still, analysts have estimated that there are jaw-dropping losses across the board: one study, for example, calculated that New York City office buildings lost 49 percent in long run value between 2019 and the end of 2022, and $664 billion in value destruction across all US office markets.

The International Monetary Fund –which many people more often think of as opining on developing countries—in January issued a cautionary report on US commercial real estate. “Prices in the US commercial real estate sector have plummeted more in the present monetary policy tightening cycle than in previous episodes,” the report noted, citing the comparatively steep rise in interest rates, stricter lending standards, and pandemic-catalyzed trends that drastically lowered demand.

“Rising delinquencies and defaults in the sector could restrict lending and trigger a vicious cycle of tighter funding conditions, falling commercial property prices, and losses for financial intermediaries with adverse spillovers to the rest of the economy,” it concluded.

For its part, the ratings agency Fitch predicts that commercial office mortgage backed securities (CMBS) delinquencies will rise to 8.1 percent this year –higher than during the Great Financial Crisis of 2007-09—and 9.9 percent in 2025. Estimating that distressed property debt is being valued at about half of what it was worth when issued, Fitch also forecasts that the CRE recovery will be much slower than after the GFC.

Default rates on commercial mortgage-backed securities already have been rising, from 3.12 percent in early 2023 to 4.71 percent in February 2024, according to the securitized mortgage database firm, Trepp.

So what does this mean for different types of commercial real estate, for banks, and for municipal tax coffers?

I would tell you more today, but Substack tells me there’s no more room.

So, stay tuned for the next installment tomorrow morning.