Problems at the office
The office credit market is in trouble, but the broad CRE sector appears healthy.
The stress the Federal Reserve’s rapid interest-rate hikes has brought to the real estate sector first surfaced last year in the housing market. The dramatic increase in mortgage costs reduced activity in line with policymakers’ desire to cool inflation. Recently, cracks have appeared in commercial real estate (CRE), most prominently within the office subsector. Conditions there can only be described as weak and likely to get worse. While this promises to be a drag on economic growth, several factors persuade us that a broad credit contraction and subsequent recession is not a foregone conclusion.
The distress in the office market is well publicized. In addition to loans repricing to higher rates, demand has deteriorated. A secular change brought on by Covid-related lockdowns and the swift adoption of WFH have reduced the need for office space. It appears that return-to-office mandates have plateaued, suggesting that development might be permanent. Some estimates put the vacancy rate around 20% in major urban areas. With approximately $400 billion in office loans set to mature this year and another $500 billion in 2024, the stage is set for a battle between lenders and borrowers as new terms are negotiated.
Some borrowers are considering avoiding the fight altogether by walking away from their properties. It may seem a radical response, but with reduced equity, higher interest expense and potential of needing to provide additional equity investment (to meet lenders’ changing credit requirements), it can make sense. Softening that fall is that commercial mortgages typically are non-recourse loans—meaning borrowers are not on the hook beyond the forfeiture of their property. In fact, some large real estate investors have already handed over the keys of their office buildings to lenders.
These conditions are worrisome but not as dire as some fear:
- The office credit market not monolithic While banks, especially smaller ones, do hold a large portion of loans secured by office properties, the debt is spread across numerous other channels, from insurance companies to private investment vehicles to securitized markets. This dispersion provides some stability.
- What goes up… Although a large share of loans feature floating-rate terms that already are facing higher interest expense or cost to hedge the exposure, many have fixed rates that don’t reprice until maturity. Should the Fed win its inflation battle and ease policy, the rate pressure will decline.
- Big buildings, small footprint The office subsector is relatively small compared to overall CRE. So, while it makes sense that a pullback in credit would result as lenders absorb office-loan losses, wholesale restriction across channels is less likely.
While the adjustment to higher rates is a challenge across CRE, we are not yet seeing fundamental deterioration elsewhere. In fact, several property types are in particularly good shape. Industrial warehouses as facilitators of e-commerce are enjoying a sea change in demand. With warehouse costs a far smaller portion of the overall expense of home delivery than, say, transportation, rents have surged to the point that in-place levels are far below current market rates (with some portfolios reporting a more than 50% difference) providing a cushion against any future slowdown and a solid outlook for revenue growth as leases mature. Other well-positioned sectors include senior housing (those boomers aren’t getting any younger), single family rentals (elevated home prices make renting an economical alternative) and self-storage (WFH is driving demand). Finally, the ongoing tightening in credit availability means less competitive supply, a benefit for current property owners.
The concern that deterioration in credit availability will impede growth is warranted, but in our opinion, fear that the office market’s challenges will drive a full-blown recession is not. Despite the narrative presented by some media outlets and analysts that it is an acute problem, the story likely will play out over many years. We view the office credit woes as a detriment but not a mortal blow to the broad economy.