Crash, Train Wreck, Or Apocalypse?

These days, dire warnings about commercial real estate appear almost daily. While office markets are stressed due to increased work-from-home, some real estate professionals see an increasingly dichotomous market, divided into “haves and have-nots.” Investors, tenants, and cities — particularly those with older, decaying buildings — will need to pay close attention to where they fall and how bad things could get in the coming months.

Dramatic negative commercial real estate valuations are easy to find. That San Francisco standard foresees an “epic commercial real estate crash” looming over this city, comparing it to an oncoming train with “the city, its budget and its ability to provide track-bound services.” not to be surpassed Bloomberg tweeted “Remote work is killing Manhattan’s commercial real estate market” with similar problems spreading to other cities.

But even that language pales in comparison to what NYU professor Arpit Gupta and his colleagues are saying, predicting an “office real estate apocalypse.” Using data from New York City, they estimate “a 45% decline in office values ​​in 2020 and a 39% long-term decline, the latter representing a $453 billion loss in value,” throwing the city into a “fiscal doom loop.” could. Similar damage could hit other cities and thus the national economy.

How then can we make sense of other bad – but not apocalyptic – dates? CommercialEdge’s monthly National Office Report for September found flat average office listing prices at $38.70 per square foot, “down 0.1% year over year.” Bad but not apocalyptic. And as I’ve recently noted, some cities, particularly in the Sun Belt or those with strong life science industries, are seeing strong rental markets.

What do other data tell us? Moody’s documented that commercial mortgage-backed securities saw “a huge spike in default rates” in the second quarter of 2020, right as the pandemic hit. But banks, life insurance investors and others restructured loans and offered forbearance, lowering their default rates. This strategy will be more difficult to follow when new pressures hit the office market, particularly when the Fed hikes rates and borrowing becomes more expensive across the board.

So far, at least commercial banks seem to have their real estate loans under control. Their billing and late payment rates hit 0.07% in Q2 2020, the peak of the pandemic. But for the first two quarters of 2022, the Fed is reporting those rates at zero, no signal of a dramatic decline in credit quality.

And even 2020’s bad numbers didn’t compare to the 2008 financial crisis. Between 2009 and 2010, commercial bank defaults exceeded 2% for seven consecutive quarters. Tighter regulation has since helped control loose bank lending, so luckily we have no signs that commercial lending failures are hurting the broader economy.

A look behind the aggregate numbers reveals some positive signs for commercial real estate. Over the past year, sunbelt cities like Charlotte and Austin, or life sciences-centric cities like Boston, have seen double-digit rent increases. Google
and other tech firms have leased large spaces in cities like New York and Chicago.

The greatest risk in commercial real estate is older, less desirable office space. The level of this in each city is central to the overall risk assessment. A PERE Roundtable magazine, which tracks private equity real estate investments, found a “very challenging” but uncertain market, with risks ranging from inflation in construction and financing costs to a looming recession.

PERE experts see a “split” market with more modern buildings (particularly those that are ESG compliant) and some cities well positioned to weather the crisis. PERE investors see a “new normal” with less full-time office occupancy, but with offices still facing an “unknown” aggregate demand from clients.

But these are the views of real estate investors who (as they say on the street) are “talking about their book” and could sway the numbers positively. In contrast, consider the “apocalypse” analysis by NYU and Columbia professors. Combining work-from-home data with real estate investment trusts (REITs) financials and other financial information, they forecast “long-term office valuations 39.18% below pre-pandemic levels” with “lower quality office stocks… a more stranded company”. Attachment.”

If they’re right, cities – and economies – are in for a rough ride. Although some older buildings may be converted into apartments, this is not an easy or immediate process. Plunging property values ​​could create significant tax problems for many cities, leading to cuts in social services, education, public health and other key government functions. We’re not in an apocalypse yet, but we all need to keep the possibility in mind.

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