The bill for the office property is arriving at last after four and a half years of the pandemic sending workers home.
High borrowing prices have further devastated the office construction industry, which is already struggling with rising vacancy rates due to the rise of remote work regulations. The Federal Reserve is now planning to decrease interest rates, but it might be too late. A constant thump of distressed sales is being caused by investors, banks, and property owners finally coming to terms with the fact that certain commercial buildings will never regain their pre-pandemic value.
With about $1 trillion in commercial real estate loans due this year, the market’s problems have the attention of Congress. One member from New York even went so far as to label it a “ticking time bomb” for banks. In an effort to alleviate the housing crisis, a coalition of lawmakers from both parties is working to streamline the process by which developers can turn idle office spaces into residences.
Rep. Mike Carey (R-Ohio), who presented a bill this summer granting a temporary 20% tax credit for qualified property conversion expenses, stated, “This would absolutely help lenders recoup some of their investment while allowing them to align with the current needs of the market.”
Carey, who co-sponsored the measure with California Democrat Jimmy Gomez, stated, “The pandemic caused a seismic shift in work patterns.” “There is a lot of unrealized potential in these empty office buildings,” the author says.
From January through March, there was just one office property transaction, but in the past four months, seven have been sold at a loss of over $100 million apiece. With the market resetting, investors and banks will have to operate on thinner margins and take huge haircuts; in July, one midtown Manhattan office building sold for 97.5% of its original price. At the same time that the economy is cooling, that could put a damper on lending in other places.
New York state legislators have also tried to stem the tide by promoting housing conversions: developers in New York City can get a 90% tax break if they reserve 25% of the units in an office conversion for affordable housing.
Conversions aren’t always feasible, and not all office buildings are good fits.
“It will happen when it can, and it’s a good thing,” said Lisa Pendergast, executive director of the Commercial Real Estate Finance Council. “For the time being, it won’t be sufficient to rescue the office market.”
According to Senate testimony given by Fed Chair Jerome Powell this summer, commercial real estate risk “will be with us for some time, probably for years.” Thus, Powell has publicly expressed his concerns. For the first time in almost four years, the Federal Reserve is anticipated to lower interest rates this month.
The Mortgage Bankers Association estimates that commercial real estate loans with a balance of around $930 billion will mature this year. Commercial mortgages typically have shorter repayment periods than residential mortgages and typically need larger, lump-sum payments known as “balloon payments” to be paid off at the end of the loan term. Refinancing will be necessary for a number of those loans, and the new interest rates will be much higher.
Smaller banks lack the capital reserves and other business lines that larger banks have, therefore authorities are concerned that over 70% of commercial real estate mortgages held by banks are on the balance sheets of these institutions.
The impending debt crisis “puts extreme pressure on U.S. regional banks that are weighed down by loans for commercial buildings that are worth a fraction of their initial price, making them vulnerable to bankruptcy,” Carey said, referring to the commercial real estate market.
With a combined total of around $3 trillion in commercial property debt, banks dominate the market for commercial mortgages. The Federal Deposit Insurance Corp. reports that approximately half of all banks’ loan portfolios are comprised of commercial real estate loans, and that nearly all banks (98 percent) participate in this sort of lending.
“The banking system’s excessive exposure to commercial real estate remains a ticking time bomb,” stated Rep. Ritchie Torres (D-N.Y.). A reduction in interest rates could alleviate some of the symptoms, but it won’t fix the underlying problem. While “extend and pretend” may buy time, it won’t solve the problem permanently.
Homeowners and lenders alike were able to “extend and pretend” during the early panic about pandemic-related property value drops by negotiating loan extensions in the hopes that prices would eventually rise again. Because of the sales freeze, it is difficult to ascertain the actual worth of any particular piece of real estate. The MBA reports that last year there was a 47% drop in lending for commercial real estate.
“Operating expenses for all types of buildings have gone up dramatically in the last few years, particularly insurance premiums,” commented Real Estate Roundtable president and CEO Jeff DeBoer.
According to Jamie Woodwell, VP and head of commercial real estate analysis at the MBA, “uncertainty about where rates would go, and a pullback in deal activity” characterized the previous couple of years. “Some people are making a move from the sidelines, embracing the current rates and taking action,” the author says.
Owners frequently need to put up more money to get their loans extended now that the real, lower worth of certain property is becoming apparent.
Columbia University business school professor Stijn Van Nieuwerburgh noted that office assets “don’t end up being refinanced without an additional equity infusion from the owner” in three out of four cases. “Is the owner’s action amounting to throwing good money after bad?”
According to MBA, office properties make for around 740 billion of the over $4.7 trillion in outstanding debt for commercial real estate.
“My baseline scenario is this will be a protracted slump rather than a virulent crisis,” Van Nieuwerburgh said, adding that anything may happen in the world to speed up such downturns. “I am prepared for commercial real estate to continue losing ground, with the possibility of a more severe downturn.”
According to Trepp data, the office sector accounted for roughly two-thirds of the newly defaulted loans on commercial mortgage-backed securities, which showed an uptick in the delinquency rate for July. About $1.9 billion in office loans became suddenly delinquent in July, causing the office default rate to rise above 8% for the first time since November 2013.
Scott Rechler, CEO of the New York landlord RXR, which went bankrupt last year over a $240 million loan associated with a skyscraper in Manhattan, says that the reset’s glacial pace is both good and bad.
“The fact that it hasn’t sort of hit, sure, is good,” Rechler said, adding that the storm has been lingering off the coast for some time. On the plus side, though, interest rates have been higher for a longer period of time, which is adding fuel to the fire, isn’t it? As a result, its landfall becomes more akin to a Category 5 hurricane.
Conversely, he noted, banks have been able to accumulate reserves due to the storm’s delayed arrival, which has been made possible by loan extensions and revisions. The “denial” phase of mourning is giving way to “acceptance” and the marking down of holdings, he added, as more and more banks do this.
Unlike 2008, “there is a clear acknowledgment that if you’re kicking the can — this is different from 2008 — that this is not going to resolve itself in just, you know, prices and values re-inflating because of an injection of capital into the system,” Rechler said.
“So the day of reckoning needs to come at some point or another,” he continued. “Right here, I believe it is.”
