Crash, train accident or apocalypse?

Terrible commercial real estate warnings pop up almost daily these days. As office markets are stressed due to the increase in working from home, some real estate professionals see an increasingly bifurcated market, divided “into haves and have-nots”. Investors, tenants and cities, especially those with old and decaying buildings, will need to pay close attention over the coming months to see where they stand and how badly things could go.

Dramatic negative commercial real estate appraisals are easy to find. The San Francisco standard predicts an “epic commercial real estate crash” that threatens this city, likening it to an approaching train with “the city, its budget, and its ability to provide track-related services.” Not to be outdone, Bloomberg tweeted “Remote work is killing Manhattan’s commercial real estate market” with similar issues spreading to other cities.

But even that language pales in the face of what NYU professor Arpit Gupta and his colleagues are saying, predicting an “office real estate apocalypse.” Using New York City data, they estimate “a 45% decline in office value in 2020 and 39% longer term, the latter representing a $453 billion value deduction,” which could plunge the city into a “catastrophic fiscal loop”. Similar damage could affect other cities, and by extension the national economy.

How then to make sense of other bad, but not apocalyptic, data? CommercialEdge’s monthly “National Office Report” for September found flat average office listing rates, $38.70 per square foot, “down 0.1% year-over-year.” Bad, but not apocalyptic. And as I recently noted, some cities, especially in the Sunbelt or those with strong life science industries, are experiencing strong rental markets.

What does the other data tell us? Moody’s has documented that commercial mortgage-backed securities saw “a huge increase in high default rates” in the second quarter of 2020, just as the pandemic hit. But banks, life insurance investors and others restructured loans and offered forbearance, lowering their delinquency rates. This strategy will be more difficult to follow if further pressures arise in the office market, especially with the Fed raising interest rates, which makes borrowing more expensive across the board.

So far, at least the commercial banks now seem to have their home lending under control. Their charges and delinquency rates reached 0.07% in the second quarter of 2020, at the height of the pandemic. But in the first two quarters of 2022, the Fed is bringing those rates back to zero, not a signal of a dramatic decline in loan quality.

And even the bad numbers of 2020 had nothing to do with the financial crisis of 2008. Between 2009 and 2010, delinquent commercial bank loans exceeded 2% for seven consecutive quarters. Tighter regulation has since kept loose bank lending in check, so thankfully we have no signs of commercial loan defaults dragging down the broader economy.

Going behind the aggregate numbers shows positive signs in commercial real estate. Over the past year, Sunbelt cities like Charlotte and Austin, or cities with life science concentrations like Boston, have seen double-digit rent increases. Google
and other tech companies are leasing large amounts of space in cities like New York and Chicago.

The biggest risk in commercial real estate is older, less desirable office space. The amount of this in any city is critical in assessing its overall risk. A roundtable in PERE magazine, which tracks private equity property investment, found a “very difficult” but uncertain market, with risks ranging from inflation in construction and financing costs to an impending recession.

PERE experts see a “bifurcated” market, with more modern buildings (especially 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 “unknown” overall customer demand.

But these are the opinions of real estate investors, who could be (as they say on the street), “talk their book” and put a positive spin on the numbers. In contrast, consider the “apocalypse” analysis of NYU and Columbia professors. Combining work-from-home data with financial information from real estate investment trusts (REITs) and other financial information, they predict “long-term office valuations 39.18% lower than pre-pandemic levels. with “a lower quality office stock…a more widely blocked asset.”

If they’re right, cities – and the economy – will be hurt. Although some older buildings can be converted into housing, it is not an easy or immediate process. Collapsing real estate values ​​could lead to significant fiscal problems for many cities, leading to cuts to social services, education, public health and other essential government functions. We’re not in an apocalypse yet, but we all need to keep an eye out for that possibility.

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