A Perfect Storm for Commercial Real Estate?
A potential crisis for commercial landlord and an opportunity for tenants.
By Valentino DiGiorgio, Esq.
May 17, 2023
A combination of remote work, rising interest rates and loan and lease maturities and renewals may create a perfect storm for commercial real estate owners and lenders. Last week, the Wall Street Journal reported that the owners of an office building for sale in San Francisco, which was worth approximately $300 million before the pandemic, is now anticipating bids of around $60 million, creating huge losses for the owner. Admittedly while this is an extreme example, and San Francisco has its own local problems, it may be indicative of a nationwide crisis in the commercial real estate market as many, including 99-year-old investor Charlie Munger, have been warning us about.
The pandemic and the resulting government lock down of the economy greatly accelerated a trend that economist and sociologists have been predicting for years, the rise of the stay-at-home worker. Given the rapid and prolonged increase in remote working, many businesses simply have too much space.
While vacancy rates in warehouse and industrial space nationally are low (according to Cushman and Wakefield), office vacancies reached an all-time high of 12.9% last month marking its sixth consecutive quarterly increase. Big tech companies such as Meta, Lyft, and Salesforce have already begun shedding millions of square feet of office space.
Meanwhile, there are nearly $450 billion in commercial real estate loans that are set to mature in 2023, and much of that was originally financed at lower interest rates. JPMorgan estimates roughly 20% of those could default.
According to CNBC, analysts have warned that developers might default on a big chunk of $3.1 trillion of U.S. commercial real estate loans that are outstanding. With almost a quarter of mortgage loans on office buildings facing refinancing in 2023 (according to Mortgage Bankers’ Association data), office building owners face the prospect of refinancing at rates significantly higher than the 3 percent loans currently in banks’ portfolios.
Refinancing current low interest loans with higher interest rate loans will be challenging as commercial real estate owners will do so at the same time as tenants are renegotiating their leases. Commercial leases typically have five-year terms with options to renew. Tenants who entered new five-year terms in 2019, just before the pandemic started, now find themselves with fewer workers in the office and much less need for the square footage they bargained for in 2019. As a result, many of those business owners will be looking to renegotiate their leases, with lower rental rates and downsizing their space.
The value of commercial real estate, being based largely on the cash flows generated thereby, will undoubtedly take a hit if tenants give back space and are successful in negotiating lower rents – which seems likely given the potential glut in office space.
If history is any guide, the pain in commercial real estate might be severe. The two most recent commercial real estate crashes saw values fall 17% (1989-1993) and 35% (2007-2010). That would suggest that prices could come down a lot further than the 8% they've already fallen - a comparison that is more troubling when you consider that those crashes came before the remote work revolution.
While this could be a problem for commercial landlords and their lenders, it is also an opportunity for business owners looking to renegotiate their leases and get more favorable terms. Commercial landlords should seek to get in front of this situation by communicating with their tenants about their needs, providing incentives to renew, being creative with business development and marketing opportunities for their tenants and increasing the value and attractiveness of their properties.
We have extensive experience renegotiating leases for commercial landlord and tenants alike. Please feel free to reach out to us if we can be of assistance as you navigate this turbulent commercial real estate market.
Valentino has over 25 years’ experience advising entrepreneurs, financial institutions, small and large businesses, governments, and non- profit companies. Contact Valentino at firstname.lastname@example.org to help your business.
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