Three years ago, much of the world was in lockdown and the 'great remote working experiment' had begun. Today, firms continue to announce permanent remote/hybrid work policies and most experts agree that the global pandemic dramatically accelerated the evolution of work. This rapid shift has caused a steep decline in the demand for physical office space, which has raised concerns about the future of commercial real estate (CRE) markets. A real estate crisis is developing and, in order to survive, building owners will need to get smart to repurpose and differentiate their properties or risk them becoming stranded assets.
Physical office occupancy in the US office market fell from 95% at the end of February 2020 to 10% at the end of March 2020 and it had only just crept back to 47% by November 2022. The situation is similar in developed office markets around the world, and the typical concentration of offices in urban centers also poses fiscal challenges for local governments, which rely heavily on property taxes levied on commercial real estate to provide public goods and services. As other CRE sectors experience similar dips, fears are growing about a “fiscal doom loop” that would worsen city life and the business environment.
Sentiment toward multifamily housing does remain positive as rents continue to rise, but office and retail property valuations could fall by up to 40% according to Morgan Stanley projections, significantly increasing the risk of defaults on CRE loans. As much as 70% of commercial real estate loans that mature over the next five years are held by banks and, because office assets are often financed with debt which resides on banks’ balance sheets and in Commercial Mortgage Backed Security (CMBS) portfolios, large declines in value would have consequences for institutional investors and overall financial stability suggests Bloomberg.
“Almost $1.5 trillion of US commercial real estate debt comes due for repayment before the end of 2025. The big question facing those borrowers is who’s going to lend to them?” writes Neil Callanan, Bloomberg’s London Bureau Chief. “Adding to the headache, small and regional banks — the biggest source of credit to the industry last year — have been rocked by deposit outflows following the demise of Silicon Valley Bank, raising concerns that will crimp their ability to provide finance to borrowers.”
The impending wall of debt is anticipated to escalate before showing signs of improvement. Banks play a significant role in this ecosystem, not only as lenders but also as buyers, which will further intensify the wave of refinancing approaching its due date. Rising interest rates and concerns over defaults have already taken a toll on CMBS deals, with sales of non-government-backed securities experiencing a decline of almost 80% in the first quarter of 2023 compared to the previous year, hinting at the emerging crisis in the commercial real estate sector.
On top of this developing debt crisis; environmental trends continue to drive regulation and demand for greener buildings, enterprise tenants have become much more aware of the productivity benefits of comfortable workplaces, and building occupants have developed an appetite for healthier and more flexible work environments. Consolidation will leave many commercial assets stranded in this new landscape, but those that do survive the transition would have done so by providing green, productive, healthy, and comfortable spaces.
In the decade before the pandemic, CRE outperformance typically hinged on skilful deal-making, when astute acquisitions, moderate operational enhancements, and leveraging declining capitalization rates was enough to yield significant returns. While prudent purchasing remains vital, the current landscape underscores a new significance of operations —a domain that has become increasingly competitive in recent years. Only operation-focused property owners can reduce their environmental footprint and prioritize the human-centred workplace advancements that are now critical to CRE survival.
“Real estate was once an industry years behind in digital capabilities, but it is now catching up. Today, the largest owners are collecting and harnessing the power of their vast data troves to make better decisions and build applications that serve asset managers, tenants, and residents alike,” reads a Mckinsey study on the New Imperatives for CRE. “The next phase of the industry’s digital transformation requires improved change management and fundamentally new ways of approaching the business. It also calls for investments in new types of talent to build, maintain, and enhance the tools that the transformation requires.”