The commercial real estate sector is in trouble for two big reasons: High vacancy rates, and falling property values.
Nationally, about 18% of America’s office space lacks tenants. There may have been some overbuilding, but this is primarily due to the switch to working from home. The pandemic spurred that, but technology made it possible, and there’s no going back from technological change. Some experts believe it’s irreversible and America is stuck with a surplus of office space. Some suggest converting it to residential housing.
The other big problem, falling property values, is due to both vacancies and rising interest rates. Politico explains the problem (here):
“The way these loans are structured, you’re mostly paying interest, not principal, so you have to roll over most of the loan when it comes due …. The bank will say, no, the interest rate is now 6 percent instead of 3 percent … which means that your building is now worth 40 percent lower.”
Lenders say “no” when the collateral is worth less than the loan amount. Why collateral declines in value is straightforward. Unlike houses, people buy commercial real estate as investments. If I want a 3% return on a building, I’ll pay 33.3 times the rent income for it; but if I want a 6% return, I’ll pay only 16.6 times the rent income for it. If the rent income is less because of higher vacancies, that depresses the value even more; and if commercial buildings are hard to sell because nobody wants them, that depresses their value even more.
When lenders write loans, they consider whether they can get their money back by selling the collateral if the borrower fails to repay the loan. If they originally lent $1 million on a building worth $1 million which can now be sold for only $600,000, they’re not going to re-lend $1 million loan on it; the most they’ll lend is $600,000. Of course, it isn’t hard to see that a borrower unable to roll over a $1 million loan may not be able to pay it back, either, if he can’t sell the building for $1 million. Even if he could dip into other assets to make up the $400,000, he’ll likely be motivated to walk away from it. That means a lot of defaulted loans and distressed sales.
I’m using these made-up numbers for illustration purposes, but they show what’s happening in the American economy’s commercial real estate sector: Falling tenancies and rental income, falling property values, and hard-to-sell properties leading to loan defaults which, if there are enough of them, topple banks. This isn’t just theory; the data show the delinquency rate for office property loans has risen from 3.4% to 5.4% over the last year. Over the same period, commercial property loan originations have dropped by 56%, and “sales transactions aren’t … taking place.”
This problem won’t cause another 2008-type financial crisis because less money is at risk. At that time, residential mortgages were about 80% of all household debt, and reckless mortgage lending resulted in millions of bad loans. This problem is much smaller, but likely will take down more regional and small banks, which collectively hold about 70% of America’s commercial real estate loans, and this could push the economy into a recession. But it won’t have the impact of the subprime home loan collapse.
Meanwhile, given a nationwide housing shortage, and especially with some workers returning to offices, it makes a lot of sense to convert unused office space into apartments and condos. That won’t be cheap, but is cheaper than building new residential buildings. The big questions here will be building suitability, location, and financing the conversions. And government stepping in to help might cost taxpayers less than another banking bailout.