Office Building Crash is Coming

This article first appeared on www.loadedforlife.com 

The Covid-driven shift to working from home combined with companies realizing they can drastically cut costs by reducing office space is likely to result in a serious decline in commercial real estate, particularly office buildings. The rise in interest rates which began in March 2022 will help fuel this downturn. The rising cost of capital is making office buildings more expensive at a time when landlords face a declining pool of tenants.

Lenders are Scared, Vacancy Rates are Rising

This situation is further exacerbated by a general risk aversion among banks. Lending tightened after the collapse of Silicon Valley Bank, Signature Bank, and First Republic Bank earlier this year. These were not small banks. First Republic was the second-largest bank collapse in U.S. history and Signature was the third largest. Banks are skittish to lend against office buildings which are increasingly difficult to value, due to falling rental demand and oversupply. Statista reports the national vacancy rates for office buildings in the first quarter of 2023 were 18.6%, which is the highest in 30 years, and some markets are a few percentage points higher. As leases come due, many companies will not renew for the same amount of space, reflecting the continuing trend of employees working from home. This means higher vacancy rates and lower profits in the months to come.

Possible Repeat of the Global Financial Crisis

Morgan Stanley reports that nearly $1.5 trillion in commercial real estate debt will mature by the end of 2025. At the same time, loans on office buildings are seeing higher delinquencies and an increase in defaults. We may not have seen the last bank failure for the near term. In some ways this situation is reminiscent of the 2007-08 residential real estate collapse, where banks are heavily focused on retaining cash to prevent a run and are reluctant to lend against an asset class facing increasingly troubled waters. According to Morgan Stanley, the decline in commercial real estate prices could be up to 40%. For comparison to the global financial crisis, home prices fell by 27.4% from their peak in 2006 to their low point in 2012, according to the S&P CoreLogic Case-Shiller U.S. National Home Price NSA Index.

An Office Recovery Is Not Like Residential

When the global financial crisis occurred, financially secure investors bought foreclosed homes with cash and converted them to rental properties. This included small mom and pop investors as well as large private equity firms like Blackstone. The process put a floor below home prices and led to a recovery. However, the same process will not happen on a wide scale for office properties because office space is not easily converted to more profitable uses.

Cost of Conversion May Be Excessive

Although demand remains high for residential apartments in areas that also have surplus office space, it is often not cost effective to convert the property. Retrofitting a building from commercial to residential may be more expensive than building from scratch, depending on how the building is configured. Some office buildings can be converted to self storage, but this will not be enough to put a floor below office buildings.

Risk of Contagion in the Economy

Even if you are not invested in office buildings you should be concerned about this trend. Unfortunately, when one asset class declines dramatically, it can spread like a virus to other asset classes and the broader economy. During the global financial crisis the decline in residential properties led to higher job layoffs as unemployment went from 5% to a peak of 10%. Consumer spending fell as buyers feared job losses or falling behind on mortgage payments and this led to an economic slowdown.

The real estate downturn also set off a major stock market decline. The S&P 500 stock index fell 37.5% from December 2007 to June 2009 and the NASDAQ stock index fell by 30.9%. Although many economists are downplaying the potential for a recession in the next six months, it is wise to be cautious in the coming months until more data exists. Banks are offering certificates of deposit at rates near 5% and this is not a bad place to park cash for a few months to see if asset prices fall and new buying opportunities emerge.