Why is the $20 Trillion Commercial Real Estate Market Melting Down?

The commercial real estate market has gotten a lot of press lately and for all the wrong reasons. Brookfield, one of the world’s largest public real estate companies, announced earlier this year that it would default on over $161 million worth of office building mortgages. Pacific Investment Co. subsequently announced that it would default on $1.7 billion in office mortgages. Its holdings include office space in some of America’s largest cities, including San Francisco and New York. Park Hotels and Resorts has recently announced that it would default on a $725 million mortgage loan on two hotel buildings in San Francisco. Given all the negative news coming out of the commercial real estate industry, many are starting to wonder if a meltdown is in the near future. Unfortunately, the two leading causes of the current wave of defaults aren’t going to change anytime soon, which means that the meltdown which has already started could speed up in the next two years.

Rising Interest Rates

The FED has hiked rates ten times in the last year. This has put an immense amount of pressure on commercial real estate companies that need to refinance loans. As real estate and finance professor Stijn Van Nieuwerburgh from Columbia Business School recently explained, companies typically pay mostly interest on a commercial loan rather than pay down the principal, which is rolled over when the loan comes due. Unfortunately, a loan with a 3% rate a decade ago would not have a 6% rate, far higher than many companies can afford to pay. This destroys the equity the company built when purchasing buildings, which is why some firms are choosing to sell their commercial buildings at a loss. Wells Fargo, for instance, recently sold the 13-story Financial District office tower it bought for $105 million in 2005 for a measly $45 million. However, not all commercial real estate holders are this lucky. The higher interest rates, coupled with the current wave of defaults, have made it harder than ever for potential buyers to get commercial mortgage loans.

Reduced Occupancy

Lowering rates would likely help some commercial real estate investors avoid default. However, it wouldn’t provide as much relief as the market needs, according to Alan Todd from Bank of America. Another huge problem facing commercial real estate investors is the post-pandemic work-from-home trend. Stanford recently found that over 25% of paid full-time workdays are worked from home. An eye-popping 40% of workers either have a completely remote or hybrid work set-up. This not only puts pressure on commercial office space but also on downtown businesses that rely on traffic from office workers. Unlike interest rates, which can change over time, the work-from-home trend represents a long-term shift in the way companies do business. Workers have protested against employers who tried to call them back to the office. What’s more, job postings mentioning remote work have increased by 400% since COVID-19 started.

What Does the Future Hold?

About $1.5 trillion in commercial mortgages will come due in the next two years. Defaults on even a small percentage of these loans would have a huge negative impact on the entire financial system. About 70% of bank-held commercial mortgages are held by small and regional lenders. Without

expected revenue, these banks could crash, especially if depositors panic and race to withdraw money from their accounts. Bank shutdowns would limit loan options for small businesses, thus leading to a decrease in potential employment opportunities. It would also make it difficult if not impossible for aspiring homeowners to get residential mortgage loans, leading to a crash in the residential real estate agency. It should also be noted that FDIC, which took the unprecedented step of covering deposits over $250,000 when SVB closed earlier this year, doesn’t have extra funding for similar payouts. It would thus be forced to charge more to insure solvent banks. These banks would in turn pass the extra costs to consumers. Put simply, a commercial real estate meltdown could trigger a recession by limiting access to the liquidity needed to keep the economy running normally. What’s more, the market appears to be in the early stages of such a meltdown and commercial investors would do well to plan accordingly.

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