Commercial Real Estate Trends in 2023
In the second half of 2023, commercial real estate is facing an unprecedented crisis. Morgan Stanley suggests that recent loan defaults by “prominent office landlords” and a “decline in demand for office spaces” as warning signs that a commercial real estate market crash may be likely in 2023.
The collapse of Silicon Valley Bank, the 16th largest bank in the U.S., in March 2023 was the largest since Washington Mutual in 2008. The bank primarily served tech firms and venture capital-backed start-ups, and chose to invest its bank deposits in long-term instruments such as U.S. treasuries and agency mortgage-backed securities. The run on the bank began when the tech sector’s venture capital began to dry up, and companies withdrew money to make payroll and meet other expenses. Ultimately, the bank simply didn’t have enough cash on hand to return to depositors.
Many smaller and medium banks are in a similar position. The ones heavily invested in commercial real estate lending may be vulnerable. Signs of risk began with the pandemic of 2020, when quarantining kept most workers at home either through loss of jobs, layoffs, or reassignment to working from home. People began to pivot from commercial centers to nesting at home, even going so far as to move to less populated areas with larger homes to accommodate at-home work, play, hobbies, and family comforts. That left a vacuum in office buildings, brick and mortar stores, hotels, and other public spaces. Meanwhile, business owners, doctors and teachers had to pivot online from in-person services. Takeout meals, prescription fillings and grocery store shopping became DoorDash deliveries, paid for in advance, and delivered to consumers’ doors.
It wasn’t long before the commercial real estate sector felt the pain of change – less demand for office spaces, expiring leases and rising vacancies, falling rent prices, small enterprises unable to hang on and closing their businesses, higher maintenance and repair costs due to supply chain delays and lack of skilled labor, and by 2022, rising borrowing costs as the Federal Reserve began the first of 11 overnight rate hikes to banks in order to tame runaway inflation.
Large markets such as Manhattan and Silicon Valley have record-high vacancy rates of 20% or more, revealing a dearth of new tenants. According to a recent report, office building vacancy rates rose to a record 18.2% in 2022 and 13.1% in the first half of 2023.
New bank loans are more costly and come with stricter qualifications, along with maturing loans in need of refinancing. With one quarter of office buildings due to refinance in 2023 in the face of more vacancies and higher interest rates, some commercial property owners might not be able to secure affordable financing which could lead to decreased deal volume and increased defaults due to these increased risk factors. The impact on communities could be significant as reduced property values and lower tax revenues cause city managers to reduce their budgets and services.
Are there any bright spots in commercial real estate? Absolutely. Not all commercial properties are suffering losses. Businesses supporting e-commerce, including data centers, warehouses, and distribution centers, are thriving. Hotels and brick and mortar retailers are reporting comebacks.
Analysts at Realtor.com say that commercial lending activity is increasing week by week. Commercial loan delinquencies have increased, and are anticipated to increase in the second half of 2023, but current defaults remain below 1%. The reasons are two-fold. Banks have imposed strict lending standards for years and have limited their exposure to commercial real estate defaults. In June, 2023, commercial real estate loans rose to $1.92 trillion from $1.90 trillion in March.
The reason for the increase is possibly the transition of many businesses and families to seek a better quality of life in less expensive suburbs and in the Sunbelt, which is why high-dollar hubs like Silicon Valley, Manhattan and Seattle are losing tenants. The Sunbelt encompasses 18 states in the Southeast and Southwest, and accounts for 50% of the national population and 75% of total U.S. population growth. In the next 10 years, Sunbelt states will grow by 19 million people while other states’ population will grow only by about 3 million.
Business-friendly areas like Nashville, Dallas/Fort Worth, Atlanta, Raleigh, Phoenix and Charlotte are attracting commerce and all ages of residents in search of lower cost of living, mild climate and jobs. Texas has created one million jobs since March 2020. Florida and California added 722,000 and 608,200 jobs, respectively. Nashville is the top-rated metro area, while Dallas/Fort Worth area is number two and Atlanta is third. Also in the top 10 are Raleigh, Phoenix and Charlotte with Miami as number seven.
It could also be that firms are holding onto their spaces in case the economy recovers; they don’t want to break their leases; or they’re able to downsize office space. The biggest unknown for the office sector is the new reality of hybrid workers who only come into the office part-time. The job market is robust, with a record-high number of openings on the market. As of June 2023, there were 5.3 million or 3.5% more jobs available than before the pandemic, and the unemployment rate is at a record low of 3.6%. Jobs increase demand for commercial real estate, but even so, The Emerging Trends in Real Estate report finds that approximately 10% to 20% of existing office space should be repurposed or torn down. So, it’s not a matter of jobs – it’s where to put the workers. Will they work remotely or in the office?
Second, commercial real estate is diverse and while the office sector may be underperforming, other sectors such as multi-family housing, industrial and warehouse spaces, retail and hospitality are doing well.
· Multi-family construction has overperformed for the last couple of years with 22% more units available but only half of those were absorbed. That’s causing the vacancy rate to rise from 5.3% a year ago to 6.9% in 2023. Rents have dropped, too, but the outlook is that multi-family will remain strong due to a strong job market, low housing affordability, lack of housing inventory to purchase, and higher mortgage interest rates.
· The industrial sector is stronger today than it was before the pandemic. Like multi-family housing, builders erected more industrial sites, resulting in a 4.7% vacancy rate, but rent growth is at 8.9% – faster than before the pandemic.
· With the advent of e-commerce, brick-and-mortar retail was challenged by the pandemic but it’s bouncing back with a vacancy rate of only 4.2%.
· Hotel revenues per room are up 13% from the nadir caused by the pandemic and quarantining. Leisure and business travel are up, making the outlook for the hospitality sector positive.
The wild card for 2H23 is inflation. In June 2023, inflation was 3%, the closest it’s been to the Federal Reserve’s target rate of 2% since the pandemic. With rent growth decelerating, it could be the Fed won’t raise rates any further past September, which could eliminate the possibility of a mild recession and put all commercial sectors back in the black. NAR expects the GDP to increase by about 1.2% by the end of 2023 and 1.7% in 2024.