The coming commercial real estate crash that may never happen

Almost a quarter of office-building loans need to be refinanced in the next year at higher rates and lower quality properties where vacancy rates are high are at the greatest risk.

Only two months ago, SL Green & Co. chief executive Marc Holliday was sounding happy. The head of New York’s biggest commercial landlord firm told Wall Street analysts that traffic to the company’s buildings was picking up, and more than 1 million square feet of space was either recently leased or in negotiations. The company’s debt was down, it had finished the structure for its 1 Madison Avenue tower in Manhattan, and local officials had just completed an extension of commuter rail service from Long Island to Green’s flagship tower near Grand Central Station.

“We are full guns blazing,” Holliday said on the quarterly earnings call, with workers headed back to offices after a pandemic that rocked developers as more people worked from home, raising the question of how much office space companies really need any more. “We can hopefully …continue on a path to what we think will be a pivot year for us in 2023.”

Then Silicon Valley Bank failed, and Wall Street panicked.

Shares of developers, and the banks that lend to them, dropped sharply, and bank shares have stayed low. Analysts raised concerns that developers might default on a big chunk of $3.1 trillion of U.S. commercial real estate loans Goldman Sachs says are outstanding. Almost a quarter of mortgages on office buildings must be refinanced in 2023, according to Mortgage Bankers’ Association data, with higher interest rates than the 3 percent paper that stuffs banks’ portfolios now. Other analysts wondered how landlords could find new tenants as old leases expire this year, with office vacancy rates at record highs.

How much an office crash could hurt the economy

There are reasons to think the road ahead will be rocky for the real estate industry and banks that depend on it. And the stakes, according to Goldman, are high, especially if there is a recession: a credit squeeze equal to as much as half a percentage point of growth in the overall economy. But credit in commercial real estate has performed well until now, and it’s far from clear that U.S. credit issues spreading outward from real estate is likely.

“There’s a lot of headaches about calamity in commercial real estate,” said Kevin Fagan, director of commercial real estate analysis at Moody’s Analytics. “There likely will be issues but it’s more of a typical down cycle.”

The vacancy rate for office buildings rose to a record high 18.2% by late 2022, according to brokerage giant Cushman & Wakefield, topping 20 percent in key markets like Manhattan, Silicon Valley and even Atlanta.

But this year’s refinancing cliff is the real rub, says Scott Rechler, CEO of RXR, a closely-held Manhattan development firm. Loans that come due will have to be financed at higher interest rates, which will mean higher payments even as vacancy rates rise or remain high. Higher vacancies mean some buildings are worth less, so banks are less willing to touch them without tougher terms. That’s especially true for older, so-called Class B buildings that are losing out to newer buildings as tenants renew leases, he said. And the shortage of recent sales makes it hard for banks to decide how much more cash collateral to demand.

“No one knows what is a fair price,” Rechler said. “Buyers and sellers have different views.”

What the Fed has said about commercial real estate

Federal Reserve officials up to and including Chair Jerome Powell have stressed that the collapse of Silicon Valley Bank and Signature Bank were outliers whose failures had nothing to do with real estate – Silicon Valley Bank had barely 1 percent of assets in commercial real estate. Other banks’ exposure to the sector is well under control.

“We’re well aware of the concentrations people have in commercial real estate,” Powell said at a March22 press conference. “I really don’t think it’s comparable to this. The banking system is strong, it is sound, it is resilient, it’s well capitalized.”

The commercial real estate market is a bigger issue than a few banks which mismanaged risk in bond portfolios, and the deterioration in conditions for Class B office space will have wide-reaching economic impacts, including the tax base of municipalities across the country where empty offices remain a significant source of concern.

But there are reasons to believe lending issues in commercial real estate will be contained.

The first is that the office sector is only one part of commercial real estate, albeit a large one, and the others are in unusually good shape.

Vacancy rates in warehouse and industrial space nationally are low, according to Cushman and Wakefield. The national retail vacancy rates, despite the migration of shoppers to online shopping, is only 5.7%. And hotels are garnering record revenue per available room as both occupancy and prices surged post-Covid, according to research firm STR. Banks’ commercial real estate lending also includes apartment complexes, with rental vacancies rates at 5.8 percent in Federal Reserve data.

“Market conditions are fine today, but what develops over the next two to three years could be pretty challenging for some properties,” said Ken Leon, who follows REITs for CFRA Research.

Still, most debt coming due in the next two years looks like it can be refinanced, Fagan said.

That’s one of the reasons Rechler has been drawing attention to the issues. It shouldn’t sneak up on the market or economy, and it should be manageable with the loans spread out across their own maturity ladder.