Navigating the Changing Landscape of Commercial Real Estate

Historically, downturns in the commercial real-estate market have been closely tied to disruptions in the debt markets, and this cycle is no exception. 

However, unlike previous downturns, such as the Great Financial Crisis or the Savings and Loan Crisis, the current shift has not been triggered by imprudent debt underwriting or excessive leverage.  Rather, the swift and substantial rise in interest rates, combined with lingering effects from the pandemic, has led to market-wide challenges. 

Rising Rates, Shrinking Profits

The higher interest-rate environment signals a significant spectrum of consequences for property owners and purchasers:

• For owners seeking to refinance, higher rates result in higher debt service costs.
• For owners seeking to sell, offers have frequently come in below expectations, as buyers factor higher borrowing costs into their underwriting.

This disconnect has created a wide bid/ask spread, leading to a marked decline in transaction volumes.  Many owners are unwilling to accept lower bids and are instead opting to hold onto their properties.  The increase in interest rates also results in higher capitalization rates, which results in lower mark-to-market values for those investors who choose to retain their properties. 

Borrowers unable to refinance or sell may be faced with default.  With $300 billion in CMBS and Freddie Mac loans set to mature in the next two years, and roughly 40% of the maturing loan balances unable to meet a minimum 10% debt yield threshold[i], the market is paying close attention. 

Lenders must decide whether to work with borrowers on defaulted properties or foreclose.  Thus far, lenders have shown a willingness to “extend and pretend,” offering flexibility to borrowers, when feasible, in an effort to avoid forced sales. 

Empty Desks, Disappearing Value: The Office Market’s New Normal  

While the commercial real-estate market as a whole is experiencing a recalibration, the impact of rising interest rates and other challenges varies by sector, with the office sector facing the most dramatic transformation.

As this sector adjusts to the post-COVID-19 world, extreme challenges from both the revenue and expense sides of cash-flow statements continue to apply pressure.  Many companies have adopted long-term remote-working policies, causing both a reduction in the demand for office space and changes to tenant preferences—the vacancy rate for the top 15 markets in the US was 19.5% during the second quarter of 2024[ii]—but not all properties and locations have been equally affected. 

Source: Colliers

Commercial real estate is experiencing a “flight to quality,” as tenants prefer the best locations, extensive buildouts, and amenities to entice employees to the office. 

• Many high-quality Class A properties in prime locations are still seeing strong demand.
  • 30% of Class A buildings are fully occupied and another 20% have over 85% occupancy.[iii]
  • Class A asking rates increased 1.2% from the second quarter of 2023 to the second quarter of 2024.[iv]
• At the other end of the spectrum, older Class C buildings in less desirable locations are facing obsolescence.
  • The bottom 10% of office assets account for over 730 basis points of current vacancy, which nationally stands at 20.5% as of the second quarter.[v]

Suburban office locations are also outperforming properties in central business districts.  Conversion to other uses, such as multifamily, is often challenging, as the physical layout of a building may not be suited to other uses.  Government tax incentives may be the only economically viable option for the redevelopment of many buildings. 

Meanwhile, financing for office properties is scarce.  Lenders are hesitant to provide loans for office space amid the uncertain environment, and refinancing options are limited.  Even when existing lenders are willing to provide an extension on a loan, they often require principal paydowns, higher spreads, and additional contingencies.  The office market is facing a near-closed capital market;  during 2023, only 35% of CMBS office loan maturities paid off, reflecting the sector’s struggles. 

Despite this capital-market weariness, office-related distressed sales have yet to reach the peaks seen during the Global Financial Crisis:

• It took until 2012 for distress to peak from a crisis that began in 2008.
• One reason for this lag is the long-term nature of office leases—it takes years for existing leases to run off and for vacancy rates to rise.
• Lenders also learned during the GFC that ‘fire sales’ may not be in their best interest.

The market is now asking when lender patience will run out.

Market Implications

Due to the aforementioned factors, a period of price discovery is occurring across the broader space, and price changes vary significantly across sectors, markets, and strategies, with early signs of deceleration beginning to appear. 

• Office Sector: Struggles with lower occupancy and a near-closed capital market, limiting access to refinancing and new loans.
• Multifamily Sector: After record-low cap rates pre-pandemic, this space now faces the prospect of negative leverage.
• Industrial Sector: This space benefited from changes to consumer behavior during the pandemic, but barriers to entry remain in focus, as development increased supply in certain markets.
• Retail Sector: This space has proven resilient, with grocery-anchored retail thriving throughout the pandemic.
• Hospitality Sector: Mixed results—operationally, vacation hotels experienced heightened demand during the pandemic, while business-travel-focused hotels face continued challenges from the increased popularity of video conferencing.

As the repricing process continues to unfold, property owners are eagerly awaiting potential rate cuts, while discerning investors are stepping in to fill capital voids and watching closely for emerging distress opportunities.  In this evolving real-estate landscape, investors who act nimbly and strategically will be well-positioned to capitalize on emerging opportunities, while others risk being left behind.

[i] https://www.trepp.com/trepptalk/an-update-on-refinancing-risk-for-maturing-loans-debt-yield-scenario-analysis

[ii] https://www.colliers.com/en/research/nrep-usofc-leading-us-office-markets-snapshot-q2-2024

[iii] Cushman & Wakefield - Cushman & Wakefield Releases Mid-Year Macro Outlook for Commercial Real Estate (cushmanwakefield.com)

[iv] https://www.colliers.com/en/research/nrep-usofc-leading-us-office-markets-snapshot-q2-2024

[v] U.S. Office MarketBeat Reports | United States | Cushman & Wakefield (cushmanwakefield.com)