How bad is the real estate market?
This is the question that has been haunting investors for several months now.
The real estate sector is indeed going through a difficult period due to the increase in interest rates by the Federal Reserve to fight stubborn inflation. The central bank raised its interest rates during its most recent meeting, putting its benchmark rate between 5% and 5.25%.
The Fed meets next on June 14-15, followed by another Federal Open Market Committee meeting on July 26-27. Speculation is for a pause at the June meeting but an interest-rate hike in July.
One of the consequences of this monetary policy is that it has increased the debt payments of property owners who are very leveraged. Commercial real estate actors currently owe $1.5 trillion to banks, pension funds, and insurers, according to industry data.
This enormous debt, which must be paid before the end of 2025, was secured by a national portfolio of office, retail, industrial, and multifamily properties that may not be valued at where they were 5 or 10 years ago when those loans were issued.
Office Buildings Are Empty
This reality is aggravated by the office spaces that are increasingly empty in the big cities. Large companies, i.e. those employing more than 50,000 employees, plan to reduce between 10% and 20% of their office space by 2026, according to a survey by real estate agent Knight Frank. The survey is based on a sample of around 350 businesses around the world, employing a total of 10 million people.
“Firms are looking to work their offices harder, but still offer some flexibility to staff,” Dr Lee Elliott, global head of occupier research at Knight Frank, said in a statement accompanying the report.
This survey confirms the narrative that workers have abandoned office buildings, preferring to work from home. The consequence is that demand in the commercial real estate market has plummeted, bringing with it a decline in property values.
Elon Musk, the billionaire serial entrepreneur indicates that the situation will continue to deteriorate because, he says, the phenomenon of empty offices is becoming widespread.
“Are office buildings empty in your city?” a Twitter account with which the Tesla CEO regularly interacts with on the platform, asked on June 9. “Shares of Boston Properties, the largest office REIT by mkt cap, have plunged by 63% from the peak in Feb 2020, to $54.11. It owns the Salesforce Tower in SF, where two office towers just sold for 70% off the original listing price.”
Musk answered the user’s question with a question that indicates that the problems in the commercial real estate are widespread.
“Where are they not?” the billionaire said.
According to the billionaire, the situation will continue to deteriorate in the commercial real estate sector, where investors have been waiting for an increase in delinquencies for months, because of higher rates and lagging office demand.
Delinquencies in office debt seem to have hit their tipping point in May, according to real estate analytics firm Trepp, whose data relate to commercial mortgage-backed securities, or CMBS. The numbers track securitized loans that are in trouble, having moved to third-party negotiations between the lender and the borrower.
Delinquency rates on commercial office property have more than doubled in the past six months to 4%, Trepp said in the report. It’s the first time office delinquencies reached 4% or more in five years.
“The office rate jumped 125 basis points to 4.02%,” Trepp said. “The last time the office rate was above 4% was 2018. At that time, many loans originated in 2006 and 2007 were still outstanding accounting for the high level. That is not the case currently.”
The CMBS market is roughly a fifth of the total U.S. commercial real estate lending, but constitutes an indicator of the situation of the sector.
Offices have been the most heavily watched part of the real estate market as firms look to aggressively reduce space. Sublease space is at or near record highs in many markets, Trepp said, as demand from big tech firms has eroded sharply. In addition, many companies are letting leases expire or are renewing with smaller footprints.
At the end of May 2023, Google, for instance, announced it was offering up 1.4 million square feet in Northern California for sublease.