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While the Office Building Bust is very old news for Trends Journal subscribers—we had forecast this three years ago—it is now just making it into the mainstream news.
After predicting earlier this year that office building values would fall 15 to 20 percent, real estate services firm CBRE says those values probably will decline an additional 10 percent below those levels, CEO Bob Sulentic told Bloomberg.
Companies, including CBRE itself, Sulentic said, are still trying to find the optimal balance between remote and on-site work.
When those two forces come into equilibrium, workers probably will spend about 25 percent less time in a centralized office than before the COVID War, he expects.
Remote work has contributed to a national office vacancy rate in this year’s third quarter of 18.4 percent, CBRE calculated.
Sustained high vacancies, inflation, and high interest rates have conspired to sink the value of U.S. 2 office properties by an average of 21 percent during the 12 months ending 31 October, data service Green Street reported.
Brookfield Asset Management and Columbia Property Trust are among the major office landlords who have defaulted on office building loans or walked away from their properties, as we reported in “Top Private Equity Firm Defaults on Two Office Towers,” (21 Feb 2023) and “Office Tower Owner Defaults on $1.7 Billion in Mortgages” (28 Feb 2023).
TREND FORECAST: The value of older office properties will continue to fall through 2024 and way beyond.
While workers are drifting back to central offices in some cities, the national office occupancy rate in the most recent week remained at 49.6 percent, according to Kastle Systems’ 10-city weekly survey of swipe card use in more than 2,000 office buildings. The rate has hovered slightly above or below 50 percent for almost a year. This indicates that the figure is likely to be permanent.
As we had forecast since the beginning of the COVID War in 2020, the new work-at-home trend would permanently diminish the office real estate sector.
Trends now show the sector splitting in two.
Newer buildings with popular amenities—on-site gyms and coffee bars, green energy systems—are drawing tenants willing to pay premium rents. Older buildings unable to justify investment in amenities or infrastructure upgrades are seeing tenants leave and few new ones arriving.
As much as 25 percent of current office space in Western economies will become redundant over the next 10 years.
Many of those buildings will be taken by lenders and many will be seized by municipalities for back taxes.
However, banks and towns will be reluctant to own properties that are liabilities instead of assets.
Lenders and cities will work with office building owners, adjusting loan terms and rates and varying zoning and occupancy requirements to keep as many of the buildings in productive use as possible.
Still, a number of buildings will become worthless. Those will be sold for the value of the building lots they occupy or be taken by local governments for use as schools, storage space, or refurbished for office use.
We were the first to call the Office Building Bust and have greatly detailed its implications in articles including:
● “THE NEW LIFE OF LOCKDOWN” (19 May 2020)
● “REMOTE WORK = COMMERCIAL BUST” (2 Jun 2020)
● “SLIDING VALUE OF OFFICE SPACE HITS URBAN CENTERS” (11 Aug 2020)
● “WORK FROM HOME, CITY REAL ESTATE DOWN” (20 Oct 2020)
● “COMMERCIAL REAL ESTATE IN A TAILSPIN” (20 Oct 2020)
● “OFFICE WORKERS STAY HOME” (8 Dec 2020)
● “RETURN TO OFFICES POSTPONED: COMMERCIAL REAL ESTATE BUST?” (14 Sep 2021)
● “WORKERS STAYING HOME, COMMERCIAL REAL ESTATE DISASTER LOOMING” (19 Oct 2021)
● “COVID WAR KEEPING WORKERS OUT OF THE OFFICE” (16 Nov 2021)
● “NYC BUSINESSES: BYE, BYE NYC” (16 Nov 2021)
● “DELOITTE ABANDONS MORE LONDON OFFICE SPACE” (26 Apr 2022)
● “GM SOFTENS BACK-TO-THE-OFFICE REQUIREMENT AFTER WORKER BACKLASH” (4 Oct 2022)
● “BUSINESS OFFICE BUST BEGINS TO BITE” (20 Dec 2022)
● “NEW YORK CITY’S WORKFORCE SHARPLY SHRINKING” (24 Jan 2023)
● “OFFICE OCCUPANCY HALF OF WHAT IT USED TO BE” (7 Feb 2023)
● “TOP TREND 2023, OFFICE BUILDING BUST: THE COMMERCIAL REAL ESTATE FACE OFF” (28 Mar 2023)
● “TOP TREND 2023, OFFICE BUILDING BUST: INVESTORS BACK AWAY FROM DOWNTOWN PROJECTS” (27 Jun 2023)
● “TOP TREND 2023, OFFICE BUILDING BUST: EMPTY OFFICES MULTIPLY IN SILICON VALLEY” (27 Jun 2023)
● “TOP TREND 2023: OFFICE BUILDING BUST, HSBC LATEST TO FLEE LONDON’S CANARY WHARF” (5 Jul 2023)
● “TOP TREND 2023, OFFICE BUILDING BUST: OREGON’S LARGEST CITY LOSING POPULATION” (5 Jul 2023)
● “SPOTLIGHT, TOP TREND 2023: OFFICE BUILDING BUST” (11 Jul 2023)
● “SPOTLIGHT, TOP TREND 2023: OFFICE BUILDING BUST” (25 Jul 2023)
● “SPOTLIGHT, TOP TREND 2023: OFFICE BUILDING BUST” (1 Aug 2023)
● “COMMERCIAL REAL ESTATE TIME BOMB” (15 Aug 2023)
● “TOP TREND 2023, OFFICE BUILDING BUST: TENANTS SIGNING MORE OFFICE LEASES BUT FOR LESS SPACE” (12 Sep 2023)
● “SPOTLIGHT, TOP TREND 2023: OFFICE BUILDING BUST” (3 Oct 2023)
COMMERCIAL REAL ESTATE LENDING FELL BY HALF IN THIRD QUARTER
Mortgage originations for commercial and multifamily properties plummeted 49 percent in this year’s third quarter, year on year, according to the Mortgage Bankers Association (MBA).
Applications for new mortgages, not refinancings, were down 7 percent compared to this year’s second quarter.
Mortgage originations dove 76 percent in health care, while those for hotel, multifamily, offices, and retail space fell by about half.
This year so far, originations are 44 percent below last year, driven by “some properties’ fundamentals, uncertainty about property values, and higher and volatile interest rates,” MBA chief commercial real estate analyst Jamie Woodell said in a statement.
“Greater certainty around those conditions is a key prerequisite to breaking the logjam of transaction activity,” he added.
Banks have reined back lending since three U.S. banks failed in quick succession last spring. Loans to riskier sectors such as office real estate have seen some of the sharpest declines.
With about $1.5 trillion in commercial real estate loans coming due over the next few years, defaults are likely to rise, as we detail in “Worse to Come for Office Sector, CBRE Forecasts” in this issue.
Selling prices for office buildings could drop as much as 40 percent from their peak before stabilizing, Capital Economics said in a report.
TREND FORECAST: Once again, U.S. equity markets are spiking while there is a banking crisis on the near horizon. Lenders will continue to be hesitant and/or deny renewing office landlords loans.
Newer buildings with gyms, coffee bars, green energy systems, and other amenities are drawing tenants, commanding premium rents, and showing the industry’s best cash flows. They will be first in line to receive favorable loans.
The older the building, and the more in need it is of upgrades and repairs, the less likely it is to receive funding.
Banks will continue to cut back on loans to all but the least risky applicants.
Lenders are facing stricter regulations as well as the prospect of a rising tide of defaults on business and personal loans as well as credit cards. They have had to stockpile extra cash reserves against those bad loans coming over the horizon. That leaves them less money to lend, making them even more risk-averse.
Lenders will work with troubled borrowers, modifying lengths and terms of loans in efforts to keep a loan from failing entirely. Despite those efforts, more landlords will default or walk away from their buildings.
The office sector will see a rising curve in loan defaults through 2024 and probably beyond.
CONVERTING OFFICES TO APARTMENTS HAS BECOME EVEN HARDER
Cities and office building owners hoping to convert outdated office blocks into apartments face new obstacles, as interest rates are stuck at high levels and the apartment market has been flooded by enough new buildings to stagnate rental rates, The Wall Street Journal reported.
In 2022, 3,575 apartment units were created from office space, less than 1 percent of new apartments built, according to rental listing site RentCafé.
The number will increase this year, brokerage CBRE predicted, because office vacancies are rising and owners—especially owners of older buildings needing upgrades—are becoming desperate for alternatives.
New York, San Francisco, and Washington, DC, are among cities overstocked with vacant office space and taking steps to boost conversions. Tax incentives and streamlined approval processes are “rocket fuel” for such projects, Sheila Botting at brokerage Avison Young said to the WSJ.
Still, conversions can be fraught with problems.
The easiest office towers to convert are the oldest, which often are smaller than newer buildings, and in need of updates. However, only about 1 percent of U.S. buildings meet those criteria, Botting said.
Not only are construction loans far more expensive now than last year, but also many banks have tightened their lending strategies and are shying away from commercial real estate loans, which include apartments.
The loans are expensive, in part, because they usually need to include funds for major interior demolition to reorganize floor space into apartments and corridors and replumbing for kitchens and bathrooms.
In addition, asking rents for apartments nationwide slipped 1.2 percent since November 2022, according to the ApartmentList website. That makes apartment projects less inviting to investors.
Many municipalities have eyed failing office buildings as possible housing for homeless persons. However, without major government financing, such transitions are unlikely to be numerous enough to make a dent in the homelessness issue, analysts told the WSJ.
TRENDPOST: Again, this is old news to Trends Journal subscribers. In “Plan to Turn New York’s Vacant Hotels To Housing Not Working” (5 Apr 2022) and “Wall Street, Dead Street. Office Buildings Going Condo” (28 Jun 2022), we highlighted the difficulties building owners and city governments have bumped into in attempting to turn failing office towers into living spaces.
Inflation and high interest rates have made that task even harder.
As more landlords default on loans and property taxes, it will also hit cities hard.
WEWORK BANKRUPTCY WORSENS BUILDING OWNERS’ PLIGHT
More than 20 percent of U.S. office space is vacant, CNN reported, with almost 15 percent of Dublin’s offices empty in Ireland and 8 percent across Europe.
Now WeWork, the global chain of co-working spaces, has claimed bankruptcy, dumping even more unused space on the market. (See “WeWork Finally Goes Bust” in this issue.)
The company plans to abandon marginally performing sites, it said in its bankruptcy filing.
As of 1 July, WeWork reported having 777 locations around the world, including 193 in the U.S., where gig workers and start-ups could rent desk space, share copiers and other equipment, and network in trendily-decorated surroundings.
COVID-era lockdowns robbed it of users and its finances never recovered.
This sudden loss of a key tenant hits landlords at a time when they already have slashed rents to hold other tenants, are paying higher maintenance costs, and must convince a skeptical lending market to refinance loans that will carry sharply higher interest rates.
“Office properties—already facing financing hardships and [lower] values—now face a potential new wave of unexpected vacancies,” thanks to WeWorks’ failure, economist Ermengarde Jabir at Moody’s wrote in a 7 November report.
About $270 billion in commercial real estate loans are coming due this year, data service Trepp reported.
Additional empty office space could force landlords to cut their rental rates even more, CNN speculated, which could lead to more landlords defaulting on their loans, a trend already underway. (See “Top Private Equity Firm Defaults on Two Office Towers,” (21 Feb 2023) and “Office Tower Owner Defaults on $1.7 Billion in Mortgages” (28 Feb 2023).
“WeWork’s bankruptcy is another huge problem for the office market to contend with,” Stijn van Nieuwerburgh, real estate professor at Columbia University’s business school, said to CNN.
Defaults and lowered property values could damage small and regional U.S. banks, which hold more than half of America’s commercial property loans.
Losses on those loans, coupled with more than an estimated $400 billion in unrealized losses on low-yield bonds bought during the COVID era, could put many more banks at risk of failure.
Investors’ anxieties about the health of the banking sector grew after three U.S banks failed within two weeks of each other last spring, prompting depositors to shift tens of billions of dollars in deposits out of banks and into money market funds, as we have documented in “Cash Flight to Money Market Funds Worsens Banks’ Plight” (4 Apr 2023) and “Money Market Funds Up $1 Trillion This Year” (19 Sep 2023).
In any case, the imploding commercial property market and resulting defaults could lead banks to make fewer loans, shrinking overall economic activity.
Ultimately, any such problems will encompass city budgets. Lower property values and abandoned buildings cut property tax revenues that, in turn, will force cuts in services to city residents.
TRENDPOST: New York City derives 21 percent of its annual budget from taxes on office buildings. Illustrating that a bad situation is getting much worse, foot traffic in Manhattan is down 33 percent from pre-COVID War levels. Thus, it is not only a loss in taxes from the Office Building Bust, with foot traffic down so too are sales taxes. The longer this persists the more businesses will go out of business, which will in turn drain more of the city’s tax revenue.