We examine the post-pandemic challenges facing the commercial office space market, and the potential economic impacts of recent trends.
August 17, 2023
By Atul Bhatia, CFA
This year has seen a near-constant stream of negative news from the U.S. commercial real estate sector. Multiple large properties are in default, office occupancy levels have fallen, and rising interest rates have made refinancing problematic.
Conditions appear unlikely to improve in the near term. Banks, for example, are pulling back from the sector, with nearly 80 percent of senior loan officers expecting a deterioration of credit conditions in commercial real estate, or CRE as it is often known.
We think there are significant headwinds in the sector, and see a real risk – indeed, a likelihood – of further price declines in some commercial assets. At the same time, we think the broader risk to the economy and financial markets overall is limited, due to some inherent characteristics of CRE markets.
To begin, it’s important to recognize that there is not just one type of commercial real estate, but many, each of which has its own supply and demand characteristics. Industrial and warehouse properties, for instance, have seen very high demand and stable to rising lease rates on a national basis, according to global property firm JLL. Office space, on the other hand, is experiencing double-digit vacancy rates as remote work continues to be a key factor in attracting and retaining workers.
Line chart showing the 30+ day delinquency rate for mortgages by property type. The rate on office properties has exceed that for multi-family and industrial properties by an increasing amount since 2017. Office delinquency rates are now nearly eight times those of multi-family.
Source – RBC Wealth Management, Bloomberg; monthly data showing 30+ days delinquency, through 8/1/23
Even within a single asset type, there are differences between regions, and even from building to building. Upscale retail locations are, broadly speaking, outperforming midgrade malls, and higher growth in the American Southeast is cushioning CRE declines relative to some of the larger coastal urban areas.
For now, the core of the problem is large office towers located in central business districts. The economics of these properties often require high occupancy rates to support the high costs of upkeep and amenities. With occupancy rates declining since the start of the pandemic, many office towers have been caught in a vicious cycle of declining rental income that makes it too costly to upgrade properties, causing existing tenants to decamp, which in turn puts more pressure on rental revenues. Higher interest costs resulting from the Federal Reserve’s rate hike campaign have only added to the pain.
This situation is unlikely to change soon, in our view. Attempts to force employees into offices appear unlikely to succeed, and we believe corporations will continue to reduce floor space – and costs – while seeking to attract better talent with geographic flexibility. This will likely reduce total demand for office space, particularly in high-cost central business districts.
It’s not unusual to see demand decline for particular assets, and markets have various adjustment mechanisms. The first is price. As mentioned, commercial rents are falling alongside occupancy in many urban central business districts. Buildings remain viable as office space so long as the income produced at these new rental rates is sufficient to cover their operating costs. Current owners may have to default because they took on too much debt, but new and better-capitalized owners can continue to manage the properties.
In some cases, however, the rental income will never be sufficient under realistic assumptions regarding new demand levels and rental rates. Markets adjust for this by reducing supply, a process that is underway; the total square footage of office space in the U.S. recently fell for the first time since JLL began tracking the data in 2000. This decline is partly due to redevelopment, as properties currently configured for corporate offices are repurposed for retail, housing, or hospitality in response to local economic factors. Such conversions may involve on-site renovation or teardown, but in either case the removal of office square footage brings the market closer to balance.
We see three characteristics of CRE that may make it easier for the broader economy – and financial markets – to absorb financial losses in the sector.
The first is scale. The entire U.S. commercial real estate market is estimated to be worth roughly US$20 trillion, but only an estimated US$3 trillion of that is office space, according to the National Association of Real Estate Investment Trusts. That’s large, but in the context of the roughly US$160 trillion in estimated U.S. household assets, we see it as manageable.
Another key factor is that investor portfolios generally have low direct exposure to the sector. Even assuming a relatively hefty 10 percent allocation to CRE, a total wipeout of that holding would only negate roughly the last six months of equity gains, assuming that the balance of the portfolio were invested in the S&P 500. Painful, certainly, but not catastrophic, in our estimation.
Finally, we believe banking system exposure to CRE is quite manageable. The median allocation to CRE loans among the 20 largest U.S. banks is only 9.3 percent, with office properties accounting for less than 2 percent of loan books based on 2022 year-end filings. Banks are generally secured creditors, and thus face a loss only after asset values decline by at least 20 percent. Some projects will lose more than that, but we think the overall banking system exposure is reasonable, even if some individual banks may experience stress.
By no means would we suggest that there is no risk of broader market fallout from commercial real estate declines. We see two likely vectors of transmission. One would be if investors who have borrowed against their CRE holdings are forced to raise additional funds as the collateral value of their commercial securities falls. The famous adage is “Sell what you can, not what you want to,” and we could see sales of CRE leading to other assets being sold and triggering contagion.
There is some risk of this, most notably from insurance companies, which tend to invest in large commercial projects and are subject to regulatory requirements around liquidity and asset-liability matching. But as noted above, CRE holdings generally make up only small portions of investor portfolios; few investors are 100 percent levered and unable to absorb markdowns.
The other major risk would be a policy mistake. Following the March turmoil in regional banks, U.S. regulators have proposed significant additional capital requirements for lenders. Ironically, this could represent a meaningful risk vector, as declining CRE values push current capital ratios lower. If banks try to get ahead of potential losses through aggressive sales that drive prices down, the result could be a negative spiral in asset prices. We see this as an unlikely scenario, but if it were to develop, we think regulators are sufficiently flexible and rational to extend capital raising timelines.
Global cities have faced terrorist attacks, natural disasters, and world wars, and to date they have always emerged stronger and more vibrant. Perhaps a transition to a hybrid work model will prove to be a bridge too far for urbanization, but we doubt this is the beginning of the end for cities.
The material herein is for informational purposes only and is not directed at, nor intended for distribution to or use by, any person or entity in any country where such distribution or use would be contrary to law or regulation or which would subject Royal Bank of Canada or its subsidiaries or constituent business units (including RBC Wealth Management) to any licensing or registration requirement within such country.
This is not intended to be either a specific offer by any Royal Bank of Canada entity to sell or provide, or a specific invitation to apply for, any particular financial account, product or service. Royal Bank of Canada does not offer accounts, products or services in jurisdictions where it is not permitted to do so, and therefore the RBC Wealth Management business is not available in all countries or markets.
The information contained herein is general in nature and is not intended, and should not be construed, as professional advice or opinion provided to the user, nor as a recommendation of any particular approach. Nothing in this material constitutes legal, accounting or tax advice and you are advised to seek independent legal, tax and accounting advice prior to acting upon anything contained in this material. Interest rates, market conditions, tax and legal rules and other important factors which will be pertinent to your circumstances are subject to change. This material does not purport to be a complete statement of the approaches or steps that may be appropriate for the user, does not take into account the user’s specific investment objectives or risk tolerance and is not intended to be an invitation to effect a securities transaction or to otherwise participate in any investment service.
To the full extent permitted by law neither RBC Wealth Management nor any of its affiliates, nor any other person, accepts any liability whatsoever for any direct or consequential loss arising from any use of this document or the information contained herein. No matter contained in this material may be reproduced or copied by any means without the prior consent of RBC Wealth Management. RBC Wealth Management is the global brand name to describe the wealth management business of the Royal Bank of Canada and its affiliates and branches, including, RBC Investment Services (Asia) Limited, Royal Bank of Canada, Hong Kong Branch, and the Royal Bank of Canada, Singapore Branch. Additional information available upon request.
Royal Bank of Canada is duly established under the Bank Act (Canada), which provides limited liability for shareholders.
® Registered trademark of Royal Bank of Canada. Used under license. RBC Wealth Management is a registered trademark of Royal Bank of Canada. Used under license. Copyright © Royal Bank of Canada 2024. All rights reserved.