Warning Signals in U.S. Commercial Office Markets Haven’t Stopped Flashing

Owners of commercial office space have seen their property values plunge since the onset of the pandemic three years ago.

The downhill slide isn’t over. That reality will have profound implications on investors, lenders and the broader economy throughout the months ahead.

Compounding Troubles For Office Real Estate

Property investment has plummeted. Leasing activity has dropped. Delinquencies have surged, and maturing mortgage loans face starkly higher refinancing rates.

Large global firms plan to reduce office space as the trend toward remote work that accelerated during the pandemic persists. Yet in some markets, plentiful available space hasn’t dissuaded new construction.

Combined, the warning signals haven’t faded for a U.S. commercial office property market often so opaque that industry observers can’t agree on its total value, with estimates ranging from near $1 trillion to more than $3 trillion.

That broad range, though, simply may highlight the difficulty in assessing current values in a market that has lost an estimated third to half of its worth since the beginning of 2022. And that could weigh heavy on banks and financial institutions.

“Office assets are often financed with debt which resides on banks’ balance sheets and in commercial mortgage-backed security (CMBS) portfolios, large declines in value would have consequences for institutional investors and for financial stability,” according to a joint study by Columbia University’s Graduate School of Business and New York University’s Stern School of Business.1

In the Tank

By any measure, the market for office property has tanked.

Office-based real estate investment trusts (REITs) measured by the FTSE Nariet Equity REIT Index dropped 37.6% in 2022 and another 18.1% in the first four months of this year.2

Nationwide, the Columbia/NYU study found that the commercial office market suffered $506 billion in losses in the three-year period ended December 2022.

Additional declines remain likely. For the nation’s largest office market, New York City, the Columbia/New York University study predicted that the market’s value by 2029 will remain 43.9% below pre-pandemic levels—51.6% lower if work-from-home habits don’t revert to pre-pandemic norms.1

Similar anticipated declines in myriad other markets have ominous implications for investors, property owners, tenants, lenders and even municipalities relying on commercial property taxes to fund their budgets.

It’s Not Over

Darin Mellott, vice president of capital markets research with commercial real estate and investment services firm CBRE, said it’s important not to paint all office properties with a “broad brush.” He noted that some high-end, in-demand office space continues capturing record-high rents.

Nonetheless, amid cyclical headwinds and longer-term structural changes, he estimates average office U.S. property values have dropped by at least a third—and will keep dropping before stabilizing in late summer 2024.

“We will see substantial amounts of distress in coming quarters,” Mellott said.

Governments relying on property tax revenue also would face a reckoning. New York City, for instance, relies on property tax revenue from office buildings and retailers for almost a third of its budget. The study’s predicted decline in office values would trim the city’s tax revenue by 6.5%.1

Lethargic Leasing

The U.S. office market’s weakness partly reflects an 18.5% decline in property lease revenue in the 2019-2022 period, according to the Columba/NYU study.

In the first quarter, leasing activity dropped for the third straight quarter, sinking 42% below pre-pandemic levels.34

Meanwhile, a third of all office market leases will expire between now and 2026.

Across the U.S., 22.1% off all office space currently is available for direct lease or sublease.5

In downtown San Francisco, a third of all office space is available; Houston, Atlanta and Salt Lake City all have availability exceeding 30%.

A survey of executives in charge of real estate at 350 multi-national firms, employing a combined 10 million people, found that half plan to cut office space in the next three years—some by as much as 20%.6

At the same time, postings for non-remote jobs—jobs requiring office space—have dropped by 22% in the past 15 months.5

Office Investment? Not So Much

Investors have shied away from putting money into offices.

Global fund managers have cut allocations to commercial real estate to the lowest since the depths of the 2008-09 global financial crisis—a little more than a year after they reached their highest level in 16 years.7

Firms from Apollo Global Management to Berkshire Hathaway have issued dire warnings about the commercial property market. One property economist, Kiran Raichura with Capital Economics, described the outlook for the U.S. office sector as “particularly bleak.”

Liquidity problems within the market have mounted. First-quarter dollar volume of office investment sales fell to the lowest level since 2010.5

Troubled Loans

In addition, Mellott estimates $340 billion of office loans on bank balance sheets will mature in the next two years. About $30 billion of those may default, he said.

“We don’t see this as a systemic issue,” Mellott said. “(But) this may exacerbate some problems in the system, and we may see a few more institutions fail.”

Maturing office loans that don’t default will face much higher refinancing costs, however—40-60% higher than just two years ago, according to CMBS research firm Trepp.

An analysis by firm shows the vast majority of loans in most markets still won’t have trouble refinancing. But other markets face big hurdles: 77% of office loans in the Denver market, 62% in the Houston market and 36% in the Washington D.C. market maturing by 2024 may have trouble refinancing.

Source : Investopedia