Still Too Early to Speculate on Commercial Office Property

So much has been written about the deteriorating conditions of commercial office property and the debt burden that sector will face over the next two years. Demand for office space has reached seriously low levels in the United States. It has now been nearly four years since the outbreak of the pandemic, and there is no end in sight to the alarming vacancy rates in some of America’s major cities.

The practice often referred to as “extend and pretend” was popularized post-pandemic, when lenders agreed to extend mortgages in hopes that, given more time, building owners would be able to attract more tenants and raise rents again. Lease income is rapidly shrinking, and the Fed is still a couple of months away from considering its first quarter-point rate cut.

The ripple effect of the maturing crisis has yet to be felt in the regional bank sector, where most of the loan exposure exists, but with nearly one-third of office property owners on a default watchlist, the market might start to take notice. In the fourth quarter of 2023, vacancies rose to 19.6% on a national average and have remained at that level through the first quarter of 2024, according to iOptimize Realty.

This is the highest number the office sector has seen on record since the metric began to be tracked in 1979. The worst office markets in the United States are in San Francisco, with a staggering 36% vacancy rate among office buildings; Denver, which is experiencing a 31% office vacancy rate in its central business district; Seattle, where the vacancy rate shot up this past year to 28% and Dallas — once thought impervious due to migration of businesses from other states and home to two dozen Fortune 500 companies — which has a downtown vacancy rate of 26%, according to CoStar.

With these four cities experiencing an office property apocalypse, they are just leading a much larger list of major cities that are in a negative spiral that underscores a number of rising problems for urban dwellers. The current crash in office valuations translates to lower tax revenue that negatively impacts the ability of municipalities to maintain public services. Cities have been dependent on property tax as a key source of revenue and now face a cycle of buildings being sold at fire sale prices.

While the number of office buildings in these cities reaching critical stress is still minimal, the number is increasing sharply, especially for older buildings. “There is a lot more trouble coming,” said Mark Silverman, a partner and leader of the CMBS Special Servicer group at the law firm Locke Lord, who represents lenders in disputes with commercial mortgage borrowers. “If we think it’s bad now, it’s going to get a lot worse.”

The problem is most acute for building owners whose mortgages are coming due and who are losing many tenants. About a quarter of existing office property mortgages held by all lenders and investors, or more than $200 billion, are set to mature this year, according to the Mortgage Bankers Association and CoStar. Through the end of 2026, nearly 14,000 properties accounting for 32.7% of all office property mortgage volume, with $300 billion of loans, are coming due.

Delinquencies are on the rise and should give investors pause if considering trying to pick a bottom in the office property sector. The overall Trepp US CMBS delinquency rate increased to 5.35%, an increase of 38 basis points for the month. (The all-time high on this basis was 10.34%, registered in July 2012. The COVID-19 high was 10.32% in June 2020.) The CMBS delinquency rate has increased in four of the past six months, accounting for $2 billion across all five major property types, with the office sector accounting for half of the net increase.

What is interesting is to see shares of the Real Estate Select Sector SPDR ETF (XLRE) trying to break out to the upside at a time when commercial office property looks to be taking on more water. It should be noted that 60% of the fund’s holdings are in real estate investment trusts (REITs) that invest in e-commerce warehouses, data centers, cell towers, self-storage and healthcare facilities and mixed use. Office REIT exposure is only 0.95% of the fund.

Specialty REITs are starting to trade much better with the prospect of future rate cuts becoming a more credible proposition. The timeline on when to start bottom fishing for commercial office real estate looks to be longer as long as the hybrid model for the nation’s workforce remains in place. Major metro cities are beset with high crime rates and inflated cost of living for downtown residents. The dystopian conditions of once thriving cities — now suffering from businesses and stores closing their doors, filth, homelessness, disrepair of infrastructure and lack of new capital — have many cities in what seems to be terminal decline.

One would think that Washington D.C., home to the federal government, would be nearly bullet proof economically, and not in need of financial triage. But D.C. is an illustration of a city with a massive oversupply of office and retail space, fewer commuters and a looming fiscal crisis tied directly to a shortfall from declining property taxes due to downtown business closures and fewer property purchases. The District of Columbia government projects that city revenues will decline by $81 million in fiscal year 2024, $183 million in 2025 and $200 million in 2026. Washington’s Metropolitan Transit Authority faces a $750 million shortfall because of a sharp decline in ridership.

History is on the side of urban revitalization and a return of increasing populations and businesses to the cities. However, that requires a change in policies and affordability. At this point in time, the distress major cities are experiencing appears to be festering, and with these deep-set issues come the challenges facing the office property sector, that while cheap on valuation versus five or 10 years ago, could face a tsunami sized wave of high-profile defaults.