Key Points
- The future of work is trending towards a hybrid model, with an average of 3–4 days (up from 2–3 currently) spent in-office predicted.
- The shift to hybrid work will lead to a 20% reduction in office occupancy, causing a significant impact on commercial real estate lease rates and valuations.
- Owners of office buildings, particularly older and less desirable ones, are grappling with decreased valuations and the high cost of maintaining unused properties. This situation challenges banks, particularly smaller ones with large CRE loan portfolios.
- Over half of the $2.9 trillion in commercial mortgages are due for renegotiation within the next two years, and lending rates have already risen significantly, some as much as 450 basis points, causing asset prices to plummet.
- High-profile loan defaults and increasing rates of borrower delinquencies underscore the severity of the situation. At least $80 billion in office space loans are due this year, and many owners will need help refinancing, given the drop in property value and the rising cost of capital.
- Owners and banks may be able to withstand the downturn, but it will not be without high financial costs that may outweigh the benefits.
- While federal and state governments have the potential to minimize these losses, past instances suggest intervention will only occur when broader systemic threats arise, often with the government stepping in to support critical banks in the commercial real estate sector to prevent widespread fallout.
The Work From Home Aftermath: Unveiling the Future of Commercial Real Estate
As dawn breaks over the concrete canyons of our metropolitan centers, an eerie quietude persists. Once throbbing centers of enterprise, office buildings stand empty, their echoing halls a testament to a world transformed. The once distinct realms of home and office are now blurred, and this fusion is not a transitory pandemic response but the imprint of a new work order — hybrid, flexible, unmoored from a physical location.
This fundamental transformation forms the foundation of Ardent's Future of Work Thesis. It's not all painless; the hybrid model carries unexpected implications that ripple through our lives. For example, we found the subtle yet relentless encroachment of loneliness to be a pervasive side effect of remote work, as many adults can no longer share stories around the office water cooler. But there are larger, more daunting challenges emerging on the horizon, particularly the significant shifts and uncertainties surrounding the future of the commercial real estate (CRE) sector.
To understand this brave new work world, we have engaged in an in-depth exploration involving stakeholders across the CRE industry, from property developers and lenders to investors, company leaders, and employees. The following sections detail our findings, forecasts, and an examination of potential solutions that may illuminate a path forward in this transformed landscape.
Anticipating the 3–4 Day Office Norm
With the pandemic in our rearview mirror, the tension between employers and employees will likely resolve with a compromise of 3–4 days of in-office work per week. When the world shut down in early 2020, the corporate world adapted with impressive agility. Despite initial apprehension, work continued, productivity thrived, and new collaboration tools and processes were created swiftly, proving the viability of remote work.
But as life regained some normality, we shifted to a hybrid work model. While in-person and fully remote work models were effective, it was hybrid work that proved to be difficult. Many managers were challenged with coordinating schedules and desk sharing. Employers, witnessing 2022's productivity figures, began to question the effectiveness of the hybrid model. High-profile companies reacted by encouraging or even mandating more in-office time. In April, J.P. Morgan ended remote work for leaders across the organization and mandated 5-days on-site. Meanwhile, Google has begun to factor in in-person attendance as part of performance reviews to encourage office collaboration further.
Employees, however, have tasted the freedom of remote work and aren't keen to give it up. Many have relocated to the suburbs, expecting only occasional commutes into their offices downtown. Others have seen significant savings in childcare costs and reoriented their household management around the expectation of remote work. A study by Microsoft examined the disparity between actual productivity and leaders' perceptions of productivity within corporations. Although the research demonstrated that employees maintained their efficiency, 85% of corporate leaders reported challenges maintaining confidence in their employees' productivity — a phenomenon researchers coined "productivity paranoia." The study further corroborated the employees' perspective that remote work is efficient, arguing that there is minimal justification for returning to the office, notwithstanding the apprehensions of management. These employees are not backing down. Recent months have seen protests against full-time office requirements imposed by corporate giants like Amazon and Disney.
As the debate rages on, a shift in workplace attendance has also begun, nudging the average number of in-office days upwards. While the norm was fully remote or 1–2 days in the office, many businesses now land on 2–3 days in the office as a more sustainable compromise. However, the crux of this emerging paradigm hinges on a critical compromise between employers and employees, and we predict the industry standard to shift from the current 2–3 days to an average of 3–4 days in the office.
The Consequences of the New Normal
As we embrace the 3–4 day hybrid work week, we anticipate around 80% of pre-pandemic capacity to return to the office, a trend supported by data from Kastle Systems. While offices were never 100% fully occupied, this new norm significantly deviates from pre-pandemic levels, marking a substantial transformation in office usage.
The further reduction in office occupancy will directly impact lease rates, causing them to drop proportionately. This fall in demand means less rental income for property owners, significantly impacting their financial projections and sustainability. In such a scenario, property owners will inevitably grapple with managing the costs of maintaining underutilized buildings and servicing their associated loans. Additionally, declining lease rates have already caused a significant ripple effect through the retail sector since fewer customers are coming in to support their businesses.
The emerging trend referred to as the "flight to quality" has seen companies wanting less office space but in increasingly high-grade, Class A buildings. While remote and hybrid work has reduced demand for office space overall, Class A properties are faring relatively well. In contrast, Class B and C office buildings face mounting challenges, especially those with shorter leases and outside prime locations.
Property Valuations
The repercussions of this dynamic become more serious when considering the effect on property valuations. Projections indicate that office building values could decline by 10% to 30%. The expected drop presents a significant problem for the commercial real estate industry, particularly for owners of older buildings that may already need help with desirability. As of March 2023, prices have fallen by 15% overall and 25% for offices on average. While that is what the latest numbers show, the picture is far more grim anecdotally for Class B and C: experts shared that they have already seen property valuations decline as much as 50%, and they expect some to slide further to 70% less than their pre-pandemic values. In this scenario, owners' equity is diminished so much that despite efforts from the banks to assist, many properties will hand over the keys to their debtors.
Borrowers
On the borrower's side, owners grapple with the mounting challenges of repaying, servicing, and refinancing their CRE loans. Rising interest rates make it expensive to service existing debt and much harder to refinance, putting the owners under considerable financial pressure. Most CRE loans are short-term and come due over the next three years. As much as $270 billion of commercial real estate loans are set to mature in 2023, with $80 billion tied to office space, according to Matt Anderson, Managing Director at Trepp. Overall, almost $1.5 trillion of US commercial real estate debt is slated for repayment before the end of 2025. When they come due, the likelihood of loan defaults is high. Morgan Stanley recently projected that the impending refinancing crisis would lead to a peak-to-trough CRE price decline worse than the sector experienced in the Great Financial Crisis.
You can see the downward spiral forming, demonstrated by an increasing proportion of commercial office mortgages with delayed payments and several high-profile defaults. Brookfield defaulted on $784 million in loans linked to two Los Angeles skyscrapers. Blackstone failed to meet payments on a $270 million loan for a Manhattan multifamily property portfolio. RXR also needed help to pay a $260 million loan for 61 Broadway. These instances underscore the widespread impact and seriousness of the unfolding crisis.
Lenders
The lenders are in the throes of a different set of problems. The recent collapse of Silicon Valley Bank (SVB) has sounded a note of caution, urging banks to bolster their reserves and practice heightened financial scrutiny. This has resulted in a significant contraction of banks' overall lending capacity. A drop of nearly $105 billion in a fortnight ending March 29 is a testament to this contraction, a trend that began before SVB's failure and has amplified since.
Consequently, banks may decelerate their lending practices and toughen refinancing conditions by demanding more collateral from borrowers. However, given the borrowers' reduced equity in their properties, such collateral may not be available, a direct fallout of the slump in asset prices.
The impact of these conditions is acutely felt by small to medium banks, accounting for 31.5% of total US office loans. These loans represent more than 20% of their total assets, meaning that a slight uptick in defaults could be disastrous. Additionally, regional banks typically finance small and mid-tier CRE projects, which are perhaps most at risk of default. The combined effects of these events and trends are a stark reminder of the intricate connections within our economy and the potential for a shift in one sector to have far-reaching implications.
City Government
The issues outlined predominantly impact metropolitan regions and downtown hubs, which were once the gathering points for some of the largest corporate workplaces. Cities across the United States, such as Washington D.C. and San Francisco, are contending with the financial implications of the shift towards remote work and the commercial real estate sector slump. With fewer commuters, local economies dependent on their patronage are experiencing a downturn. Local businesses, from shops to restaurants and service providers, have seen a customer decline, decreasing local sales tax revenues. In addition, the rise in vacancies in commercial properties has caused a drop in property values, reducing property tax revenues — a crucial income source for many cities. This interplay between remote work trends, the commercial real estate sector, and city revenues has broad societal implications, extending beyond individual businesses, property owners, and small-to-midsize banks. Cities nationwide, especially those heavily reliant on commercial real estate and office worker spending, will likely face similar challenges, prompting the need for revised city planning strategies and budgeting processes to ensure fiscal stability.
On the other hand, numerous suburban regions are experiencing beneficial transformations due to the rise of hybrid work models. Commercial real estate in these areas has experienced a lesser degree of depreciation. In some places, such as Northern New Jersey and the outskirts of Dallas, there is a promising opportunity to develop multi-purpose commercial properties. These properties could potentially attract the attention of individuals who no longer commute into the city as frequently.
The Path Foward:
Room for Correction
Some property owners and banks may be able to bear office asset repricing without government aid. While many owners have seen a considerable reduction in their equity, some may have enough to withstand the steep drops in valuations.
Borrowers struggling to keep up with their loans in a high-interest-rate environment might not need to surrender their properties. But given current market circumstances, J.P. Morgan contends that lenders are less likely to seize commercial properties; they would have to manage or sell, particularly under stressed valuations.
Rather than foreclosing, lenders might offer short-term forbearance or modify the loans. Banks possess the leeway to extend a loan's maturity, accept a discounted payoff, or receive a "deed in lieu" of foreclosure, which transfers all property interest to the lender to offset a defaulted loan.
Banks have multiple reasons why widespread defaults on office loans may not cause a banking crisis. Commercial real estate is one segment of a bank's loan portfolio; within that, office buildings form only a part. Although the office sector has the highest vacancy rates, occupancy in other CRE sectors, such as industrial and retail, remains high, with vacancy rates significantly below pre-pandemic levels.
However, small and mid-sized banks are far more susceptible to the repercussions of an office market downturn. These smaller institutions have 4.4x more exposure to U.S. CRE loans than larger banks. CRE loans comprise 28.7% of the total assets for a group of small banks evaluated by JP Morgan, in contrast to only 6.5% at large banks. Additionally, in response to the collapse of SVB, stricter lending standards and profitability issues in the banking sector could curtail available financing and increase costs for small and medium-sized businesses.
Converting Spaces: Repurposing Office Buildings
The CRE sector's magnitude and the steep fall in office space prices have opened up an economic void that necessitates swift intervention. The office sector, one of the most extensive CRE property types, represents a massive market of over $3 trillion. It also holds $2.9 trillion in commercial mortgages and $5.4 trillion in total CRE debt, constituting 15% of the overall CRE market.
One often discussed way to address this situation is repurposing office space. However, conversion is not a straightforward process, and each potential new use presents its complexities:
- Residential Conversion: The demand for multi-family residential housing is immense, but residential conversion is complex and costly. Based on our interviews with industry experts, only a fraction of existing infrastructure is economically viable for conversion due to the cost and complexity of transforming spaces for individual units. Each unit would need exterior windows, separate plumbing, bathrooms, kitchens, etc. Given the need for exterior windows, some office buildings may need a courtyard built into the center, leaving less leasable space to bring cash flow. Those modifications and the modernization of older buildings make many projects economically untenable.
- Life Sciences: The Boston Metropolitan area has long since demonstrated the potential of utilizing downtown spaces for research laboratories. Although vacant office buildings provide an extraordinary opportunity to establish high-tech, leading-edge research environments that could emerge as innovation hubs, there is an overabundance of available space that even research needs cannot fully occupy.
- Educational Institutions: Affordable properties in urban centers could appeal to universities seeking to offer students new experiences through satellite campuses. For instance, the University of Southern California recently unveiled a "capital campus" in Washington, DC, for students interested in politics and diplomacy. While repurposing office space for educational purposes is a mindful alternative, the demand is dwarfed by the supply.
- Industrial: The recent supply chain and logistics challenges brought about by the pandemic have led to suggestions for repurposing the surplus of office space into industrial warehouses. Although office-to-industrial conversions have gained popularity (with about 45 occurrences since 2018), these transformations often necessitate a complete demolition of the office building, making it very costly to perform. The reason lies in the specific requirements of warehouses, including high ceilings, ample parking space, and enhanced power capabilities, which typically can't be met by simply retrofitting the existing building.
Government Intervention
Given these challenges, a comprehensive and multifaceted intervention strategy from the government may be necessary. For those with stakes in equities and office real estate, significant value has already evaporated, and it's expected that further losses are on the horizon. As a result, foreclosures on such properties are set to increase, potentially placing some financial institutions at risk of failure. Both federal and state governments have the capability to minimize these losses, but based on historical actions, our outlook regarding their intervention remains skeptical. Examining past economic disruptions of similar magnitude, it becomes clear that government intervention typically kicks in when broader systemic threats emerge. In the realm of commercial real estate, this often translates to the government stepping in to support major banks deemed crucial to the system to prevent the fallout from spreading to other sectors dependent on these banks.
Still, there are solutions that could help, as we've seen the way they can transform other sectors like the electric vehicle industry. Below are some examples of initiatives that would bring aid to not just the lenders but the full scope of stakeholders feeling the brunt of the consequences of remote work.
- Financial Incentives: The federal government could institute measures to make repurposing vacant or underutilized office spaces financially appealing. Tax benefits could defray demolition costs and encourage new construction, making acquiring and repurposing these properties more feasible.
- Regulatory Adjustments: Governmental bodies could reconsider zoning laws and building codes to make converting commercial spaces into residential, educational, or other uses easier and less costly.
- Public-Private Partnerships: The government could also partner with private entities to jointly finance and facilitate the transformation of unused office buildings into spaces that meet current societal needs.
- Subsidies: Developers could receive subsidies for converting unused commercial spaces into community-focused facilities, such as public housing or educational institutions.
The success of such a strategy would take time, but it could lay the groundwork for a much-needed industry transformation. In the face of an evolving work environment, a well-crafted, long-term intervention strategy could be pivotal for the survival and revival of the CRE sector and for protecting the banks most vulnerable to this industry.
If you have a perspective on the topics described, we would love to hear from you!
