Report on “Last year was bad for commercial

real estate. 2024 could be worse.” By Rachel

Seigel (Washington Post)

Detailed Report by Sammar Gannouni

REE 3043, Fundamentals of Real Estate

 The article examines the perplexing state of the U.S. office market, where rents are either

unchanged or rising in spite of rising vacancy rates and an abundance of available sublease

space. The main cause of this situation is the significance of rent levels in assessing the value of

a property, which impacts landlords' tactics to avert rent reductions even in the face of dwindling

demand. Rather than lowering the listed rent prices, landlords prefer to provide incentives like

lavish interior build-outs and extended periods of free rent. With this strategy, they can continue

to project high rents, which is important for property values and advantageous loan terms.

A historic level of office vacancy has resulted from the pandemic-accelerated shift

towards flexible and hybrid work models, which has significantly reduced demand for office

space. Despite these difficulties, the article makes the point that lenders and property owners are

starting to face the realities of the market by reorganizing mortgages or selling distressed

properties, which in turn causes changes in rents and property values to better reflect the state of

the market. One market where these changes have resulted in discernible drops in asking rents is

San Francisco.

To elaborate on the analysis, the relationship between market dynamics and landlords'

strategic choices in the US office market provides an intriguing perspective on the state of the

economy today. In addition to demonstrating how flexible and resilient property owners can be

in the face of shifting market conditions, this scenario also points to a potentially big change in

the commercial real estate market that could have far-reaching effects.

Landlords' calculated choice to keep or raise rent in the face of an increase in available

units is indicative of their sophisticated understanding of property valuation and the significance

of perceived value. Although unique, this strategy raises concerns about sustainability and the
possibility of a mismatch between valuation metrics and market realities. It may be suggested

that depending too heavily on incentives to draw in new tenants—thereby reducing the net cost

while keeping nominal rents high—is a temporary fix that won't deal with underlying changes in

the market for office space.

The pandemic has greatly reduced the need for traditional office space by accelerating

trends toward flexible and hybrid work models. This change calls into question the conventional

metrics used to value office real estate and raises the possibility of a long-term decline in demand

for these properties. The current state of affairs may herald a more significant shift in the

commercial real estate market, where the value of office space is adjusted to take these new work

habits into account.

Moreover, a more precise alignment of rents with market demand may result from the

probable market correction brought on by distressed sales and mortgage restructuring. However,

property owners may have to endure a difficult adjustment process if they suffer large losses on

their investments. Yet, these adjustments may result in a more stable and healthy equilibrium for

the market as a whole.

Examining the office market's development from a wider economic and social angle

brings up significant issues related to infrastructure, urban planning, and the nature of work in

the future. The function and design of office spaces may need to change as more businesses and

employees adopt remote and hybrid work arrangements. This may have an impact on city

centers, where office buildings typically occupy a central role. It may also have an impact on

local businesses that employ office workers as well as public transportation systems.
 Democracy Dies in Darkness

ECONOMY

Last year was bad for

commercial real estate. 2024
could be worse.
Four years after the pandemic hit, offices, downtowns and the banking system wait to
see how long the consequences will linger

By Rachel Siegel

March 30, 2024 at 6:00 a.m. EDT

More than $900 billion in loans backing office buildings, retail centers, hotels, warehouses and more will come due
this year — and analysts who track commercial real estate are already worried that this slice of the economy could
soon threaten regional banks and municipal finances.

That hefty amount — roughly 20 percent of all commercial real estate loans on the books nationwide — faces
deadlines for repayment this year. But coming on the heels of a dismal 2023, when hundreds of billions of loans
coming due got short-term extensions, experts are on high alert that 2024 may not go better.

The near-failure earlier this month of New York Community Bancorp and its rescue through $1 billion in new
investments led by former treasury secretary Steven Mnuchin’s private equity firm, reignited concerns about
regional banks that began after two firms collapsed in spring 2023. Midsize banks underwrite a huge volume of
loans for commercial real estate, so if developers and property owners have a hard time paying them off, that could
set off a chain reaction in the financial sector, too.
“There are going to be challenges,” said Matt Reidy, director of commercial real estate economics at Moody’s. “It
could look a lot like last year.”

The office market could bring the most serious issues. For example, more than $17 billion of commercial mortgage-
backed security (CMBS) office loans are coming due in the next 12 months, double the 2023 volume. Among those,
75 percent have certain characteristics that could make them hard to refinance, according to estimates from
Moody’s. That can include properties with canceled leases, vacant buildings or other cash-flow problems.

From there, options for borrowers can range from less-than-ideal to bleak. In many cases, borrowers took out
cheaper loans before inflation spiked and interest rates shot up. If companies were to refinance now, they’d probably
be shouldering higher borrowing costs on top of their existing problems. Otherwise, borrowers can try pushing a
deadline off into the future — or face defaulting altogether.

There is hope for some improvement this year: Moody’s data showed the office loan payoff rate in January and
February was 48 percent, several notches above 2023’s overall performance of 35 percent. Plus, not all property
types are as desperate as offices. Hotels, for example, are generally performing much better after rebounding from
the pandemic. Industrial properties finished last year strong, too.

But economists emphasize that it is way too early to draw bigger conclusions about whether the higher payoff rate
will keep up, or if more bad news is yet to come. Based on the portfolio of loans coming due this year, Moody’s is still
eyeing some $10 billion of CMBS office loans that are looking troubled. If all of those loans default, the CMBS office
delinquency rate could rise from the current 6.2 percent to more than 13 percent. That would spell trouble for banks
holding the loans — especially if their portfolios are strongly weighted toward the office market — and for
downtowns already struggling to attract new tenants.

Even if it takes a few more months to get a complete picture, early signals should bubble up somewhat soon, said
Lonnie Hendry, chief product officer at the analytics firm Trepp.

“Do they get extensions or modifications? Are they able to refinance?” Hendry said. “If that doesn’t happen and
they’re lingering, that could bode negatively for the stuff that’s remaining for 2024.”

Zoomed out, the country has made a remarkable comeback since the pandemic upended every corner of the
economy and daily life. Growth is keeping a solid pace, the job market is still tight and the Federal Reserve’s
aggressive attempts to hike interest rates and tame inflation didn’t cause the recession that seemed practically
guaranteed.
But hazards tied to commercial real estate — namely offices — still loom. Buildings nationwide sit empty as
companies rethink how much in-person space they need, settle for smaller spaces or go completely remote.
Restaurants in major downtowns are still closing their doors, bemoaning quiet weekdays and empty weekends.
Some economists fear a kind of “doom loop” that starts with empty buildings here and there, and then spirals into
something scarier for city budgets that rely heavily on property and wage taxes.

Ultimately, the hazards will bubble up from individual banks and borrowers themselves, many of whom are using a
practice known as “extend and pretend” to get through these bumpy years.

Popularized after the Great Recession, the first step is to extend a loan’s deadline, keeping the payments and interest
rate on the same schedule rather than refinancing or paying it off. Then the borrower and bank effectively “pretend”
that the value of the loan is still intact — and hasn’t gone down. That means banks don’t have to write down loans
that aren’t worth what they were when they were first made.

The workaround gained traction after the Great Recession when the Fed was lowering interest rates, and keeping
them low, to stimulate the economy. Back then, it meant that struggling borrowers could refinance their loans and
get rates that were oftentimes lower than what they’d paid before.

But over the past two years, rates have moved in the opposite direction. The Fed’s sprint to hoist borrowing costs
and catch up with soaring inflation ultimately brought rates to their highest level in 23 years. The central bank is
expected to cut rates multiple times this year, but those moves won’t bring borrowing costs down considerably. And
in the end, that could leave lenders and borrowers to face the tough reality that they can’t “pretend” their properties
and loans haven’t lost value any longer.

Hendry said the strategy of extending and pretending might be the wrong medicine for the current moment.

“There’s some revisionist history about why it worked, so people are leaning into it now,” Hendry said. “If enough
lenders extend loans and the market doesn’t improve, it could have some real catastrophic impact.”

One sign of trouble is that some buildings are already selling at steep losses. Data from Trepp shows that commercial
property prices declined last year by 5.3 percent. In downtown Washington, one building that cost $100 million in
2018 sold in December for just $36 million. Outside Boston, an office that fetched $43 million six years ago just sold
for $6 million.
Overall, the discouraging picture has policymakers and economists keeping a close eye on small and midsize banks
— lenders with less than $250 billion in assets — which hold about 80 percent of the overall stock of commercial
mortgage loans, according to Goldman Sachs estimates. That scrutiny intensified last year, after two regional banks
— Silicon Valley Bank and Signature Bank — suddenly failed, though not primarily due to commercial real estate
loans. The collapses caused brief but considerable panic throughout the financial system and prompted an
emergency government response.

NYCB wound up buying up a large share of Signature’s assets after that, which added to some preexisting trouble.
Much of the bank was concentrated in rent-controlled apartment complexes as well as offices — a combination that
made cash flow even tighter when people are still working from home and residential landlords also can’t keep up
with market rents.

Still, regulatory experts say they are confident that commercial real estate isn’t on the verge of imploding or
endangering the entire financial system. They argue that the risk is well understood, and that banks are aware of the
loans on their books. Even if 2024 brings a batch of defaults, the consequences could feel more like a rising pool of
water than a sudden tidal wave.

For its part, the Fed is looking at the potential for large commercial real estate losses as a financial stability risk. The
central bank is also using a marked drop in commercial real estate prices as part of its regular test of the banking
system’s resilience to major shocks and stressors.

“We have identified the banks that have high commercial real estate concentrations, particularly office and retail and
other ones that have been affected a lot,” Fed Chair Jerome H. Powell told lawmakers earlier this month. “This is a
problem that we’ll be working on for years more, I’m sure. There will be bank failures, but not the big banks.”