by Bryan Perry
July 30, 2024
Much has been written about the deteriorating conditions of commercial office property and the debt burden which that sector faces over the next two years. Demand for office space has reached seriously low levels in the U.S. It has now been over four years since the outbreak of the pandemic and “remote work,” and there is still 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 in post-pandemic years. That’s a situation where lenders agree to extend mortgages in hopes that, given more time, building owners will be able to attract more tenants and raise their rents again. But lease income is rapidly shrinking, and the Fed is still nearly two months away from considering its first quarter-point rate cut on September 18th.
The ripple effect of this 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 watch-list, the market might start to take notice. In the fourth quarter of 2023, vacancy rose to 19.6% on a national average and has remained at that level through the first quarter of 2024 according to iOptimize Realty.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
This near-20% vacancy level 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 U.S. are San Francisco, with a staggering 36% vacancy rate among office buildings. Denver is experiencing a 31% office vacancy rate in its central business district. Seattle’s vacancy rate shot up last year to 28%. Dallas, once thought impervious to the office vacancy crisis due to the migration of businesses to Texas from other states – and as home to two dozen Fortune 500 companies – has a downtown vacancy rate of 26%, according to CoStar.
These four cities are not alone in 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. Office vacancy is also running at 25% in Houston, Atlanta, Portland, San Jose and Los Angeles. The current crash in office valuations translates to lower tax revenues, which negatively impact the ability of municipalities to maintain public services. Cities have been dependent on property taxes as a key source of revenue, and now they face a cycle of buildings being sold at fire sale prices.
“There is a lot more trouble coming,” said Mark Silverman, a partner and leader of the CMBS Special Service group at the law firm Locke Lord, who represents lenders in mortgage disputes. 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, worth 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 they are 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 in the last month. (The all-time high 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.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Shares of the Real Estate Select Sector SPDR ETF (XLRE) are 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 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.
Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.
Specialty REITs are starting to trade much better, with the prospect of future rate cuts becoming a more credible proposition, but 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 cities are beset with high crime rates and inflated cost of living, and the dystopian state of our once-thriving cities, now suffering from businesses and stores closing their doors, plus rising filth, homelessness, crumbling infrastructure, and lack of new capital, have many cities in a state of decline.
Washington DC, home to our federal government, 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 DC government projects city revenues will decline by $81 million in fiscal year 2024, $183 million in 2025 and $200 million in 2026, and Washington’s Transit Authority faces a $750 million shortfall this year.
If we wish to see a return of our workers and businesses to inner cities, we need to see 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. While cheap in valuation versus five or ten years ago, they could still face a tsunami of high-profile defaults.
All content above represents the opinion of Bryan Perry of Navellier & Associates, Inc.
Also In This Issue
A Look Ahead by Louis Navellier
The Case for Cutting U.S. Interest Rates This Week
Income Mail by Bryan Perry
A Bottom in Commercial Office Property Values Now Looks Further Out
Growth Mail by Gary Alexander
The American “Income Gap” is Much Smaller Than Advertised
Global Mail by Ivan Martchev
The Yen Strikes Back
Sector Spotlight by Jason Bodner
Managing Change in Markets Can Be Stressful – But Profitable
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Bryan Perry
SENIOR DIRECTOR
Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.
Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license. All content of “Income Mail” represents the opinion of Bryan Perry
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