'Worst' yet to come for commercial real estate: Conference Board

By Jim Tyson for CFODive.com

• U.S. commercial real estate will likely face greater turbulence this year and next as roughly $1 trillion in debt comes due, hybrid work erodes demand for office space and interest rates persist at higher levels than predicted, according to Conference Board economists.

• “I think the worst of this is still ahead — there is no easy fix,” Conference Board Senior Economist Kurt Reiman said in a May 22 webcast, referring to the stress on CRE. “It’s a first-in-a-generation, if not a lifetime, event.”

• An unusually high level of CRE debt is maturing after the price for office properties slumped more than 35% from its peak and as “the building owner faces higher expenses,” Reiman said. “So that’s a potent, potentially toxic mix.”

The value of office commercial real estate will likely plunge 26% by the end of next year as many companies adjust to the work-from-home trend by shrinking work space or moving to cheaper properties, according to Moody’s Analytics.

Valuations across all CRE types will probably slump 10% peak-to-trough during the next 18 months, Moody’s said in a March report, with the office subsector hit the hardest. Banks have the resources to handle the likely turbulence even though CRE accounts for the largest portion of their debt.

Federal Reserve Chair Jerome Powell predicted that CRE losses will mostly harm small- and medium-size banks and cautioned that efforts to ensure stability will need to persist for many years.

“There will be losses by some banks,” Powell said in testimony to the House Financial Services Committee in March, adding that medium- and small-size banks hold higher concentrations of troubled loans. “It’s going to be a problem we’ll be working through, I think, for several years.”

The Fed, Treasury, bankers and CRE executives for months have warned of potential market turbulence as property owners struggle to refinance debt at higher rates. The central bank, seeking to curb inflation to 2%, has held the benchmark interest rate since July at a 23-year high.

Falling demand for office space and the subsequent defaults and banking stress will probably vary by region and by the type and class of property, Reiman said.

“It’s the major metro areas that are facing more of the damage,” he said. “The largest lenders are probably lending there, but it’s not just them,” he added. “It is the smaller banks — they have a large exposure.”

Many lenders have extended maturity dates rather write off the loans, Reiman said. “‘Extend and pretend,’ that is something that we’re seeing in the small- and mid-size banks.”

The rebalancing in CRE “is a slow, steady process, but it does have the potential to become a vicious spiral,” prompting a tightening of standards on several categories of lending, a pullback in business investment and a decline in consumer borrowing, he said.

Not every analyst sees gloomy prospects for CRE.

The CRE “outlook for the second half of 2024 is largely positive — multifamily continues to perform, as do industrial and retail,” JPMorgan said this month in a mid-year report.

Still, “challenges could lie ahead,” JPMorgan said, noting that “the higher interest rate environment appears to be here to stay, and office vacancies continue to climb.”

Wars in Ukraine and the Middle East and the coming U.S. election may also jar the economy and undermine CRE stability, JPMorgan said.

“The combination of an upcoming presidential election and ongoing congressional gridlock could affect consumer confidence and spending, ultimately contributing to an ongoing high interest rate environment,” JPMorgan said.