ANALYSIS: Will Commercial Real Estate Be the Next Market to Crash?

Commercial real estate properties sit on the market in Costa Mesa, Calif., on April 9, 2021. (John Fredricks/The Epoch Times)

News Analysis

A storm is brewing in the U.S. commercial real estate market, according to Charles Munger, vice chair of Berkshire Hathaway.

The 99-year-old legendary investor told the Financial Times in an interview that U.S. banks have plenty of “bad loans” and will be vulnerable when the “bad times come” and commercial property prices crater.

“It’s not nearly as bad as it was in 2008. But trouble happens to banking just like trouble happens everywhere else,” Munger said.

“A lot of real estate isn’t so good anymore. We have a lot of troubled office buildings, a lot of troubled shopping centers, a lot of troubled other properties. There’s a lot of agony out there.”

With the banking system facing immense uncertainty, there has been widespread concern that the commercial property sector is the next shoe to drop in the current financial turmoil, because of a perfect storm of rising interest rates, declining occupancy levels, and a tsunami of loan refinancing.

But do the data and industry experts support Munger’s warning?

The Health of Commercial Real Estate

In recent months, market experts and many Wall Street giants have been ringing alarm bells surrounding the health of commercial real estate (CRE).

“The CRE industry is very vulnerable right now,” Adam Robbins, a strategic real estate adviser at Real Estate Bees, told The Epoch Times, noting that rising interest rates are creating a distressed environment because they’ve “put many property owners at risk with short-term loan maturities.”

“Owners who need to refinance may find it difficult if they do not have adequate equity or the necessary cash to make up any shortfall,” he said.

Many of the commercial loans set to expire this year originated about 10 years ago, when interest rates were much lower. As a result, industry observers note that borrowers would need to see higher rent levels or an increase in valuations to service their debts.

Berkshire Hathaway Chairman Warren Buffett (left) and Vice Chairman Charlie Munger are seen at the annual Berkshire shareholder shopping day in Omaha, Neb., on May 3, 2019. (Scott Morgan/Reuters)

One of the early warnings came from Lisa Shalett, chief investment officer of Morgan Stanley Wealth Management, who wrote in a research note that more than half of the $2.9 trillion in commercial mortgages will be renegotiated over the next 24 months “when new lending rates are likely to be up by 350–450 basis points.”

UBS economists expect that about $1.2 trillion of the outstanding $5.4 trillion in CRE debt will “mature” and be up for refinancing.

“Rising interest rates, a slowing economy, and increasing vacancy rates in office buildings have weighed on the sector in the last couple of years,” Swiss-based UBS stated in a report. “Now, an expected credit crunch on the back of rising cost of funding for banks may further compound its troubles.”

With the growing odds of defaults and delinquencies and the number of loans poised to mature, there’s concern that a collapse of the CRE market could create a contagion event that would spread beyond financial institutions and landlords.

“Coupled with the fact that banks are tightening their lending policy in response to the recent turmoil, commercial real estate is in a precarious position,” Moody’s Analytics wrote in a report. “However, this time around, banks are in a better position to handle the issue.

“A decade of regulatory reforms and generally more conservative underwriting at the lending level have held CMBS delinquency rates well below 2 percent and will hopefully keep delinquency rates low.”

Howard Marks, co-founder of Oaktree Capital Management, is anticipating defaults on office building mortgages and other CRE-related loans. However, the verdict is out on “what the magnitude will be.”

UBS is penciling in defaults, but it believes that “CRE exposure at banks is currently manageable with potential loss levels even in a hard landing scenario.”

Overall, commercial property prices are projected to plunge by as much as 40 percent, “worse than in the Great Financial Crisis,” according to Shalett.

Moving forward, this will be an issue that the finance sector will be forced to confront over the next two years, according to Jeffrey Fine of Goldman Sachs’s Asset & Wealth Management business.

“We’ve got a big right-sizing in the market that we’re going to have to confront that is going to be the talk of the next six to 12 to 18 to 24 months in our space,” he said.

Bad News for Small Banks?

Stress in the commercial real estate sector couldn’t come at a worse time for the banking system.

Three of the four largest bank failures in U.S. history occurred in just two months, and there could be more distress in the coming months amid elevated interest rates.

Within the confines of CRE, the chief concern is that small banks could be devastated by a collapse of the commercial property market, particularly in the office sector.

Citigroup data show that small lenders account for 70 percent of CRE loans. A separate JPMorgan Private Bank report highlighted that smaller institutions hold about four times more exposure to CRE loans than their larger counterparts.

“Within that cohort of small banks, CRE loans make up 28.7 percent of assets, compared with only 6.5 percent at big banks,” the JPMorgan report reads. “More worrying, a significant percentage of those loans will require refinancing in the coming years, exacerbating difficulties for borrowers in a rising rate environment.”

That’s something that will play out slowly and unfold over a period of many years, according to Lotfi Karoui, an economist at Goldman Sachs Research.

“History would tell you that losses play out over many years,” he said. “They don’t materialize instantaneously.”

The Rise of ‘Zombie Offices’

The COVID-19 pandemic might have permanently changed the commercial real estate market.

Major urban centers and midsize U.S. cities are being overtaken by “zombie offices,” according to Richard Rubin, CEO of commercial real estate management firm Repvblik.

“This is the phenomenon where an office tower or suite sits unused, but continues to operate,” he told The Epoch Times. “It’s currently happening in cities from Los Angeles to New York and all states in between, including Michigan, Nebraska, Minnesota, and more.”

The national office vacancy rate surged by 20 basis points year-over-year to almost 17 percent in March, according to CommercialEdge’s National Office Report in April.

Cushman & Wakefield, a commercial real estate services company, estimates that more than 300 million square feet of U.S. offices will be obsolete by 2030.

In June 2022, a joint paper by New York University and Columbia University researchers projected that if remote–hybrid work partners become the norm, then office-building values could tumble by $500 billion by 2030.

Rubin and many of his industry colleagues think that this will be viewed as an opportunity to reuse and convert these office establishments into residential housing options in the future.

It isn’t only office space that’s being unused. Vacancies at traditional brick-and-mortar stores are also growing, according to Joe Fairley, vice president of business development at Laser Facility Management.

“We do have other changing characteristics of the commercial real estate market, such as many traditional retailers failing, with many saying they will close locations, such as Amazon, Bath & Body Works, Foot Locker, and even Walmart,” he told The Epoch Times. “Others are simply going into bankruptcy, such as Party City, Bed Bath & Beyond, and others. There is even talk about Dollar General constricting in the near future.”

Working from home has been one of the chief contributors to CRE’s demise.

Thirty-five percent of workers with jobs that can be done remotely are working from home all the time, up from just 7 percent before the pandemic, a March 2023 Pew Research Center survey found. Another third of people who are currently working from home most of the time say they would do so permanently if they had a choice.

Seventy-seven percent of employed job seekers say remote work is important when looking for employment opportunities, according to a recent Career Builder poll.

WFH Research, a data-collection project, recently estimated that about 30 percent of all work completed in January happened at home.

Many hiring managers reveal that it’s hard to find employees when one of the requirements is in-office work. Human resources experts say that companies mandating in-office work could lose out on 70 percent of candidates.

Ultimately, could the commercial real estate market be harder to revive if companies keep their remote work policies intact and no longer require as much square footage as they did before?