Council Post: Bracing For A Possible Commercial Real Estate Crash (2024)

Zain Jaffer is the founder and president of Zain Ventures, a family office that invests in real estate and proptech.

After the spate of bank closures that included Silvergate, Signature NY, Silicon Valley Bank (SVB) and Credit Suisse, there is now talk of a major crisis—not just in the banking sector, but in other sectors, especially in commercial real estate.

There is an oversupply of office space in big cities like Los Angeles, San Francisco and New York that has been complicated by the work-from-home and quiet quitting trends.

I see high interest rates as being likely to help force a dry-up of credit and debt since it would simply be too expensive for many to take out a loan.

While a potential economic recession may lead to trouble in the commercial real estate sector, investing in high-demand areas and avoiding panic can help mitigate temporary disruptions.

Impact Of Fed Rates On Regional Banks

Credit and debt are necessary for the proper functioning of economies, especially in real estate, because most projects are leveraged. If it shrinks, the economy shrinks.

Most mortgages in the U.S. are issued by smaller regional banks and not by Wall Street banks. Their relationships with regional clients in deciding on loans are often more personal in nature than the AI data-driven algorithms used by Wall Street.

As the Fed raises rates, this has caused banks to have devalued assets in their books because older mortgage-backed securities and long-term treasuries acquired before have become less marketable compared to the newer higher interest bonds. Many banks holding these older instruments could see their asset values drop, like what happened to SVB.

Many regional bank stocks are getting hammered by the markets these days if you check the regional bank indices, but some investors looking for bargains are buying as well.

Effects Of A Possible Commercial Real Estate Crash

While there may be particular places a real estate crash could happen, I do not believe there will be a crash in the entire sector. However, I definitely see some signs of trouble ahead in certain areas.

In general, across the sector, there will likely be fewer buyers as they have trouble getting cheap mortgages and development loans. Unless there is a shortage, prices look to stay depressed in certain areas due to a lack of buyers. But it may also be strong in areas where demand outstrips limited supply.

Vacant Office Spaces

Demand outstripping supply is not the typical case, though, for cities such as Los Angeles, San Francisco or New York, where there is an oversupply of commercial real estate, specifically with a lot of vacant office space (registration required). A recent report by CommercialEdge shows occupancy rates for commercial real estate in many big cities as very low. This adds to the problem for the banks, and they may end up foreclosing on office spaces that only have a few tenants signing leases.

Aside from the aggressive overbuilding of office spaces in certain big cities, there is also the trend of working from home and quiet quitting. Although these office spaces may still have paid leases, with an impending recession and with a lot of people working from home, it is possible that some tenants may terminate their leases early or shrink their space.

Raising lease rates is probably out of the question with the amount vacant office spaces available. But for areas that are booming where there are office space shortages, there may be pockets of growth. Again it really depends on the specific area.

Commercial Retail

Commercial retail is the same. Although people are starting to go back to shopping malls, the pandemic really pushed e-commerce to the forefront. The Federal Reserve Economic Data chart shows a long-term trend of e-commerce growing relative to total retail.

Risk Of Foreclosure

If a developer has a commercial loan at a variable floating rate, a higher rate may have kicked in, but the lease payments might not be enough (or just enough with no profits) to cover the loan dues. Some are able to avail of interest rate hedges to protect themselves, but not everyone does. Some may simply walk away from the project and get foreclosed if the new situation no longer makes sense.

Many lenders have financial covenants and debt service coverage ratios (DSCR) that may put properties at risk of early foreclosure if these are triggered. With many economists forecasting a recession later in the year, the risk is increasing that properties may get foreclosed if tenants can't pay rent, lease payments or if disappointing earnings force companies to cut back office rentals and leases.

Even if tenants renew their leases, they may renegotiate to shrink the spaces they are leasing since they may only need a physical presence and shared working spaces. Many banks are in a spot and are less flexible since their asset values have gone down.

Real Estate Investment Strategies

Some are trying to convert some of these office spaces into residential condominiums, which can involve major changes in zoning, plumbing, etc. Because of this, I don't think it often makes sense cost-wise.

In terms of my suggestions of where to invest for now, I would probably avoid office space, especially in the big cities. More in-demand areas I foresee include single or multifamily housing and industrial warehouses, especially in areas where demand outstrips supply. But again, it depends on the particular conditions in that area you are looking at, so be sure to do your research.

Overall, while it is important to be realistic and prepared, panic doesn’t do anyone any favors and just becomes self-fulfilling.

The conditions for real estate vary in different places and by type of property. For most people, their home is their biggest asset, and companies still need a physical presence somewhere, so these elements of the sector should remain as healthy as we can keep it.

Even with debt being expensive these days and profit margins tight for banks, I believe approaching the future with levelheadedness is one of the best ways to make it through a possible recession.

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