The commercial real estate market, especially in the office building sector, is about to enter a perfect storm of declining occupancy rates, lower rents, high interest rates and less access to credit. This in turn will challenge banks and other financial firms that lend to the industry as well as pension funds that have significant exposure.
There is a narrative that the U.S. Federal Reserve will keep raising interest rates until they “break something.” Well, with their rate hikes, the Fed has put at risk not just breaking the commercial real estate industry – but shattering it.
Over the next five years, more than US$2.5-trillion in commercial real estate debt will mature, according to The Kobeissi Letter, which tracks and comments on global capital markets. Some US$1-trillion of that debt is believed to be in need of rolling over in the next two years.
Much of this debt was financed when interest rates were almost zero. Now, it needs to be refinanced at much higher rates and in a market with less liquidity.
If rising interest rates and a huge impending rollover of debt were not foreboding enough, the industry is facing radical societal changes of a magnitude not seen since the development of the modern skyscraper.
The Toronto market provides an illustration.
Skyscraper after skyscraper rose over the past several decades, changing the city’s skyline. There had always been a willingness for banks, corporations, law and consulting firms to pay a hefty premium to be located in the financial district.
These days, the advent of new technology has lessened the need for a highly concentrated financial district. In the meantime, workers have enjoyed sticking to their home offices.
These are global trends, and the declining rates of commercial real estate occupancy can be seen across Canada. Downtown office vacancy rates across the country jumped to 17.7 per cent at the end of last year, from 10.2 per cent before the pandemic, according to Capital Economics.
Commercial real estate is a deceptively simple business. There are a few parameters that make the difference between success and failure.
First, occupancy levels. The higher percentage of space one can rent the higher the revenue. Second, how much rent being charged. This is subject to supply and demand.
Next, since most commercial real estate is financed largely by debt, the level of interest rates is critically important, too. Like financial institutions, commercial real estate companies must be conscious of the maturity profiles or their assets and liabilities. The second to last thing a commercial real estate company wants is to be caught in long-term leases while their debt has a short average maturity while rates skyrocket. The last thing they want is to have tenants leave and rents fall while rates soar.
Unfortunately, nearly everything seems to be going wrong right now.
All this suggests the industry is entering a cyclical bear market. Vacancy rates are rising and will continue to rise as the economy weakens, putting downward pressure on rents and top-line revenue. As debt matures, interest costs will explode. Companies that became addicted to cheap interest rates will have to adjust.
Lenders such as banks and pension funds will see their collateral values decline as the value of buildings plummet. Loan-to-value ratios will drop, making lenders unwilling or even unable to refinance borrowers. This will put further pressure on the financial system.
Commercial real estate booms and busts aren’t anything new.
Between the fourth quarter of 2009 and the last quarter of 2022, the Fed’s commercial real estate index, which reflects the value of buildings, rose by 128 per cent, or about 6.5 per cent annually. During the financial crisis, the index dropped almost 40 per cent from the third quarter of 2007 to the 2009 bottom. In the previous bear market from the end of 1989 to the end of 1993, the index fell by 26 per cent.
But now, the adoption of remote working will make for a particularly challenging period ahead. The days where anyone with enough capital could thrive in commercial real estate are over.
Investors would be wise to underweight commercial real estate investment trusts in their portfolios, or at least be conscious of debt levels and leases coming due relative to loan maturities in the near future. Office REITs are trading at an almost 40-per-cent discount to net asset value, so the market is already signalling problems ahead. Those looking for buying opportunities should seek out names with low levels of leverage.
Be mindful, too, of how much exposure banks in one’s portfolio has to commercial real estate.
We are in for a bumpy ride.
Tom Czitron is a former portfolio manager with more than four decades of investment experience, particularly in fixed-income and asset-mix strategy. He is a former lead manager of Royal Bank’s main bond fund.