US Commercial Real Estate Market: Adapting to Rising Interest Rates


US Commercial Real Estate Market: Adapting to Rising Interest Rates


The US commercial real estate (CRE) sector is navigating through turbulent times. Rising inflation and interest rates, compounded by the lingering impacts of the Covid-19 pandemic on office space utilization, are exerting immense pressure on the sector. This environment represents a stark deviation from the past four decades, characterized by a steady decline in interest rates. With central banks globally embarking on a path of tightening monetary policy, the CRE market's financial dynamics are evolving dramatically.


Historical Perspective

Historically, the CRE sector has been seen as a reliable hedge against inflation. Data from McKinsey illustrates that during six of the previous seven inflationary periods (1980-2022), the US CRE sector outpaced inflation, outperforming equities, BBB-rated corporate bonds, US treasuries, and even gold.

However, these economic parameters no longer hold true. The fast-paced increase in interest rates is reversing the previous trends. When interest rates were low, investors could refinance their properties, building up high multiples of debt while witnessing their asset values climb. The tides are now turning, and such balance sheets, especially in the office space segment, are facing a potential wipeout.


The Rising Interest Rate Environment

With the end of the low inflation, low interest rate era, real estate investing now requires property owners to have the operational prowess to generate the rental incomes necessary to meet their mortgage payments. This implies a significant shift in how investors approach and manage their property portfolios.

Lending conditions are projected to remain stringent as central banks await clear evidence of inflation returning to target levels before considering peaking interest rates. Optimistically, conditions could begin to improve next year, should the Federal Reserve and the Bank of England consider rate cuts, and CRE valuations find their footing.


The Bank Runs and the Domino Effect

The rising interest rates are already stressing the banking sector. Bank runs at Silicon Valley Bank, First Republic, and Signature Bank have incited fears of a wider contagion. These banks have been key players in lending to the US commercial property sector.

Banks are now facing what is being termed a "perfect storm": the dual threat of a higher default risk on CRE loans and a sharp adjustment in property valuations, combined with increased funding costs and compressed net interest margins.

The Man Group hedge fund has warned that the tightening liquidity among banks could further constrict lending conditions, predicting that the US CRE market could be the "next domino to fall" in the ensuing banking crisis.


Office Space: The Epicenter of the Storm

The office space sector has emerged as a significant concern for real estate investors. The trend towards remote work, which appears to be more than a temporary phenomenon, has led to low office utilization rates. Even as some workers return to offices, this figure has stalled at about 50% of pre-pandemic levels.

The implications are twofold: vacancies hinder rental growth, and to compete with the convenience of working from home, office spaces require high capital expenditure. With the length of commercial leases, there is a growing sentiment in the market that the full impact of these changes is yet to materialize.


The Forecast up to 2024

Going forward, the outlook for the US CRE market remains fraught with challenges, at least till the end of 2024.

In the short term, the challenge lies in refinancing the estimated $270bn in CRE loans due this year, with office space accounting for around a fifth of these loans. Geographically, cities like Chicago, New York, and San Francisco are under greater pressure than Sun Belt cities such as Atlanta, Miami, and Phoenix.

The direct risk to the $23tn US banking system from CRE seems relatively low, with CRE representing 14% of bank assets. However, the magnitude of the impending reckoning is reminiscent of the 2007–09 global financial crisis. JPMorgan estimates a climb in the liquidation rate for commercial mortgage-backed securities (CMBS) in the US office sector to 20% by the end of the decade, with loan extension options only softening the blow until 2025–2027.

Moreover, the distress faced by the CRE market might trigger a significant shift in the usage of commercial properties. Some older office buildings (classed as B/C), may be converted into multifamily residential units to address the housing shortage and reduce carbon emissions from new constructions. However, this solution faces several challenges that could limit its implementation.

The US CRE market is experiencing one of the most dramatic shifts in its history, driven by rising interest rates, inflation, and the widespread shift towards remote work. As we look towards the end of 2024, the sector will need to adapt and evolve to meet these challenges head-on. Market players will need to exhibit resilience, ingenuity, and a willingness to explore new models of operation to navigate these uncharted waters successfully.