Updated: May 25
TL:DR: The commercial real estate market in the US is facing significant challenges, including a decline in retail foot traffic, a shift towards remote work impacting office spaces, and a surge in construction leading to oversupply. Rising interest rates set by the Federal Reserve are adding to the problems by reducing property values and creating cash shortages for banks. Small and mid-sized lenders, which make up the majority of commercial mortgages, are struggling, resulting in a halt in lending. The potential consequences include property devaluation, foreclosures, and a crisis in the industry. Repurposing office spaces and focusing on self-storage and logistics centers are seen as potential remedies. However, despite the challenges, the industry has shown resilience and adaptability in the face of changing circumstances, with opportunities emerging in certain sectors. The future of commercial real estate in the US is uncertain but promises an exciting journey of transformation and adaptation.
If you happen to know someone navigating the world of commercial real estate—be it buying, selling, managing, or constructing—I suggest you give them a hug. They could certainly use it.
Lately, commercial real estate has been surfacing in the news more & more. Granted, it lacks the punchy appeal of headlines like "The Debt Ceiling" or "Donald Trump Indicted," but among the columns of financial newspapers, bulletins, and blog posts, it has been causing a subtle, but constant stir. For the past few years, whispers of, "Is Commercial Real Estate OK?" have been floating through the air, and, unfortunately, the consensus appears to be leaning towards "probably not."
Crash Course - What is Commercial Real Estate?
One way of describing commercial real estate would be through the maxim of "If you don’t live in it, it's commercial real estate.” Anticipating the cries of "Hold on, what about apartment buildings?!" - They're part of the commercial mix (usually anything over 4 units). The "you" in this equation is, of course, the investor. So, to put a finer point on it, commercial real estate is any structure designed to pad the pockets of the investor.
This extensive category covers a medley of properties such as multifamily complexes, industrial warehouses, retail outlets, malls, hotels, restaurants, and even vacant land. It also includes less glamorous structures like parking garages, and the fun stuff like amusement parks! The golden rule here is: if it's minting commercial value, it's squarely in the realm of commercial real estate.
"So, if I rent out my apartment, does it turn commercial?" Nice try, but no cigar. Renting out your personal dwelling doesn't morph it into a commercial property because its primary function is to provide you shelter. Now, if you snap up the whole apartment building, you've just entered the commercial zone.
And voilà, you've just completed your tutorial in commercial real estate. Now you're geared up to be the life of the party at your next martini mixer.
What's been happening in Commercial Real Estate?
In recent decades, Commercial Real Estate has transformed into a continually evolving arena, experiencing a remarkable spectrum of shifts in market dynamics and financing structures; some cyclical, others more endemic to changes in American life. These fluxes in consumer preferences, intertwined with a singularly challenging fiscal climate, and exacerbated by the Real Estate industry's notoriously delayed response time, have created a situation rife with price disparities and refinancing hazards. In short, we find ourselves in an ecosystem where landlords are barely treading water with properties valued lower today than they were yesterday, while banks are reticent to lend due to an already tempestuous interest rate landscape.
This in’t your Mom’s America anymore.
First off, let's tackle the seismic shift in the American shopping scene. Once upon a time, malls were the fashion meccas of suburbia, bustling with weekend window-shoppers. Yet, these icons have seen a drastic reduction in foot traffic. Why, you ask? Simply put, American consumers have smartened up - hunting for discounts at outlet stores, reveling in the convenience of e-commerce, and reevaluating their dining choices. The quintessential suburban afternoon spent shopping at Macy’s or Boscov’s, rounded off with a meal at the ever-present Applebee's or the 'unforgettably-glamorous’ Cheesecake Factory, seems more a relic of the past. Instead, we now pop into our favorite neighborhood local on our way back from the Loft outlet, or, even more likely, order DoorDash while leisurely browsing Amazon in our PJs.
The halcyon days of the 1980s, when over 1,200 malls graced the nation, are gone. Fast forward to the present, and that number has nose-dived to a stark 700, and some naysayers predict it could tumble further to a scant 100 in the coming decade. The figures, sadly, don't inspire confidence. With the catalysts for this downturn showing no signs of letting up, mall vacancy rates are unsettlingly hovering around 11%, outstripping the national average for other retail spaces by a factor of two.
Secondly, let's roll up our sleeves and talk about work - or rather, the changing locales of it. The pandemic served as a catalyst, propelling us towards a work-from-home or hybrid reality. As the tug-of-war over the future of work continues between team leads and team members, the reverberations on commercial real estate are unmissable: Office vacancy rates have hit their highest since the 1990s (16.3% Urban; 17.1% Suburban). With 30% of US businesses that transitioned to remote work during Covid planning to stay that way, and the rising influence of remote or hybrid work in employee retention, it's reasonable to anticipate this trend's continued impact on the commercial office real estate landscape.
Lastly, we're in the throes of a commercial construction boom's aftereffects, a staggering 237% increase over the past decade, thanks to record-low interest rates. This surge, primarily in office spaces, has resulted in an excess supply in a world where office spaces are losing their allure. The icing on the cake? Loans on these properties account for approximately 30% of all outstanding commercial real estate mortgages that are due for renewal.
"The Great Rate Escalation."
The stage is set: a surplus of commercial office real estate is sitting vacant, flanked by legacy retail buildings that reflect the lifestyle and consumer taste of last century's America.
Enter Jerome Powell, our protagonist—or could he be the antagonist? Currently at the helm of the Federal Reserve, Powell faced mounting pressure to temper post-pandemic inflation. He thus took the action any prudent Fed chairman would and raised rates, then he kept on raising them. The Federal Reserve Funds Rate, which had been oscillating between 0.25% and 2.50% for a decade, suddenly surged, peaking at around 5% (at the time of this article).
But why, you might wonder, should this stir your cappuccino? The Fed Funds Rate sets the fundamental cost of borrowing (also known as "the cost of money" or "the price of time"). This base rate influences all others, such as the interest rate at which banks will lend money for mortgages, cars, student loans, etc. The difference in cost (the "spread") between the bank's borrowing and lending rates accommodates the extra risk undertaken when the bank dispenses loans, rather than retaining safe, government-backed money.
Therefore, when the Fed decides to scale up the rates, the cost of mortgages, car loans, and all else follows. Suddenly, everyone's inclination to borrow or pay a higher price diminishes. Imagine this: you can afford a $300,000 house with a mortgage at 3%, but if that rate ascends to 5%, that extra 2% cost has to be sourced from somewhere, leading you to either pony up more for your down payment (less likely) or downgrade your expectations of what you can buy to a less expensive home (more likely).
And here's where the plot thickens. Suppose you already purchased that $300,000 house at a 2% rate. Suddenly, due to unforeseen circumstances—losing your job, neighbors turning from eccentric to unbearable, or an unexpected desire for overseas exploration—you need to sell. But with rates now at 5%, your house at $300,000 attracts fewer buyers. How do you unload a property without taking a hit on your price? In military speak, you're FUBAR.
This, my friends, is the quandary of Commercial Real Estate, but magnified: thousands of mortgages on buildings purchased (or built) at higher valuations, are now up for sale or refinance (as the mortgage rolls over to a new rate), but the market has vanished. All that remains is a chasm inhabited by panic-stricken mortgage brokers and shell-shocked landlords, each trying to not-lose the game of musical chairs they are now caught in.
But wait, it gets worse...
Alright, so you're a landlord or developer who's managed finances well. You are resilient enough to endure a drop in refinancing rates or fortunately positioned to borrow a relatively small sum to cover the refinancing cost. However, you now find yourself asking "Where have all the banks gone?"
When Jerome Powell raised the rates, he didn't just shake up U.S. commercial real estate values; he also sent a wave of depreciation across the liquid government bond assets that banks use to manage their business (since newly issued 5% bonds are more valuable than your old 2% ones). Consequently, institutions like Silicon Valley Bank, Signature Bank, and First Republic faced severe cash shortages as their bond portfolios dwindled to nothing and they either conceded defeat or were absorbed by larger competitors. This turbulence rattled both national and regional banks, many of which were unprepared to navigate such tumultuous financial waters.
You might ask, "So what?" Here's the crucial point: these small and mid-sized lenders, the ones who are really struggling, account for 80% of all commercial mortgages in the U.S. This means the primary driver of the U.S. commercial real estate debt machinery has ground to a halt and is not too eager to lend much of anything to anyone.
So, what happens when our hypothetical landlord, perhaps overvaluing his property, needs a refinance and is rebuffed by these smaller banks? Lack of a mortgage translates to a downward spiral in his real estate's value and potentially a forced foreclosure, or fire sale as the landlord seeks to liquidate the asset. Now, multiply this scenario by thousands of landlords nationwide, and you have the perfect ingredients for a classic crisis.
What's the remedy, you ask?
Indeed, part of the process is simply accepting the inevitable. Short-term debt cycles impacting an industry are a normal part of the business cycle; they usually self-correct (or receive a vigorous nudge from a formidable economic force). What's expected to transpire is turbulence in US commercial real estate, smaller institutions spiraling into receivership, and new players stepping forward to fill the void— the quintessential circle of business life.
Astute market analysts have illuminated the disparity between the overflowing supply of commercial real estate and the lamentably inadequate housing supply (which keeps home prices high). They've proposed: Couldn't we repurpose some office spaces into living spaces?
Indeed, the transition is already underway. From stylish Art Deco skyscrapers to outdated shoe factories, a wave of conversions from old-world industry to new-world trendy residences is occurring across US towns and cities. However, this evolution is not a sprint—it's a marathon. While conversion rates have significantly increased (43% higher today than pre-pandemic levels), they're still too scant and too dispersed, affecting only a fraction of tens of thousands of units, and far from the hundreds of thousands required. Still, it's a start.
In the commercial real estate sector, other areas have performed exceptionally well, particularly self-storage and logistics centers (think Amazon warehouses, freight hubs, and the like). These sectors have grown steadily; the demand for self-storage has surpassed the construction of new units, and the need for more distribution centers has inflated alongside the post-pandemic ecommerce surge.
For investors with convertible buildings or vacant land seeking a purpose, these trends could offer a golden opportunity. But keep in mind, all real estate is a game of "location, location, location," and the inherent characteristics of the building. Therefore, investors don't always have this option.
Where does that leave our Commercial Real Estate friends?
The U.S. commercial real estate sector is somewhat akin to a Broadway actor nursing a sprained ankle—not quite at peak performance, but certainly a trooper. It's trudging along, contending with the repercussions of short-term debt cycles, shifts in workplace culture, and our altered shopping tendencies. The 'elephant in the room' scenario, undoubtedly, is the impending threat of high Fed rates, placing considerable strain on both landlords and mortgage brokers. Yet, it persists in its performance—modifying, adapting, and discovering fresh approaches to remain pertinent and profitable.
While the forecast might appear grim, every storm harbors a silver lining. One such beacon of hope is the conversion of commercial spaces into desperately needed housing units. This innovative response to the severe housing shortage is already gaining traction nationwide, though at a slower pace than desirable. Amid uncertainty, sectors such as self-storage and logistics are emerging as safe havens, surfing the tide of change propelled by the e-commerce explosion and our continuously evolving lifestyle requirements.
Where is the future of U.S. commercial real estate going? In a nutshell, it's in for a short-term tumultuous journey, navigating headwinds with a compass still recalibrating. While fresh opportunities are unfolding as our society increasingly transitions online, not everyone will have the option to pivot, and some investors will be left out in the cold. Despite the current turbulence, let's remember that this industry has a talent for resilience—they are, after all, buildings! So, whether you're an investor, a landlord, or simply an intrigued observer, brace yourself and gear up for an exciting expedition into the future of commercial real estate. Change is not only on the horizon—it's already arrived.