Known as a top tourist destination because of its warm climate, sandy beaches, historic sites and enchanting cities, Spain is a nation of nearly 47.5 million people. Beyond tourism, Spain’s top industries include auto manufacturing, agribusiness and energy.

During the year ending in second-quarter 2023, Spanish investors proved to be quite interested in U.S. commercial real estate. During this period, some of Spain’s top companies acquired 17 U.S. properties totaling more than $2.2 billion, according to MSCI Real Assets. This amount alone is impressive enough. But the shocker is that the figure is 5,000% more than what Spanish investors spent from mid-2021 through mid-2022.

The increased activity vaulted Spain to fourth place on MSCI’s ranking of the top 25 sources of capital into U.S. commercial real estate. Spain trailed only Japan, Singapore and Canada on this list. Spain’s ascent has been meteoric as it ranked No. 7 in calendar year 2022 and No. 25 in 2021.

One of the main reasons for this considerable growth in activity was the real estate expansion of Pontegadea, a multinational investment company owned by Spanish billionaire Amancio Ortega. He made his fortune by founding the fashion retailer Inditex, the largest fast-fashion group in the world and the owner of the multinational clothing chain Zara.

Pontegadea, which is developing a large real estate portfolio, has been spending hundreds of millions of dollars to acquire a variety of U.S. properties. These range from Amazon-leased office space in Seattle to warehouse and distribution centers in California, Florida and Pennsylvania.

According to MSCI, Pontegadea acquired 12 industrial properties and one apartment complex in 2023. The main seller of the industrial assets was Blackstone, one of the largest landlords in the U.S. Pontegadea appeared to be capitalizing on Blackstone’s need for cash amid the commercial real estate downturn. Blackstone was known to be selling parts of its portfolio, including casino assets and various industrial properties that were performing well.

In 2022, Pontegadea acquired five logistics centers located in Tennessee, South Carolina, Virginia, Pennsylvania and Texas. The largest single U.S. deal by Pontegadea in 2023, according to MSCI, was the August acquisition of a 45-story apartment complex in Chicago for $231.5 million.

Pontegadea isn’t the only Spanish company that has recently expanded its real estate empire. The Mallorca-based travel conglomerate RIU Hotels & Resorts acquired a six-story office building in Manhattan for $173 million. The October 2023 purchase was an intriguing move for RIU, which owns 96 hotels in 20 countries. The building was slated to be demolished to make way for a hotel tower, but the previous owner was unable to secure permits from the city. It will now be up to RIU to convince officials to back a new plan.

Only time will tell if Spain’s major investors continue to find U.S. apartment complexes, offices and industrial space enticing. But it seems like a safe bet that the wave of acquisitions by Spanish investors has yet to end. ●

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The subject of at least two books that was also mythologized in a Hulu documentary, WeWork — which at one point was estimated to be worth $47 billion — filed for chapter 11 bankruptcy this past November. The charismatic co-founder Adam Neumann, with his rock-star hair and flair for excess, is long gone, fired by the company’s board of directors in 2019 and walking away a billionaire, at least on paper.

When it comes to studying what went wrong with WeWork, the list is long, including a flawed business model in which the company made long-term leases on office space and then offered short-term rentals to individuals, startups and small businesses. The operation lost money during the best of times, leaving it unable to cope with the COVID-19 pandemic and changing attitudes about office work.

“WeWork is going to reject more leases than ‘The Golden Bachelor’ rejected potential suitors.”

Eric Sussman, adjunct professor of accounting, UCLA Anderson School of Management

There are many ironies to this story, including how some of the most powerful investors in the world were sucked into the WeWork vortex. They apparently believed Neumann’s hype that his operation would be a disruptive force in commercial real estate. But surely one of the most surprising twists is that the story doesn’t seem to be ending — at least not yet. WeWork, which still maintained 777 locations across 39 countries as of June 2023, is still alive and may end up coming out of bankruptcy as a viable company.

“The purpose of chapter 11 reorganization is to give the business a second chance at life,” says attorney Anthony Sabino, who specializes in bankruptcies. “Under chapter 11, a debtor company is explicitly allowed to continue to operate its business and maintain possession of its assets.”

Sabino says that WeWork will be able to accept or reject each of its unexpired leases. The accepted leases will either be paid or sold off while the rejected leases will become unsecured debts. “They will go to the back of the line with all the unsecured debtors scrambling for pennies,” Sabino says.

Additionally, the management team stays intact. “That is one of the zany things about chapter 11,” Sabino says. “The incumbent management team is allowed to stay in place, unless creditors unite and go to court to have them removed.”

All indications are that WeWork’s management team is moving fast on the reorganization. The Wall Street Journal reported that WeWork was proposing to reject 69 poorly performing leases, including 40 locations in New York City, and was negotiating with more than 400 landlords to amend existing leases.

“WeWork is going to reject more leases than ‘The Golden Bachelor’ rejected potential suitors,” quips Eric Sussman, adjunct professor of accounting at UCLA’s Anderson School of Management, referring to ABC’s hit dating show. As for whether the company’s fall will cripple the coworking sector, Sussman, who started a business in a coworking space, doesn’t believe so.

“Coworking has been around for decades,” he says. “WeWork was a flash in the pan with a new variant of the model, with beer kegs, pingpong tables and video games, but I don’t think there is any issue with the traditional coworking space.”

When it comes to lessons learned from this debacle, the last word goes to Aswath Danodaran, a professor of finance at New York University’s Stern School of Business. He made it clear in an email response that he was ready to move on from the WeWork story.

“The bottom line is simple: WeWork has always been a bad business with an awful management team,” Danodaran writes. “One VC (Softbank) pushed their pricing up to $47 billion before they fell apart, brought down by arrogance. It was deserved and no tears are being shed.

“If there are lessons to be learned, they are don’t be arrogant and [then] compound that arrogance with greed. But that lesson will never be learned. There will be more WeWorks in the future, with different players and different motives.” ●

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Where does Cushman & Wakefield stand on the potential for a recession in 2024?

We have not been in the soft-landing camp for some time and that is still our position. We believe that the material change in monetary policy will continue to filter through the economy and that eventually we will see a contraction in output. Our forecast is that as we head into the second quarter, we will be reaching that tipping point. That being said, it’s a very uncertain business to predict turning points.

What are some of the market indicators you’re watching?

There are a number of indicators pointing to resilience and strength in the economy, and those tend to be tied to the consumer economy. They include factors such as the labor market, which is strong. We keep adding jobs but at a slower and slower pace. So, those are great signals of resilience, but they are not forward-looking. They don’t tell you anything about the future, but there are a number of leading indicators pointing to a turning point in the economy. They include the 10-year yield curve, which has been inverted for some time. Inverted yield curves tend to be very accurate predictors of recessions.

There are a lot of recessions where the yield curve is inverted about a year in advance. There are other instances where the inversion happened 24 months in advance. Given the sheer fiscal support and monetary accommodations across the economy in recent years, it’s going to take time to work through that. But we are seeing some interest rate-sensitive sectors already in contraction. And on top of higher credit costs, the availability of credit is significantly lower than it was 18 months ago. The tightening of credit standards tends to lead the economy by six to nine months.

What do you see for commercial real estate in the new year?

Both the multifamily and industrial sectors have tremendous supply waves coming. In both sectors, we expect demand to soften, but it will be positive. We estimate between 140 million and 150 million square feet of absorption in the industrial sector, with vacancy rates peaking at about 6.2%. We expect about 320,000 multifamily units to be absorbed and for vacancies to rise to about 9% at their peak.

How about the retail and office sectors?

Our data shows that the vacancy rate for retail is sitting at a 40-year low of about 5%. While we expect demand to soften and turn mildly negative next year, we still see vacancy rates only rising to the low-6% range, which is consistent with mildly positive rent growth.

The greatest challenge is in the office sector. We still believe the sector will be recording negative demand in 2024. This masks a tremendous amount of variation, though, around the country. We’ve seen incredible resilience in many smaller markets, especially in the South. In cities like Miami, vacancies have barely budged since the pandemic.

Then you have San Francisco and New York City, which are experiencing record-setting vacancy rates. Manhattan’s vacancy rate is about 22% right now. We think it will go up to about 24%. But even here we are seeing a lot of variation. We track roughly 1,400 office buildings in Manhattan. There are about 105 or so that have vacancy rates of 50% or higher. If you take them out of the equation, the vacancy rate falls to about 15%. So, there is an uneven concentration of weakness across markets and assets. ●

The post Q&A: Rebecca Rockey, Cushman & Wakefield appeared first on Scotsman Guide.

These complex commercial property changes are having significant impacts on various stakeholders, especially those involved with finance. It is important to seek clarity and perspective on these emerging trends, their implications for all involved and ways for finance professionals to effectively navigate this evolving terrain.

“Recent trends in the commercial real estate market, particularly in renowned technology hubs like San Francisco, have included sharp downward movements in property valuations.”

At the forefront of the massive change are mortgage brokers who in the past had standardized models to assess the risks associated with properties. With fluctuating values, especially in major markets such as San Francisco, Chicago and New York City, these models now need a fresh lens.

Properties that were traditionally perceived as lucrative and virtually recession-proof are now enveloped in layers of uncertainty. This newfound unpredictability calls for a more meticulous and nuanced approach to risk assessment, ensuring that every potential pitfall is accounted for.

Recent trends in the commercial real estate market, particularly in renowned technology hubs like San Francisco, have included sharp downward movements in property valuations. As the backbone of the U.S. tech industry, cities like San Francisco have traditionally commanded premium prices. But current data paints a different picture and indicates a directional shift in macroeconomics.

Office-space dilemma

The commercial real estate market in San Francisco includes a few recent sales of office buildings at shocking discounts. Some properties are being discounted by 60% to 70% or more compared to what they were valued at just a few years ago.

Historically, office spaces in business hubs have been in high demand, driven by a thriving tech community, startups and ancillary businesses. But a combination of factors, including the broader acceptance of remote work following the COVID-19 pandemic and the high operational costs associated with maintaining offices in prime locations, has led to reduced demand and has subsequently pushed down valuations.

“As always, relationships are the bedrock of the mortgage industry. In these times, a network that includes both quality lenders and borrowers is an invaluable asset.”

JLL reported that San Francisco’s office vacancy rate increased to more than 30% in third-quarter 2023. It was the 15th consecutive quarter in which the vacancy rate increased. The dip in the city’s office valuations has had a cascading effect, leading to a deluge of tax appeals. Among the major players, Brookfield Properties requested a 75% reduction in the value of an office tower on Market Street, while Columbia Property Trust sought a 50% cut on three of its office holdings.

Blackstone wasn’t far behind, appealing for reductions of 20% to 25% for three of its waterfront properties. In the fiscal year ending this past June, tax filers in the city appealed for an average reduction of 48% on property assessed at more than $60 billion.

For cities, this wave of appeals spells fiscal strain. San Francisco, which was already grappling with a projected budget deficit of $780 million through 2025, anticipates refunding $167 million due to these property tax appeals.

Cook County troubles

While San Francisco’s declining values and increasing tax appeals create a challenging landscape, property owners thousands of miles away in Cook County, Illinois, are grappling with an entirely different kind of shock: skyrocketing property tax bills. About 40,000 residents in Cook County are filing appeals.

Amid a backdrop of rising inflation that negatively affects consumers, some commercial real estate owners have seen their tax bills double or triple in a single year. Data obtained from the Cook County Treasurer’s Office indicated that tax bills for some 20,000 properties increased by 100% or more between 2021 and 2022. A majority of these properties are residential but some are commercial.

One particularly jarring case came from the Roseland neighborhood on Chicago’s South Side, where a homeowner was served with a property tax bill that jumped 1,000% year over year. Meanwhile, in the Chicago Lawn neighborhood, a senior citizen received an 884% hike in her tax bill.

Cook County Assessor Fritz Kaegi’s office attributed these sharp increases to neighborhoods that have “undergone significant change” and that many properties were “most likely previously undervalued.” But these explanations tend to provide little consolation. Some business owners told local news services that they might not be able to keep their doors open.

Future implications

The underlying sentiment in Cook County reflects a growing sense of alarm and uncertainty that is being felt in many major cities. While property owners understand the need for periodic tax hikes to finance county services and pensions, they feel cornered by the extremity of these increases, especially given the limited time they have to arrange for payments after receiving their bills.

This may be part of the new normal as real estate markets change and fluctuate, sometimes in extreme ways. This evolving landscape is going to be difficult to navigate, especially for those in the realm of mortgage finance.

Mortgage brokers will need to develop a nuanced approach to risk assessment to find their way through this new environment. And many lending standards will need a fresh look. This includes the loan-to-value (LTV) ratio. A cornerstone in the mortgage domain, LTV ratios are greatly influenced by property valuations.

With declining prices, these ratios are bound to witness significant shifts, which could impact the capacities for potential borrowers. A property that might have fetched a substantially high loan amount a year ago might now merit considerably less, reshaping the lending landscape.

Interest rate impacts

The changes in property valuations don’t stop at risk assessments and LTV ratios. They extend their reach into the very core of property financing — interest rates and loan terms.

Many lenders, in their bid to shield themselves from potential defaults, have adopted a more conservative stance. This could manifest in the form of adjustable interest rates or more stringent loan terms, particularly for commercial mortgages in areas that are experiencing sharp valuation declines.

The age-old adage of not putting all your eggs in one basket seems more relevant than ever. The unpredictability of certain markets underscores the importance of diversification. Instead of heavy investments in a single market or property type, spreading one’s portfolio across different regions and diverse property segments might emerge as the wise strategy. This approach hedges against potential losses in one sector and also offers avenues for gains in others.

The path ahead

In the intricate landscape of today’s real estate market, commercial mortgage brokers are presented with a unique blend of challenges and opportunities. To navigate these waters, a holistic approach that combines traditional expertise with adaptive strategies is essential.

Central to this is an emphasis on a data-driven strategy. As professionals deeply entrenched in the commercial mortgage ecosystem, the ability to harness and interpret current market data is indispensable. Beyond the standard metrics, diving into granular data points can offer pivotal insights, allowing for timely and strategic decisionmaking. In a volatile market, data-informed strategies will set brokers apart.

Data cannot exist in isolation, no matter how comprehensive it is. A deep understanding of local market dynamics is more crucial than ever. Each commercial district holds unique challenges and potential. Leaning into expertise to better discern microtrends can provide a leg up, ensuring that every deal is optimized for success.

As always, relationships are the bedrock of the mortgage industry. In these times, a network that includes both quality lenders and borrowers is an invaluable asset. It ensures seamless transactions, fosters trust and positions you as the go-to expert amid market uncertainties.

It’s crucial to stay attuned to the broader policy landscape as well. Decisionmakers, including city officials, are actively working on frameworks to steady the commercial real estate market. One example is San Francisco Mayor London Breed’s proposal to offer tax incentives that would encourage companies to set up offices in the city. Keeping a finger on the pulse of such policy shifts can offer you and your clients a strategic advantage, ensuring that you’re capitalizing on every available opportunity.

● ● ●

The path forward for commercial mortgage brokers, while laden with complexities, is also ripe with potential. A combination of data-centric strategies, deep local-market insights, solid relationships and a grasp of evolving policy directions serve as a compass to guide brokers through these times. Their expertise, paired with these tools, will ensure not only survival but success in the evolving commercial real estate landscape.

The intersection of declining valuations and soaring tax appeals has caused uncertainty for commercial real estate owners. By understanding these shifts and their implications, mortgage brokers can chart a course that not only navigates through such challenges but also identifies potential opportunities for future growth and innovation. ●

The post Feeling the Squeeze appeared first on Scotsman Guide.

There is no end to the projects underway, including an ongoing adaptive-reuse plan for Los Angeles, which has been active since 1999, mostly in the city’s downtown core. In the first 15 years of the program, more than 12,000 housing units were developed, many in converted bank buildings. This year, planners have decided to expand the program citywide.

“We are in the Wild West with these projects, and developers like predictability and certainty in what they do.”

– Brooks Howell, residential leader and principal, Gensler

In Chicago, former mayor Lori Lightfoot is championing the LaSalle Street corridor revitalization, a massive $1 billion project that will repurpose 2.3 million square feet of vacant space in the city’s famed central business district into 1,600 mixed-income apartments. New York City also has a conversion program in place, but officials this year proposed state and city zoning changes that would extend flexible conversion regulations to an additional 136 million square feet of office space.

Many academic groups and private research firms are joining up with the adaptive-reuse movement. Many believe this process is a partial answer to the nation’s housing problem. A 2022 Rand Corp. report, for instance, identified 2,300 commercial properties in the Los Angeles area that, if fully utilized for residential purposes, could produce between 72,000 and 113,000 apartments, depending on the mix of unit sizes. This would equate to 9% to 14% of the housing units that Los Angeles County will need to produce by 2030. The report found that adaptive-reuse projects to convert hotel and motel rooms into studio apartments is typically a lower-risk proposition than converting office and retail spaces.

For all the excitement about such projects, however, there isn’t as much activity happening as one might expect. CBRE found that an average of 41 office conversions were completed annually between 2016 and 2022. The real estate services company estimates that the number of projects is expected to double, due to increased incentives and other help from state and local governments.

There are many difficulties for these projects to overcome, but the one aspect that may be insurmountable for many buildings is that the projects don’t tend to pencil out. Most office building conversions are too expensive to make the process financially feasible.

“There’s a lot of ink being spilled on this subject right now,” says Brooks Howell, residential leader and principal at Gensler, a global architecture, design and planning firm. “But the biggest challenge is the major cost mismatch. These buildings are going to have to sell really, really cheaply to make conversions work.”

Howell points to many parts of the building that can be problematic, including the size of the property. The sweet spot for most apartment buildings is about 350,000 square feet, which allows for the greatest efficiency in using all of the space. Larger buildings often need to be mixed-use projects with some floors remaining as office space. This is a problem because, under current circumstances, the office space may not have tenants and would essentially be unused, reducing the value of the building.

But there are many other problems with conversions, from replacing the skin of the structure, to putting in windows that open or adding balconies, which endanger the integrity of the facade. Other than the building itself, there are a variety of zoning regulations that vary from city to city which can upend a project.

There are also mechanical issues. Howell says that some of the reasons that office-to-apartment conversions are so expensive aren’t always the obvious ones. For example, it’s common to single out plumbing and other infrastructure aspects needed for apartments. Howell maintains that plumbing is a set cost and not as much of a problem as the building’s mechanical systems, including heating and air conditioning, which may cost tens of thousands of dollars per apartment unit if upgrades are needed.

“We are in the Wild West with these projects, and developers like predictability and certainty in what they do,” Howell says. “And you’ve introduced more unpredictability and uncertainty in this process. Not a lot of developers are comfortable with that, and I think that’s really what’s slowing the process.”

Due to the added costs, Howell maintains that most, if not all, of the buildings currently being converted are receiving some form of tax credits, usually because the properties are considered historic. It’s the only way for the numbers to make sense. He believes that for more conversions to work, it will require a coordinated effort by federal, state and local governments to develop tax breaks and other forms of financial incentives.

“The federal government is going to have to come up with some plan that allows this process to move quicker,” Howell says. “I’d love to see them step in and incentivize the conversion process. There are many reasons for it, including the fact that converting buildings is the most carbon-neutral way to build housing.

“The question is, how do we overcome all the different roadblocks? There is no coordinated and concerted effort to solve these problems, and there’s not one entity that seems to be in control.” ●

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In the third quarter of this year, net absorption across the sector was strongly negative, with the total amount of leased square footage declining by 12.4 million square feet at the national level. This was the largest decline in the Moody’s Analytics dataset since early 2021. Furthermore, as the chart on this page shows, the current vacancy rate has reached 19.2%, the highest level since the tail end of the savings and loan crisis in the early 1990s. We expect this bumpy ride to result in another increase of 20 to 40 basis points (bps) over the next 12 to 18 months.

On the surface, this is a sour story, with data and anecdotes likely to confirm many pundits’ expectations of an apocalypse for the office sector. And while it’s easy to concede this as one of the most challenging moments in the history of the office property type, it’s also important to recognize the depth and nuance of a story that actually began many years prior to the start of the COVID-19 pandemic.

What is this story? Well, it’s more of an epic than a tale, with an overarching theme of obsolescence and change. The pandemic served to accelerate the demand shift toward newer and more flexible spaces for the country’s massive and growing knowledge-based economy, but this evolution actually started long ago.

There are a few facts to ponder. First, the decline in leased office space in third-quarter 2023 (the aforementioned 12.4 million square feet) is only about one-third the amount of the worst quarterly decline recorded during the financial crisis of the late 2000s. Second, as shown on the chart above, the vacancy delta during the Great Recession was a massive 500 bps, whereas the post-pandemic change is about 200 bps.

Third, the most intriguing and telling fact may be that during the expansionary period of 2010 to 2019, the national office vacancy rate retreated by only 130 bps from its peak before floundering at a level above its long-run average of 16% — until the pandemic arrived. Given that construction activity during this expansion was modest at best, this is evidence of an attitude shift and evolution for the office market that began long ago.

Languishing national-level property values confirm this market sluggishness. Gains in office values from 2010 to 2019 amounted to about 50% of the commercial real estate market as a whole during this decade. But it’s also worth noting that not all properties are faring equally.

Akin to the retail sector of the past three decades, we are seeing successful office properties built between 1960 and 2000 make way for a modern standard in urban or suburban locations that have become more en vogue. Well-placed new construction has leased up reasonably well as tenants have been willing and able to move into these spaces for more than a decade.

The current flux in the office market is simply serving to update the timeline for changes that have been in the works for quite a while. This is not an end to the office, but it is a fundamental change in the locations of power and buildings within each city.

It’s expected that successful office buildings of the future will be those in mixed-use areas that much more closely resemble “24-hour neighborhoods” rather than the “9-to-5 neighborhoods” of the 1980s. Distinct zones of office activity are quickly dying and are being replaced by areas where office, retail, residential and public spaces can mingle and thrive together. Employees will come back to the office, but it will take both a high-quality building and a high-quality location to do that. ●

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“I don’t see anything changing unless and until there is a material shift in the economy. In fact, I see the trend getting stronger and I see downsizing by downtown office users continuing.”

One of the hardest-hit areas has been Chicago, which posted a suburban office vacancy rate of nearly 30% at the end of September, up from 27.3% a year earlier, according to real estate services firm JLL. One reason for the high number of vacancies may be that workers are digging in and demanding to work from home.

One recent estimate shows that 13% of full-time employees work exclusively from home, while 28% use a hybrid model. These estimates come after many months of corporate efforts to get employees back in the office. Scotsman Guide recently spoke with Richard Traub, partner at the real estate practice of Smith, Gambrell & Russell LLP, for his perspective on the suburban office dilemma and what it might take to break this paradigm shift of employees working from home.

What is your perspective on the suburbs being new centers for satellite offices?

I think the original assumption was that, following the pandemic, many employers realized that their employees didn’t want the long commute involved with coming back to the office. So, they thought, ‘We’ll bring the jobs to the employees by opening suburban offices.’ But I don’t think the employees have materialized, and now some suburban office owners are caught up in the same paradigm shift that office owners in the city are facing.

The idea of employees wanting to work from home seems to have either gotten stronger or held its ground. I think that instead of even commuting a shorter distance to a suburban office, people want the efficiency and flexibility of working from home.

What will it take to lure employees back to the office?

The problem is that you try and mandate or enforce a return-to-the-office policy, even one that could be considered flexible and not onerous, and people are simply going to vote with their feet and leave. They are saying, ‘If you mandate that I come back to the office, even if it’s in a more convenient location in the suburbs, I’m simply not going to do it.’ Perhaps a satellite office with all the latest and greatest amenities would change the equation. But with the unemployment rate at about 3.8% and businesses fighting for skilled workers, the employee still has a lot of negotiating power.

How do you expect businesses to deal with this paradigm shift?

You know, I’ve been wrong 4 billion times in the last few years. When COVID hit, I thought we’d be back in the office in three months, once I realized it was going to be with us for a while. Then I thought the vaccine would bring everybody back. When that didn’t work, I thought there would be a flight to the suburbs and satellite offices. None of those things have completely proven to be true.

My theory is that a portion of the employees of the world have the leverage right now to dictate where office work will take place. And they are voting that it take place at home. I think it’s going to take a seismic shift in the marketplace to change that dynamic, such as the unemployment rate has to rise dramatically and technology jobs have to disappear. Then the companies will be able to dictate that employees have to be in the office, or they won’t have a future with their company.

How companies deal with this issue really depends on which industry they are in and the power of the company. J.P. Morgan Chase, for instance, is demanding employees come back to their downtown offices. They are a major financial corporation, have immense power and can do that. But a law firm, for instance, has to be very careful about the demands they place on the members who pretty easily can move to a different firm or city.

What do you see happening in the coming year?

I don’t see anything changing unless and until there is a material shift in the economy. In fact, I see the trend getting stronger and I see downsizing by downtown office users continuing. I see more businesses shifting to newer buildings with more amenities in downtown Chicago, where I’m located. As I’ve said, the whole office situation is just a reflection of the overall economy and the power of the employee right now. We’ll see if and when that changes. ●

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It’s an impending volume of maturities that Yardi called “worrying,” given the perfect storm of soft demand, low property prices, rising costs, all while lenders look to reduce risk and limit their exposure to office properties.

Consider that, by dollar volume, 16.1% of the total mortgage debt in the office sector will mature by the close of 2024 and 32.7% will mature two years later. Those maturing loans are concentrated in urban Class A properties and within the largest markets in the country, with Manhattan having the most at stake. New York’s most office-saturated borough has $19.8 billion of loans for 1,159 properties set to come due by next year’s end, nearly double the dollar value of Los Angeles, the market with the second highest dollar amount of maturing office mortgages.

Ten metros have more than $5 billion in office mortgages maturing by the end of 2024, and nine metros will see at least 20% of office mortgages by dollar volume come due at that same time. Metros with the largest percentage of mortgage volume coming due in the short term include Houston at 29.7%, Atlanta at 28.8%, Philadelphia at 26.7% and Chicago at 26.4%. Further out, 10 markets have at least $10 billion coming due by the end of 2026. By dollar volume, more than half of office mortgages will mature by the end of 2026 in Atlanta (52.6%) and Houston (50.5%).

Many of the markets with a large number of loans maturing also currently have high vacancy rates, including Houston (24.9% as of October 2023), Atlanta (18.7%) and Chicago (17.9%). That combination could spell double trouble ahead for such cities, with present weakness in demand meeting a large number of loans coming due — a model recipe for potential distress.

Distress, Yardi noted, is already starting to rise, with 5.8% of office loans pooled into commercial mortgage-backed securities (CMBS) delinquent in October 2023, according to the CRE Finance Council and Trepp. That’s up from 1.8% in October 2022 and 1.9% in December 2019. Additionally, roughly $9.8 billion of CMBS loans (comprising 8.3% of all such mortgages) were already in special servicing as of September 2023.

“Those negative numbers will increase as loans mature and properties face a funding gap — in other words, they qualify for fewer proceeds than existing debt in place because banks have grown more conservative while mortgage rates have shot up as Treasury and SOFR indexes rise,” said Paul Fiorilla, director of research at Yardi.

How much office distress will keep growing, Fiorilla added, largely depends on how long rates stay high and if they rise even more.  

“The worst case scenario is if the job market weakens while property values continue to fall and interest rates rise from current levels,” Fiorilla said. “A more optimistic scenario would have the employment market remaining strong while interest rates stop rising or even fall. In either scenario, office delinquencies are likely to jump, but the optimistic scenario would mitigate the pain as opposed to creating a larger crisis.”

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These factors result in declining municipal tax revenues, forcing the local government to offer fewer services. And the decline in amenities, coupled with cutbacks in city services, forces residents to abandon downtown neighborhoods.

“Workers and corporate leaders alike are beginning to realize that sprawling offices, especially in expensive city centers, are no longer as necessary.”

While such an urban nightmare may sound unlikely, three university business professors write that there is a risk of a version of this scenario occurring. The team of Arpit Gupta at New York University and Vrinda Mittal and Stijn Van Nieuwerburgh at Columbia University have coined this scenario as the “urban doom loop,” and they detailed it in their recent paper, “Work From Home and the Office Real Estate Apocalypse.”

The urban doom loop involves a series of interconnected events that can lead to economic declines in commercial real estate and beyond. As companies reevaluate leases or withdraw from them, vacancy rates increase and landlords face challenges in securing new tenants. This results in decreased property values and potential mortgage defaults. The ensuing economic downturn affects local tax revenues, stifles consumer spending and triggers layoffs, thus creating a cycle of economic hardship.

Far-reaching consequences

The landscapes of commercial real estate and commercial mortgages are undergoing significant transformations, driven in large part by the aftermath of the COVID-19 pandemic and the accelerated adoption of remote work. The emergence of the doom loop, characterized by the potential spiral of economic challenges in commercial real estate, has economists and business experts concerned about the implications for large and midsized cities along with the financial stability of lenders.

The pandemic has led to a seismic shift in how companies view office spaces. Workers and corporate leaders alike are beginning to realize that sprawling offices, especially in expensive city centers, are no longer as necessary.

Major corporations such as Salesforce are paring back their office footprints as remote work remains attractive, leading to concerns about declining occupancy rates. This trend, coupled with reduced demand for office space, has far-reaching consequences for the commercial real estate market.

According to consulting company Buildremote, 77% of the Fortune 100 companies operate on a hybrid work schedule, while 30% of these companies have announced reductions to their office-space footprints since 2020. Also, 13% of Fortune 100 firms do not require employees to have any scheduled office visits during a given week.

These large companies have traditionally been major driving forces of downtown office usage. With these firms reducing their office-space needs and having no plans to require workers to return to the office, the first major step in the urban doom loop may be starting for many cities.

Risk factors expand

While attention has been drawn to major cities such as New York and San Francisco, midsized cities are also at risk due to their limited capacity to absorb economic shocks. Unlike metro areas with diverse economic streams, midsized cities often heavily rely on one or two key industries. Consequently, the departure of a major tenant or a decline in property values can severely impact these cities’ revenues and employment prospects.

Not every city is equally at risk. Those with a high concentration of office space but relatively little residential space are more in danger. Those that are concentrated on one industry or have a small number of employers taking up a high percentage of downtown real estate also have an increased risk because other businesses or industries are less likely to absorb excess space. Also, cities that have poor transportation options (both public and private) will have a harder time avoiding this vicious cycle.

Some cities, including Provo, Utah; Boise, Idaho; and Austin have a more resilient core given that large portions of office space are utilized by a diversified combination of government agencies, higher education facilities, private corporations and nonprofit organizations. These are also locations where residents want to live, making them less likely to join the municipalities that suffer due to an exodus from the city center.

The urban doom loop has yet to fully materialize, but warning signs are evident. Midsized cities are experiencing higher office delinquency rates and lower occupancy rates compared to larger metros. The trend could intensify as loans are due for refinancing, a situation that is anticipated to unfold over the next 12 to 24 months. The looming deadlines for commercial mortgage maturities could most acutely impact regional banks, which hold a significant portion of commercial real estate debt.

Overcoming difficulties

For commercial mortgage brokers, the path forward is somewhat opaque as interest rates have reached a point where the bid-ask spread is often too wide for buyers and sellers to close deals. Furthermore, for many properties, refinancing may not be an option as injecting more equity may not be feasible. Instead, many of these properties will be foreclosed upon by their respective lenders.

There are three areas in which commercial mortgage lenders and their broker partners can seek to weather the storm and possibly emerge even stronger. The first is to perform thorough surveillance and loss-mitigation efforts on portfolios and individual assets. By conducting stress-test scenarios at the property and portfolio levels, brokers can focus on loan workouts with many types of clients and lender partners.

The second step is to take advantage of gap equity financing programs. These are private loans that cover the gap between another loan and the total cost of a project. Whether through affiliated subsidiaries or joint-venture partnerships, lenders that continue to make market-rate loans and offer gap equity financing — also known as a bridge loan — have the highest probability of successful closings.

The third point is flexibility. Lenders and their broker colleagues who display patience, creativity and common sense on loan restructuring efforts will build plenty of goodwill with their borrowers, even after the market improves.

Conversion problems

The Federal Reserve recognizes commercial real estate as a risk to economic stability. The central bank’s recent efforts to control inflation through higher interest rates impact demand for loans and investments. In turn, this affects the broader economy and contributes to the challenges faced by the commercial real estate sector.

The decline in demand for office space is expected to impact other sectors of the commercial real estate market, such as retail, industrial and multifamily properties. Property owners are attempting to repurpose vacant offices into alternative spaces such as apartments, kitchens or spas. But such solutions are often costly and haven’t gained widespread traction. The transformation of office space is influenced by various factors, including location and property type.

Converting offices to residential buildings is expensive for a variety of reasons. For example, living spaces require natural light. The shape of an office building frequently doesn’t allow light to penetrate to an inner residence. Plumbing and electrical requirements for office buildings and apartments are also much different.

Another part of the problem is companies fleeing downtown areas. Where will these urban residents work? The number of people who live in these buildings is significantly smaller than the number of people who work in an office building. Their commercial needs are different, meaning that turning offices into apartments might not offer the same consumer support to existing retail stores.

While some commercial properties, particularly those in prime locations, may weather the storm better than others, the market is expected to see discounted rents and sales prices, especially for older assets. The repurposing of office space may also play a crucial role in determining the value and viability of other commercial properties.

This is a problem that needs creative solutions. Some answers might be found in places where office buildings are shifting to new industries rather than remaining empty. For example, insurance company Humana occupies a large amount of downtown office space in Louisville, Kentucky. When the company recently downsized, it donated one of its buildings to the University of Louisville to support the school’s Health Equity Innovation Hub. Other corporations may learn from Humana’s actions and find creative ways to reuse unwanted space.

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Commercial real estate is in a current state of flux that is shaped by the dynamics of remote work, economic uncertainties and changing consumer behaviors. The concept of the urban doom loop underscores the interconnectedness of factors that can trigger an economic spiral in this sector and beyond.

While the worst-case scenario of declining asset values, lost jobs and failed city centers is not guaranteed, the signs are compelling enough to warrant attention from economists, policymakers and industry stakeholders. As commercial real estate navigates these challenges, innovation, adaptation and strategic planning will be needed to weather the storm and seize opportunities for revitalization and growth. ●

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“The banks do not want to take the properties back like they did in 2008.”

The report offers a sobering picture of the current office environment and offers ideas for how long it may take before a recovery begins. Scotsman Guide spoke with Ressler in September to get his perspective on the office sector’s current woes, along with what can be expected in 2024.

Office experts are throwing around words such as ‘apocalypse’ to describe the U.S. office sector. Are these terms appropriate?

Well, I don’t think it’s an apocalypse like some people want to paint it. I don’t believe it’s that bad. There’s no question the office market is in a downward trend. But at the same, the banks do not want to take the properties back like they did in 2008. The institutions are trying to work out deals to extend the loans as they come due. Now, that won’t occur for 100% of the properties, but we believe that most buildings will find a financial solution. However, a loan extension doesn’t mean that the property owners won’t have to put more equity into the deal to make it work.

Your national office report states that the U.S. vacancy rate has reached 17.54%, a record surpassing 2008 levels. And one of the hardest-hit places is the Bay Area?

That is correct. We are seeing that the cybersecurity and banking folks are populating San Francisco offices more routinely. That doesn’t mean they are in their offices Monday through Friday, but they are back in the office more because their work can only be done from a central core office. Then you have the general technology sector, which has been really hammered hard with many remote workers. We anticipate it’s probably going to stay down, especially if we experience a recession in the near term. So, you have roughly 30% of the folks going back because their jobs demand it and another 30% of tech workers who don’t want to go back to the office. And then there is everyone else who is saying they feel empowered and really want to be in the office less than five days a week.

You say the return-to-the-office push isn’t over yet. Who is still holding out?

The next two years will be stabilizing periods, with each market being unique in terms of occupancy return statistics. Financial institutions and information technology companies have resumed a return-to-work policy, including a major push by Amazon.com. The federal government has indicated that employees need to go back, but even prior to the pandemic, the government was planning to downsize many offices. When the pandemic hit, obviously we saw a diaspora of government workers outside the office. The federal government hasn’t mandated in the way that Google or Disney has, for instance, but they have indicated that they want employees back in the office.

Large metro areas with the most office space in the supply pipeline include Boston, Seattle, San Francisco and Manhattan. What will be the impact?

We really think the urban cores are going to get hit hard. Boston might be an exception, but the urban cores of New York City, Philadelphia, San Francisco and many others are going to be hit harder than anywhere else because they just haven’t been populated like other urban cores, and that will slow recovery. It’s economics 101: More supply drives down demand and prices.

Your report also points out that Class A+ and A buildings have dropped in value.

That information was from a study by Trepp. They found that buildings rated ‘A+’ or ‘A’ traded for $361 per square foot in 2022, but only $233 per square foot in 2023, a decrease of 35%. The results surprised them. Keep in mind there were only a few transactions on which to base these results. But still, I don’t think there’s any givens in the office market right now.

You believe that quarterly property transactions will stay extremely low until 2025 or 2026?

That’s right — because these issues must be worked through. First, the buyers and sellers must have a sense of when the Federal Reserve will stop raising rates. Also, there’s what I call the ‘Godot recession.’ We are still waiting for it. There is the issue of surplus inventory that must be worked through, so you’ve got a combination of negatives that are knocking the heck out of the industry.

How long will it take to work through these? There is a lag effect for sure, so right now we are saying 2025 to 2026. A lot of people have said that eight to nine months after interest rates stop rising, things will take off. That rule of thumb doesn’t apply anymore. Next year is not going to be great. It just isn’t going to happen. Not the way we see it. ●

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