Commercial real estate buckling under weight of crushing interest rates

Rising interest rates have undercut another segment of the real estate market: commercial lending.

According to Fed data analyzed by Trepp, a real estate analytics company, the total volume of commercial property loans held by banks declined during the first two weeks of October.

This eye-opening development is significant because commercial property lending by banks has declined for only two months since 2014.

Zooming out, commercial property lending by banks, mortgage-backed securities, and nonbank lenders rose by less than 1% in the second quarter of 2023. That’s the smallest increase in more than nine years, according to The Wall Street Journal.

The figures add to a growing body of evidence pointing to a sharp slowdown in commercial lending.

While there’s no shortage of pain to go around, the biggest victim is office buildings.

Office buildings in trouble

Still reeling from the exodus of workers and businesses during Covid, office building owners are now struggling with higher refinance rates on their loans.

According to the Mortgage Bankers Association, nearly one-quarter of mortgages on office buildings must be refinanced this year, with rates much higher than the 3% they previously enjoyed.

Since the Fed began raising interest rates in March 2022, the average mortgage rate has roughly doubled. But unlike residential mortgages, commercial loans are usually much shorter and must be refinanced every five to ten years.

Office owners are already buckling under the pressure as delinquencies and “special servicing” spike. Loans enter special servicing when the borrower’s terms must be modified because they’re behind on payments or at risk of default.

According to Trepp, the volume of office loans in special servicing has more than doubled to $13.9 billion over the past nine months. Delinquencies have spiked by 252% over the same period.

“This is just the tip of the iceberg for office delinquencies,” Polpo Capital Management founder Dan McNamara told BNN Bloomberg, referring to the $35 billion in commercial mortgage-backed security office loans that mature this year.

The solution isn’t as easy as refinancing the loans. The “refinancing market is effectively shut to this asset class,” McNamara said.

The real issue with high vacancy

Another alarming trend in the office building industry is the sharp rise in vacancies. According to brokerage firm Cushman & Wakefield, the vacancy rate for offices rose to a record high of 18.2% late last year.

Things haven’t improved much in 2023, with Coy Davidson of the Tenant Advisor reporting a 16.4% vacancy rate in the second quarter. That’s still higher than the peak during the 2008 financial crisis when vacancies never eclipsed 16.3%.

Having a high vacancy rate is a much bigger problem than it appears at the surface. Not only do building owners lose out on rent, but the value of their properties declines when office space sits idle.

Higher vacancies mean some office buildings are worth less, especially when they’re older and need repair, according to Scott Rechler, CEO of Manhattan developer RXR.

“No one knows what is a fair price,” Rechler told CNBC. “Buyers and sellers have different views.”

A painful recovery

The post-pandemic office slump has affected many properties, including the higher-end “Class-A” buildings that usually command pricier rents and have much bigger valuations.

According to Dylan Burzinski of Green Street, a commercial real estate intelligence firm, Class-A office values have already plunged by 35% from their pre-pandemic peaks. The picture is probably much worse for B- and C-class properties, which are “down much more.”

Although commercial property values fluctuate all the time, economists are growing more convinced that the road to recovery for office space could take years, even decades.

Kiran Raichura, deputy chief property economist for Capital Economics, said it could take a painstakingly long time for office values to return to their peaks.

“It's quite possible to see that recovery take much longer than the 15 years that we've penciled in, and it could be well into the mid-2040s even,” he said, according to Business Insider.

One problem begets another

Higher interest rates have handcuffed property owners who need to refinance their mortgages, but plummeting valuations will make the process much harder.

According to Christian Ulbrich, the chief executive of commercial real estate company Jones Lang LaSalle, banks are already requesting that owners put up more equity during the refinancing process.

Many are simply deciding it’s not worth the hassle and handing over their keys to the banks.

“This is a scenario we will see now very often,” Ulbrich told CNN.