The next big commercial real estate crisis

Towering structures with the capacity for thousands are now considered excessive, while compact, clean energy spaces, with hot-desking are coming in vogue. HSBC, which has had its global headquarters in Canary Wharf since 2002, is not the first of the financial district’s long-term residents to announce a move away from the Docklands, and likely won’t be the last.

Law firm Clifford Chance announced that it would be making a similar move, while banks such as Barclays and Citigroup have closed ancillary offices and sub-letted unused floors of their buildings.

The shift to hybrid working has added further pressure to the commercial real estate sector, which is already struggling with a difficult macroeconomic environment. The issue is not unique to the UK - high interest rates across the world have hit the sector from multiple directions:

• Credit is tighter, making borrowing more expensive and refinancing more difficult. This will have a particularly significant impact on the US commercial real estate market with large loans-to-liabilities ratio compared to the rest of the economy (Gavekal, 2023). Furthermore, the Fed’s Senior loan officer survey revealed that the percentage of banks tightening standards for commercial real estate loans is higher than all other loan types. (FRED, 2023)
• Higher returns on risk free bonds have made real estate investments less attractive on a relative basis, leading to a fall in valuations. While higher rents can offset this to an extent, many landlords will likely struggle to match the rapid rise in bond yields when accounting for the fact that investors will demand a higher yield to compensate for holding a more illiquid asset.
• Falling valuations can cause loan-to-value ratios to increase. If investors cannot add more equity, or refinance, they may be forced to sell at a discount. Discounted sales can often be a signal to appraisers to mark down valuations even more, creating a vicious feedback loop. (Bloomberg, 2023)

Most commercial property is held privately, meaning valuations can take months or years to fully react to higher interest rates. However, the struggles of commercial property are evident in the share prices of publicly traded real estate companies (real estate investment trusts, or REITs). These have fallen significantly over 2022 and 2023. REITs which invest in office space have seen the largest declines, falling as much as 10% - 30% across the UK, US, Europe and Asia over the last five months.

All of this means that a significant rise in defaults in this sector is a real risk. Some defaults have been seen already among even large landlords. In February, the Columbia Property Trust defaulted on $1.7 billion worth of mortgages on seven buildings. In the same month, Brookfield Corporation defaulted on loans tied to two Los Angeles skyscrapers. The tenants of these buildings included Twitter and Deloitte.

The fact that well capitalized money managers, with reliable tenants and prime locations are finding default to be a preferrable option should be a cause for concern. It raises the question: how will the owners of older and less occupied buildings cope?

A widespread increase in defaults would have enormous ramifications for the global economy. Past crises, including the Savings and Loans crisis of the 1980’s and the Global Financial Crisis of 2008 were accompanied by surges in commercial real estate delinquencies. And time is running out. According to Morgan Stanley, (Bloomberg, 2023) $1.5 trillion worth of debt is looming for the US alone before 2025. The longer that central banks keep interest rates high, the lower the chance that a crisis can be averted.

Tao Yu, Quantitative Analyst

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