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Commercial Real Estate Risk: Economy’s Next “Pain Point”?

Isaac Nuriani    |
Apr 28, 2023
  • Analyst says commercial real estate could plunge 25% this year.
  • Lifestyle changes have fundamentally changed office & retail property markets.
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At a rather gargantuan size of $20 trillion, the U.S. commercial real estate market is a linchpin of the American economy. But trouble is lurking. For one thing, there’s the matter of rising interest rates, which is hurting property values. But that’s not all. Chronically higher vacancy rates have set in, as well, due in no small way to the internet and other technological advances that enable citizens to work and shop from remote locations.

The implications of a downturn in the commercial real estate market are significant, to say the least. As with all real estate, the lifeblood of commercial property is leverage. And as the values of commercial real estate face tremendous downward pressure, institutions that provide the financing are staring at a mountain of that same pressure, as well.

Possible turmoil emerging in the commercial real estate market is a big reason why so many remain unconvinced that problems with the banking sector are truly behind us.

“Although this is not yet a systemic problem for the banking sector,” Cornell University economics professor Eswar Prasad said recently, “there are legitimate concerns about contagion.”[1]

Prasad is referring to the nearer-term threat to financial stability posed by weakness in commercial real estate. It’s something retirement savers can add to the rapidly growing list of concerns they have to manage right now because these events can affect overall value of the dollars in retirement accounts (and purchasing power after retirement).

Beyond the matter of imminent distress in the commercial real estate market, there are worries about a lasting downturn in the sector, as well. It’s clear from the size of the market that commercial real estate is a big source of energy for the nation’s economy. Because of that, if the prospects for that market dim in a more secular way, retirement savers will also have to weigh the impact that of a potentially more “permanent” loss of growth in commercial real estate and the impact it could have on IRAs and 401(k)s.

Later, I’ll talk about one way that retirement savers can protect their accounts against near-term volatility in the commercial real estate market and optimize those accounts in the face of future industry weakness.

Before I do, however, it may be a good idea to detail the nature of both the shorter- and longer-term risks to the economy posed by a troubled commercial real estate market.

Let’s get to that right now.

Analyst: Commercial Property Values Could Sink 25% This Year

The more immediate risks to the commercial real estate market – and, by extension, the broader economy – appear to be rather substantial right now, if you judge by analyst comments in the news recently.

Rich Hill is head of real estate strategy at Cohen & Steers, a global investment manager that specializes in real estate assets. According to Hill, the overall value of commercial property could fall as much as 25% this year, and the decline in office property, specifically, may exceed 30%.[2]

The risks to the office-property market, in particular, are especially prominent. The average occupancy rate of offices nationwide is less than half of what it was just prior to the onset of the pandemic.[3] In fact, the first quarter saw office vacancies actually exceed the peak vacancy rate reached during the financial crisis.[4]

And pay attention to this part: That’s with a national unemployment rate near its lowest point in the last 50 years.[5]

In other words, the professional world – made up of employers and employees alike – has adapted to a new day-to-day working paradigm whereby much of the nation’s white-collar work is done now from home. That trend continues to gain traction as another dagger, rising interest rates, pushes even deeper into the heart of the commercial real estate sector. Now, fault lines are appearing at financial institutions.

Recently, Wells Fargo reported a 50% increase in nonperforming commercial real estate loans in just the first quarter. And Morgan Stanley said its provisioning (setting aside money to cover bad loans) is soaring based largely on the condition of the commercial property market.[6]

But as significant as a downturn could be for the world’s systemically important banks, it could prove much worse for regional banks – such as the recently failed Silicon Valley Bank and Signature Bank. That’s because loans against commercial real estate make up 40% of the total lending done by smaller banks, compared to about 13% for the largest banks.[7]

And according to analysts at Morgan Stanley, nearly one-third of the roughly $4.5 trillion in commercial real estate debt comes due in the next 2½ years.[8]

The numbers generally make clear the near-term risks to the commercial real estate market as well as to the banking sector. But the fundamental, “cellular-level” changes in the way people are now living have tremendous long-term implications for commercial real estate and broader economic growth, as well.

Let’s move on to discuss those.

Wall Street Journal: Commercial Real Estate May No Longer “Contribute as Much” to Nation’s Economy Going Forward

It’s impossible to describe all the ways the internet has changed our lives. Honestly, the briefest and most accurate assessment you can give is to say it’s changed “everything.”

“Everything” would include, of course, the way we work and the way we shop. And one of the most direct and impactful consequences arising from these significant lifestyle changes is the diminished demand for commercial property.

As with the lasting decline looming in demand for office property, because ecommerce continues to surge, retail space also has shown signs of significant vulnerability.

Noting that store closures jumped substantially this year, UBS Group AG recently estimated that roughly 50,000 retail stores will close within the next five years.[9] You may have heard storefront staple Bed Bath & Beyond just filed for bankruptcy. It’s shocking to see that from a “once an unstoppable retailer,” as NPR put it recently. The company expects to eventually close all of its locations, including its 120 BuyBuy Baby stores.[10]

Other bankruptcies anticipated among longtime “bricks-and-mortar” retail stalwarts, as well. David’s Bridal also just filed for bankruptcy, and said it’s looking at a complete liquidation if it cannot appropriately restructure its debt. In its filing, David’s identified “adverse macroeconomic trends” as one of the principal reasons for its debt woes.[11] Party City, JOANN Stores (fabrics and crafts), Dollar General, The Gap and Kohl’s are just some of the other big-name retailers that have been identified as prime bankruptcy candidates in 2023.[12]

Given this trend, it’s reasonable to expect sinking demand among tenants for retail space…along with the declining demand for office space.

“People thought of these office buildings as forever, because of course it’s going to be 98% leased forever,” says Dan Zwirn, chief executive of global asset manager Arena Investors. “People were not planning on this secular change.”[13]

But the “secular change” is real. And a recent Wall Street Journal article on the burgeoning commercial real estate crisis says the sector “won’t contribute as much to the country’s economic growth” going forward as it has historically. The Journal expands further on its negative “macro” outlook, suggesting that “depressed building values could hurt cities, which depend on property-tax revenue, and weigh on bank balance sheets, leading to less lending throughout the economy.”[14]

Once again, retirement savers must consider how they’ll manage another troublesome economic influence that stands to not only cause distress in the near term but could serve to mute IRA and 401(k) performance for a long time to come. As for how they might navigate such a potentially complex environment, I have a thought (read on).

“Trillions of Investment Dollars Suddenly Impaired” Says Strategist

The nearer-term issue for retirement savers with regard to the pressures facing commercial real estate has to do with the likelihood these troubles could manifest in yet another “global shock” to the financial system.

Last fall, the International Monetary Fund (IMF) was sounding the alarm on the risks posed by the sector, noting that “disruptions in the commercial real estate market could in turn potentially threaten financial stability through the connectedness of the sector with the financial system and the broader macroeconomy.”[15]

As this article has detailed, concerns over deterioration in the commercial real estate market have only grown since the IMF issued its warning. And they’ve been further intensified by the recent turmoil in the banking sector – which implied prevailing weakness already exists in the financial system.[16]

Understandably, there also are concerns about the exposure retirement savers have to commercial real estate. As Arena Investors’ Dan Zwirn notes, “You literally have trillions of dollars of investment that are suddenly just massively impaired.”[17]

For savers, then, shorter-term worries have to do with the instability that could arise both from a sizable downturn in the commercial real estate market directly as well as from the broader systemic volatility that such a downturn might trigger.

Then, looking out further, the prospect of more diminished economic growth arising from commercial real estate weakness is also something which retirement savers would do well to account for.

 

……..
[1] Julia Horowitz, CNN Business, “American offices are half-empty. That could be the next big risk for banks” (April 10, 2023, accessed 4/27/23).
[2] Allison Morrow, CNN Business, “Three major risks that have the banking industry on edge” (April 10, 2023, accessed 4/27/23).
[3] Jeanne Sahadi, CNN Business, “The latest on hybrid work: Who is WFH and who isn’t” (April 9, 2023, accessed 4/27/23).
[4] Konrad Putzier, Wall Street Journal, “Commercial Real-Estate Woes Run Deeper Than in Past Downturns” (April 24, 2023, accessed 4/27/23).
[5] Bureau of Labor Statistics, “The Employment Situation – March 2023” (April 7, 2023, accessed 4/27/23).
[6] Financial Times, “US banks on alert over falling commercial real estate valuations” (April 22, 2023, accessed 4/27/23).
[7] Ibid.
[8] Ibid.
[9] Putzier, “Commercial Real-Estate Woes Run Deeper.”
[10] Alina Selyukh, NPR.org, “Bed Bath & the great Beyond: How the home goods giant went bankrupt” (April 24, 2023, accessed 4/27/23).
[11] Alexander Soule, Journal Inquirer, “David’s Bridal, which has 3 stores in state, goes bankrupt” (April 18, 2023, accessed 4/27/23).
[12] JDSupra.com, “10 Retailers to Watch for a Bankruptcy Filing in 2023” (January 6, 2023, accessed 4/27/23).
[13] Putzier, “Commercial Real-Estate Woes Run Deeper.”
[14] Ibid.
[15] Andrea Deghi, Fabio Natalucci and Mahvash S. Qureshi, IMF.org, “Commercial Real Estate Sector Faces Risks as Financial Conditions Tighten” (September 22, 2022, accessed 4/27/23).
[16] Horowitz, “American offices are half-empty.”
[17] Putzier, “Commercial Real-Estate Woes Run Deeper.”
[18] CNBC.com, “Gold COMEX (Jun’23)” (accessed 4/27/23); CNBC.com, “Silver COMEX (May’23)” (accessed 4/27/23).
[19] StockCharts.com, “Gold-Continuous Contract” (accessed 4/27/23).
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