Pierre Buhler and Andrew Jones discuss the future state of the commercial real estate market in this ABF Journal article. Read a preview of the article below.

Most big commercial real estate firms, and lenders holding commercial property debt, are aware there’s a $2.7 trillion loan default problem looming. But like many businesses gradually heading for bankruptcy, owners—and indeed, banks—tend to be in denial about the approaching situation. They need to act now, before they’re faced with catastrophic loss.

Commercial Real Estate Isn’t Out of the Woods Yet

With the Fed’s most recent 25-basis point cut closely following a .5 percent cut, some might imagine that commercial real estate problems are in the past. But the commercial real estate crisis continues to show distress, with losses spreading even to AAA-rated commercial mortgage-backed securities (CMBS) once considered nearly risk-free. Top-rated bonds tied to prominent office buildings in cities like New York, Chicago, and Los Angeles have experienced significant defaults and reduced payments, shattering assumptions of stability in the sector. Single-asset, single-borrower (SASB) bonds have been particularly vulnerable as building values plummet due to declining occupancy and shifting leasing conditions. Despite a recent rebound in select markets, many office-backed SASB bondholders face steep losses, underscoring the ongoing uncertainty and the challenges in today’s commercial real estate landscape.

Covid changed demand forever

Covid’s financial and behavioral shockwaves continue to be entrenched and are far from over. Businesses have been trying to get employees and customers back to their sites, with mixed results, as the pandemic introduced a permanent discontinuity in human patterns and preferences for work, home, retail and leisure.

Taking a broad view of companies falling into bankruptcy proceedings and subsequent restructures, their behavior tends to share similar characteristics: denial, procrastination and an unwillingness to be proactive early enough in the process of decline to prevent the inevitable outcome: default and subsequent Chapter 11. Instead, companies and their leaders usually hope that circumstances will somehow improve, enabling them to meet their debt covenants. In the case of commercial real estate, this could be workers deciding to float back to the office, demand picking up and new leases being signed, all of which might save the day. But there are definite signs of a more lasting, permanent change to emerge in the workplace, with implications for commercial real estate and lending.

You only need to look at a few recent moves in Manhattan commercial real estate to confirm this point. A former NYC WeWork building is being converted into condominiums, as is a Nomad office, recently purchased by Elad Group, and Downtown property mogul Larry Silverstein is also acquiring aging midtown buildings for possible residential conversion.  So while executives all the world over are working to get people ‘back to the office’ the truth is, as leases come up, companies increasingly are taking the opportunity to cut real-estate related costs. With real estate typically making up 10 percent of a corporate cost base, these savings options become even more attractive as economic uncertainty forces firms into introducing structured cost-cutting programs and challenging cost targets. When having to choose, most boards now prefer to direct operational investments into technology rather than real estate.

Even in the past, traditional office-based businesses, which occupy much of the most expensive and investible real estate assets in cities, only used typical workspace for 40 hours of a 168-hour week.  Post-pandemic, that dropped by 40 percent to 24 hours, just 14 percent of the potential hours. No amount of focus on futuristic workplace design, flex-working solutions, or prop-tech is going to put commercial real estate demand back to where it was.  This is a deep undercutting of value, and hence price risk, in a market where price has little to do with physical supply costs.

As with many businesses facing bankruptcy, there is a deep sense of denial about this runaway devaluation. In an industry ecosystem largely segmented by asset class—office, retail, warehouse, and so on—this represents a critical strategic issue for many. Some businesses with specialized real estate teams and mono-type property holdings are most at risk — in some asset class sectors, a lot of money will be lost. Therefore, building owners need to act now if they are going to realize better than fire-sale valuations. And the banks that are lending to them need to be pushing them to act now.

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