Commercial Real Estate Might Be in Trouble. Is Residential Too?

Earlier this year, the U.S. office vacancy rate hit an all-time high. It's now at a staggering 20.2%, which amounts to nearly 1 billion square feet of office space. This article will review how this happened, why it matters, and what it might mean for the residential real estate market. 

Table of Contents

• How Did So Many Office Buildings End Up Empty?
• How Office Vacancies Impact Building Owners
• Small and Regional Banks Poised For Trouble Next
• What All This Could Mean for Residential Real Estate

How Did So Many Office Buildings End Up Empty?

When the COVID-19 pandemic hit, many companies shifted to remote work policies, allowing employees to work from home instead of the office. Consequently, the number of people primarily working from home tripled from 5.7% (roughly 9 million people) in 2019 to 17.9% (27.6 million people) in 2021, according to the U.S. Census Bureau.

Since then, some workers have returned to the office. However, many are still working remotely, at least some of the time (aka hybrid work). Furthermore, Gallup estimates that roughly half of America's 140 million jobs could be done remotely. This and the fact that efforts by employers to get workers to return to the office have largely failed suggest that remote/hybrid work is here to stay.

As a result, many companies are downsizing their office space. If not to adapt to remote and hybrid work policies, they're downsizing out of fear of a potential recession on the horizon. With the Federal Reserve raising interest rates for the 11th time this year and to the highest level they've been in over 22 years, businesses must be cautious about managing their overhead, and cutting office space is one way to do this.

Case in point: A recent McKinsey study predicts that demand for office space will be 13-38% lower than in 2019. Naturally, this could have downstream effects.

How Office Vacancies Impact Building Owners

The first ones to be impacted by rising office vacancies will be office building owners. They're the ones who hold the mortgages on the buildings. If their tenants fail to renew their leases, they may be left without the rental income needed to pay their mortgages.

Moreover, building owners with floating-rate mortgages (i.e., mortgages with adjustable interest rates) are already seeing shrinking profit margins due to rising interest rates and higher loan servicing costs.

But the real trouble for building owners will come when it's time to refinance their commercial loans. $1.5 billion in U.S. commercial real estate (CRE) debt is coming due before the end of 2025, the bulk of which was financed when interest rates were near zero. Though some borrowers choose to pay off their original loans, most try to refinance because they don't have the cash reserves to pay off the debt all at once or because they don't want to tie up large amounts of capital.

Higher interest rates will make refinancing more expensive, and banks may be more cautious about extending loans. Additionally, higher borrowing costs (coupled with higher vacancy rates) could lead to a drop in CRE values. Class A Office values are already down 35% from their pre-pandemic peak.

All of this may cause building owners to struggle to secure refinancing, and even if they do, they will be stuck with tighter cash flows and lower profits. If they can't refinance, they may be forced to default on their mortgages, which some already have and could lead to wider problems.

Small and Regional Banks Poised For Trouble Next

Not only do mortgage defaults damage the borrower's credit (in this case, building owners), but they can also cause major problems for the lender. When a borrower defaults, the lender loses the outstanding loan balance. This can lower the bank's profits and cut into its capital reserves. If a bank experiences enough loan defaults, its financial standing with depositors, investors, and regulators could be jeopardized.

What makes the current office situation worse is that nearly 70% of the country's CRE loans are held by small and regional banks, which tend to have fewer capital reserves to absorb losses. Consequently, a rise in CRE loan defaults could put a significant financial strain on the banking sector and ultimately lead to bank failures (think: Silicon Valley Bank, Signature Bank, and First Republic).

Banks that withstand the pressure may still take on heavy losses. For one, they may be required to devalue their CRE loans due to the increased risk of not recovering their CRE investments. But secondly, they may be forced to sell CRE loans to investors at a loss to replenish their cash reserves. However things play out, banks are likely to suffer.

What All This Could Mean for Residential Real Estate

If the above causal chain unfolds as described, it could eventually impact the rest of the U.S. economy, including residential real estate, in the following ways:

• A slew of bank failures could trigger an economic downturn, in which consumers spend less, including on houses.
• A drop in CRE value could decrease demand for housing in the surrounding area, leading to lower residential home values.
• A contraction of the CRE industry could cause lenders to tighten their lending standards, making it harder for homebuyers to get mortgages and reducing demand for residential properties.
• Cities, which rely heavily on commercial property taxes, may see a reduction in tax revenue, leaving them with fewer funds to develop new residential neighborhoods, thus limiting housing supply.
• Lower home values could financially strain homeowners (e.g., via an underwater mortgage), forcing some to sell their properties at distressed prices. A flood of distressed sales could further depress the area's home values.

One potential silver lining here is office-to-residential conversions. Given the nation's massive housing shortage, it would make sense to convert now-empty office buildings into multi-family properties, killing two birds with one stone. Though this strategy has challenges (not least financial and regulatory hurdles), it's already incentivized by governments in Boston, New York, Wisconsin, Washington DC, and California.

It's too early to tell exactly how the impending CRE changes will impact residential real estate. However, savvy investors, agents, and loan officers can adapt their business strategy to a changing market. That means having the right real estate data to make informed decisions will be crucial to your real estate business in helping you identify off-market deals or utilizing creative financing options to buy a property.

Whatever it is, PropStream can help. With over 155 million property records and homeowner information to go with them, we can help you find your next property deal or client lead. Sign up for a free 7-day trial today and get 50 leads on us!