Is the U.S. commercial real estate market in a bubble about to burst? Several financial market analysts would answer this question with a yes, it’s more likely than not that the sector will experience some significant financial distress. Commercial real estate has not rebounded in this post-pandemic economic environment, inflation continues to rise, and interest rates are climbing upward. Demand for office space has been significantly reduced as companies reassess and realign their office space needs.  It appears that some form of hybrid work will remain for a significant percentage of the workforce.  As a result, commercial bankruptcies are on the rise. Per Epiq data, March 2023 commercial bankruptcy filings were 79 percent higher compared to March 2022. Additionally, analysts have reported that followed by a quick deflation – the $2.9 trillion in commercial mortgages due will need to be renegotiated in the next two years. The current dynamics indicate that a financial crisis affecting the commercial real estate market is on the horizon.

But is the commercial real estate market in a bubble? By definition a bubble is an economic cycle that is characterized by the rapid escalation of market value, particularly in the price of assets. This fast inflation is quickly followed by a quick decrease in value, or a contraction, that is sometimes referred to as a “crash” or “burst bubble”. Values of commercial real estate have decreased as the need for office space has been significantly reduced. It doesn’t appear that this crash will create a financial crisis but rather, it will add distress to an already recession-like environment.

Market Conditions

BankruptcyData.com indicated that real estate companies are prime candidates to seek bankruptcy protection. As noted, rising interest rates coupled with hybrid work are the two main factors affecting the market. Let’s dive into this a little deeper.

Interest Rates

As a response to inflation, the U.S. Federal Reserve has significantly raised the benchmark interest rates to over five percent. To provide some context, these interest rates were close to zero percent in the beginning of 2022.  Regional banks have also experienced more pressure to impose stricter lending requirements. Currently, property values have plateaued and the cost to borrow money has gotten much more expensive.

Remote Work Trends

Hybrid work models are the new norm for most companies in the United States.  This has created an opportunity for organizations to transform operations in order to continue successful operations, maintain revenue streams, and create a positive company culture accounting for varying working styles. To stay afloat and meet these evolving needs, organizations are reimagining the role of the physical office.

New working models incorporate shared spaces, downsizing, or eliminating the physical office altogether. Because of the declining commercial occupancy, there is less of a market demand for traditional real estate spaces which affects the stability of the real estate market. However, there is a growing need for shared or short-term rental spaces. Many organizations want access to commercial spaces on a demand basis and ready for use, which could create a new market opportunity to fill gaps created by the decline in more traditional commercial occupancy.

Illustrations

Some examples of how these variables are affecting the commercial real estate market include:

• Many analysts have focused on New York City, one of the largest concentrated areas of commercial real estate in the U.S. Several are bracing for a challenging period for commercial real estate.
  • A major real estate firm reported that the office space vacancy rate in New York City has grown over 70 percent since the beginning of the pandemic.
  • The largest landlord for office space in New York City experienced $93 million in net losses in 2022, which is a drastic change from the $435 million in net profits experienced over 2021.
  • Researchers noted that due to the shift to remote work, the stock value of several New York City commercial real estate companies has declined on average by 32 percent in 2020.

• According to a commercial real estate analytics company, over $17 billion in mortgage bonds that are backed by commercial real estate are due in 2023. This figure continues to grow as the market values decline.
• According to public records, an investment management company ceased payment on a $325 million loan backed by an office building in Las Vegas.
• A real estate firm recently purchased an office campus located in the Chicago suburbs for under $20 million. It was recently sold for $74 million in 2018, demonstrating a significant drop in value. The property, like many others, was experiencing declining occupancy rates due to the rise in hybrid work models. The firm plans to repurpose the space.

Predictions

Based on the current state of the real estate market,  here are four predictions of what might come:

• The crash of the commercial real estate market is near and will compound an existing distressed cycle as interest rates continue to climb. Less occupancy resulting in defaults on leases and less renewals will lead to a greater need to refinance. However, refinancing will be challenging as interest rates are projected to keep rising.
• Real Estate Investment Trusts (REITs) will become distressed. REITs are companies that own and operate commercial real estate that produce income, generally from rental payments. Office buildings, shopping centers, and hotels are prime examples. When larger businesses turn to bankruptcy – like what is happening with Bed, Bath, and Beyond – then REITs are losing a big chunk of their rental income.
• Commercial real estate bankruptcies will increase over the next two to three years. As noted, filings have already increased this year and market conditions will drive more activity in this space.
• To rebound from the decline in commercial real estate values, investment firms will explore alternate ways to utilize existing office space. To increase occupancy rates, owners need consider whether they should convert their existing space to align with our new hybrid work environment. There will be more short-term rentals, hoteling services, desk rentals, and shared spaces. Converting commercial office buildings to residential use is expensive due to construction costs, planning and zoning approvals, and negative tax ramifications. Alternative uses for commercial space will also emerge including laboratories to support life sciences and teaching facilities.

Will these predictions ring true? With the ever-evolving state of the commercial real estate market, it is likely they will. Those affected should watch for how interest rates and remote work trends continue to affect the market, and the continuing role of bankruptcy to help navigate