The commercial real estate market is in a fragile state. The remote working trend is not reversing anytime soon, if ever. Some analysts believed that once the pandemic ended, people would naturally revert to the “old way” of working – going to the office either full time or most of the time. For many organizations, this is not the case. In fact, in Randstad’s 2023 Workmonitor survey, 82.9% cited flexible working hours as being important and 71% wanted flexibility in their work location. Additionally, 61% said they would decline a job if they believed it would negatively affect work-life balance. People want the option to work remotely and are prioritizing offers that allow for their desired level of work-life balance.

What this has led to is a drastic decline in office occupancy. Businesses are leasing more office space than their business now requires. According to a January 2024 article by CBS, there is over 95 million square feet of empty New York City office space. Those same metrics hold true for San Francisco. As of December 2023, roughly 36% of the city’s office space was vacant, according to the San Francisco Standard. This represents over 31.5 million square feet of office space in the city.

Taking a broader view, after Q1 last year Street Cents found there was 963 million square feet of vacant office space across the US. It will be interesting to see when this year’s statistics begin to materialize, as there are still a lot of empty offices but there is also a spike in creative solutions to fill these spaces.

The State of the Market

Rental space that is fully utilized and maintained retains its fair market value. As commercial buildings continue to experience reduced rental income, it’s market value will likely decline. This economic situation is amplified in the current economy since interest rates have skyrocketed Inability to access capital will be crippling for owners since the growth of commercial real estate has been one of the cornerstones of stability for the US economy.

As reported by ABC News in December, around $1.5 trillion in commercial real estate loans have looming maturity dates. With values dropping coupled with refinancing challenges property owners are faced with managing an asset without realizing revenue to fund those liabilities. Difficult decisions lay ahead for property owners. Many owners are working with their lenders for some form of relief to avoid a default because they are unable to make interest payment on their “underwater” existing loan. In the most extreme situations, owners have surrendered the property to the secured lenders. In June 2023, Westfield and Brookfield, two large commercial real estate companies made the decision to begin the process to transfer management of the shopping center to their lender to appoint a receiver to operate the property.

Ramifications

The decline in commercial real estate values has far reaching ramifications. First, and the most obvious, are the owners of large commercial real estate buildings in our major cities. They are continuing to manage their businesses with declining rental income through a myriad of options. Most common is continuing efforts to work with tenants to secure occupancy, negotiations with secured lenders, sale of the property, and in the most distressed situations, walking away from their investments or contemplating a formal bankruptcy to force all stakeholders to the negotiating table. Even those that seek protection of the bankruptcy court, may result in the turnover of the property to the secured lender.

In addition, regional banks, who are heavily invested in commercial real estate in their communities, are starting to feel the effects of the declining values of commercial real estate. Most regional banks have large commercial real estate holdings in their portfolio. If occupancy rates continue to decline, and refinancing options remain limited, there may be more defaults on loans that can affect the bank’s stability and profitability. In a worst-case scenario, reginal banks may encounter financial distress which would impair the strength of the overall national economy.

Municipalities will also encounter declining property tax revenue which could severely impact the budget which provides for necessary essential services of the community. The scope of municipal services are an important driver to attract new owners of property and investors into the community. The downstream effect of a declining property tax base may render a community undesirable for continued growth.

Emerging new businesses in artificial intelligence and cryptocurrency have helped curb the effects of declining commercial occupancy rates. For example, in San Francisco AI companies made up 28% of the leasing activity last year. While this is in no means quick fix, it is helping the market in some cities. In the future, any incentives for property owners to keep their buildings may help drive down the vacancy and default rates. Whether the government will create an incentive program is yet to be seen.

Creative Solutions

Assuming the commercial real estate owner can stabilize its debt payments, the second line of defense is figuring out whether the property is suitable for alternative uses. Property owners are solely focused on occupancy rates so a conversion to make leasing attractive isa priority. Since the demand for office space is low, some creative alternatives have been revealed. Here are a few types of options owners are considering:

• Keeping the space for office use but in a different manner may be a viable choice. This includes short-term rentals, shared spaces, community group meetings and events, hoteling services, and desk rentals.
• The idea of commercial space conversion to residential apartments has been explored in a few cities, but there are challenges and costs. This includes planning and zoning approvals, unrealistic layouts requiring construction, utility placement, and tax ramifications. However, this is becoming a more popular option for those investors with the capital and areas with luxury residential demand. For example, a New York architect is currently working on converting buildings once home to Goldman Sachs and J.P. Morgan Chase into apartments.
• Some untraditional options that are on the table include laboratories to support life sciences, teaching facilities, future self-driving car facilities, spas, data centers, vertical farms, breweries, and entertainment businesses.

Some have already successfully completed conversions from this list, while others are exploring their options. The fact remains that being creative may bring more upfront costs but can help save the investment and convert the space to profitability. It will be interesting to see what other creative uses may arise as property owners are faced with their debt as lower occupancy will likely continue.