U.S. offices under pressure: real estate as a defense for investors

Commercial real estate, especially office buildings, are going through a challenging period of change: rising interest rates are impacting the sector, while tenants are looking for more modern and sustainable architecture in new areas of the country.

The problem of obsolescence in commercial real estate

"There's an obsolescence problem in commercial real estate right now where you have a significant amount of older assets, and that's particularly pronounced in the office sector," says Miriam Wheeler, head of Goldman Sachs' Global Real Estate Finance Group in investment banking.

The sector is poised to attract capital from around the world in the medium term as investors seek assets better protected from inflation and geopolitical turmoil, says Neil Wolitzer, executive director in Goldman Sachs' real estate investment banking sector.

We spoke with Wheeler and Wolitzer about the rising extra yields investors are demanding to buy mortgage-backed commercial bonds instead of risk-free government securities, the large amount of debt that will be paid off in the coming years, and expectations for losses and problems.

Assessing the creditworthiness of commercial real estate

Miriam Wheeler: Let's look at the commercial bond market because it's the most liquid market: we'reIn January and February this year, we noticed some resiliency in the market. Part of this was that supply was very low - commercial bond supply fell by more than 80% in the first quarter of 2023.

But after the regional bank crisis in March of this year, the commercial bond market began to lose ground significantly to other corporate credit products, pulling back from the highs of fall 2022, while high-grade credit and high-yield credit remain relatively stable.

So, I think in general investors are concerned about commercial real estate valuations and are starting to factor in either extensions or losses in this market. We also keep a close eye on the regional bank market, as they are the largest commercial real estate lenders.

According to a Goldman Sachs study, they make up about 70% of total commercial real estate loans made by banks, and interestingly, the smaller the bank, the more exposure it has to commercial real estate. We therefore worry that as regulation tightens, regional banks will reduce their exposure to commercial real estate, which at best will lead to more difficult credit conditions for borrowers, and at worst some of these banks will withdraw from lending altogether.

We believe this will be particularly significant in the construction sector, where regional banks are active and where there is no effective substitution (unlike in the stabilized asset market, where we believe commercial bonds could take some share).

At the same time, we believe this will be a very attractive environment for some of the debt funds and private equity that has been raised as some traditional banks shrink and disintegration continues in the commercial bond market.

Trends in office real estate

There is concern about the wall of mature commercial real estate. Miriam Wheeler: It's important to look at maturity by asset class. So office assets make up about 23% of total mature assets, and I think there will be significant financial stress around those office assets.

Some of these loans will be renewed, but I think there are also borrowers who no longer have positive equity in these assets and therefore are not interested in contributing additional capital. Outside of the office, there are many available resources for remaining assets. Just look at how well multifamily and industrial properties, warehouses and hotels have performed.

Evaluations are down a bit because of rates and the liability side of the balance sheet, but there are still assets with plenty of cash and where they want to invest. I would also note that a huge amount of private funds have been raised to fill those gaps.

The state of office real estate.

Neil Wolitzer: I don't think we have a problem with office real estate - I think we have a problem with "secondary" office real estate. We have seen a similar situation with regional shopping centers in the US.

While many "secondary malls" experienced problems in their operations and eventually transitioned to other uses, the best quality malls continued to thrive and the sector as a whole saw consolidation.

Today's remaining regional mall participants are some of the best publicly traded real estate companies with strong balance sheets, significant free cash flow generation and stable operations.

I believe the same situation will be true for office assets, where high amenity and well-located office buildings will continue to provide attractive rent growth, while older assets with low amenity levels will have trouble attracting tenants and net rent growth.

The office sector's momentum comes against a backdrop of a significantly more volatile macro fund than what the regional shopping center sector has experienced over the past several years.

The office sector is much larger in size than regional shopping centers, and the cash flow characteristics are also much different than shopping centers and can be quite volatile during periods of reduced rental demand from tenants.

I think it may take a significant amount of time for offices to become preRecent developments in the regional shopping center sector may contribute to the duration of this capital allocation cycle.

Regional shopping centers are typically owned by highly sophisticated long-term institutional investors - pension funds, insurance companies, etc. Many have experienced losses due to an oversupply of misguided regional shopping centers and are now cautious about committing capital to a sector with real and perceived problems.

Miriam Wheeler: I would like to add that banks and institutional capital are now very concerned about their exposure in the office sector, so getting a new loan - even for a good office asset - is a huge challenge.

What we're seeing in the commercial bond market is that if you look at the conduit product, where lenders bundle loans secured by different types of real estate, different borrowers, historically we've had 30-35% office concentration. In recent transactions, this has already been reduced to 15-20% in line with investor requirements.

I think the pressure on the office share percentage will continue and therefore there are not many available sources for financing office real estate right now.

Important real estate trends

Miriam Wheeler: One notable shift is a preference for newer, higher quality assets, as our fellow researchers have noted. We now have a significant amount of obsolete assets, especially in the office sector. But I think it relates to the overall trend, and so when we look at lending, we focus on institutional quality assets that are new and meet the needs of today's tenants.

Neil Wolitzer: I completely agree with Miriam. Debt and equity market participants are very careful about allocating capital to the office sector, they are not only focusing on higher quality assets, but also focusing on centers of population and job growth such as Dallas, Charlotte, Austin, Nashville, etc. e.

How long do you think it will take for losses to affect the commercial real estate market?

Miriam Wheeler