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.