A malfunction? Why bankrupt commercial real estate when it hasn't happened yet?

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The value of commercial real estate was on the decline.

It seemed obvious. After remote working became mandatory because of Covid-19, landlords have had trouble filling vacant buildings. Some commercial builders who took out loans to finance projects "were just walking away, paying it back to the lender," recalls Quincy Crosby, chief global strategist at LPL Financial.

Starting in March 2022, the Federal Reserve's rate hikes to fight inflation have increased the cost of credit. According to the National Association of Realtors (NAR), office vacancy rates hit an all-time high in the first quarter of 2023 at 12.9%, up from 12% the previous year. In the same quarter, the sudden decline of several banks made the public wary, after which the Federal Reserve warned of a credit squeeze.

Predictions of recession raise concerns.

Predictions of a recession in late 2023 raise concerns that businesses will struggle to make loan payments. According to analyst reports, short sellers have been keeping a close eye on real estate investment trusts in recent months. So, where's the cave-in? Analysts say the big downturn in commercial real estate (CRE) values is likely to be a long slide. The decline in CRE will be "consistent," Crosby says. She says, referring to banks' preference for extending nonperforming loans rather than writing them off, "it's the old 'defer and pray' tactic. "

Rents continue to rise, but the situation varies

Office rents continue to rise in many cities despite vacancies, a situation that varies widely from city to city. According to a report by commercial real estate company JLL, office rents nationally rose 0.3% between the final months of 2022 and the first quarter of this year. However, rents rose faster for luxury buildings in desirable locations, with some markets including Charlotte, Nashville and Orange County, California, setting record deals, according to JLL.

Financing commercial real estate is not a problem

Financing commercial real estate is also not a problem. Commercial real estate loans are at an all-time high of $2.9 trillion as of May 2023, according to a report from the Federal Reserve Bank of St. Louis. Over the past year, commercial real estate loans have grown by about 10%. Banks are prepared to handle a potential economic downturn. The Federal Reserve says all 23 banks that passed its annual stress test showed they could withstand a serious recession. These institutions hold about 20% of all bank loans for office and commercial real estate in the downtown area. Stress testing predicted a level of losses "three times the levels reached during the 2008 financial crisis," according to the Federal Reserve. The test results, released June 28, showed that "although large banks would suffer significant losses in a hypothetical scenario, they would still be able to continue making loans.

Office space is most vulnerable

The recession is still expected and office space is most vulnerable. Despite the lack of commercial real estate collapse, many observers still expect a downturn. Commercial real estate and investment services firm CBRE predicts that the Federal Reserve's interest rate hikes aimed at curbing inflation will lead to a recession later this year, which in turn will reduce investment and real estate leasing. "The fall will be gradual and uneven," CBRE says in its latest forecast. "The economy should stabilize by early 2024, but the effects of the downturn on real estate will be felt until job growth resumes. "

Banks are already starting to write off defaulted loans

Banks are already starting to write off defaulted commercial real estate loans. The level of charge-offs indicates the direction of the market as it means that borrowers cannot afford to repay their loans. In the first quarter of 2023, the delinquency rate is 0.95%, according to CFRA Research. That's down from pre-pandemic levels of 1.01 percent in the first quarter of 2020, but, according to Kenneth Leon, director of research at CFRA Research, in a June report, "these rates are expected to deteriorate further in the second half of 2023 with a weaker U.S. economy. "

The unpredictable future of office space

The fate of office space is uncertain as new buyers emerge. As a result of Covid, some employees are returning to the office, but hybrid and remote work remains. Companies like JPMorgan Chase send employees to work in person, while others like Amazon and Apple require them to be in the office only part of the time. As a result, "the future of traditional office space is uncertain," says NAR in its April 2023 report. Therefore, property owners are looking for creative ways to utilize their vacant office space. NAR noted that universities have expressed interest in leasing office space to attract students back to the classroom. Some office buildings are being turned into apartments or apartments, although renovations are difficult and inflation has raised costs. However, Crosby says, converting office space into housing doesn't always solve the problem because demand for these units depends on employees returning to work and wanting to live nearby.

Some buyers are ready to get into the game

Despite the challenges, some buyers, albeit at a discount, are willing to join the game. Even moderate demand can mitigate the impact of a recession. "I've had sellers who turned down my offers a year ago and are now considering the exact same offer," says Dutch Mendenhall, founder of RAD Diversified REIT. "Six months from now, it will start to be a real optimal time to buy office space. "

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