Rising interest rates, tighter credit, telecommuting are all weighing on commercial real estate
Rising interest rates, the banking crisis and the pandemic’s lingering impact on labor agreements have dealt a triple whammy to the commercial real estate industry, leading some economists to believe the $5.6 trillion industry could become the next cause of a financial crisis.
Commercial real estate transaction volumes fell 65% year over year in the first quarter of 2023, Goldman Sachs wrote in its latest report on CRE lending conditions. Yield spreads on commercial mortgage-backed securities (CMBS), a proxy for funding costs and ease of credit, are at their widest in years and now far exceed spreads on high-yield corporate bonds.
The report’s authors forecast a challenging environment for the commercial real estate industry for the remainder of 2023 and expect a further decline in transaction volumes as “general financing conditions will remain challenging.”
Already, the loss of access to credit can be seen in the struggles of landlords to service their CMBS debt. The Trepp CMBS Special Servicer Rate, which tracks delinquent CMBS assigned to special servicers, rose for the third month in a row to 5.62%. Six months ago it was 4.97%. Office properties and a housing portfolio were among the biggest transfers in April, Trepp said.
Meanwhile, banks have also become more conservative in their lending practices amid recent turmoil in the banking sector following the collapse of Silicon Valley Bank, Signature Bank and First Republic Bank, the latter of which was subsequently sold to JPMorgan Chase (JPM).
Small and regional lenders, which were hardest hit by the recent crisis, represent a disproportionate share of CRE lending and have the largest exposure to the industry. Lenders with less than $250 billion in assets account for 80% of commercial real estate loans, according to Goldman Sachs.
The shares of banks such as Western Alliance (WAL), PacWest Bancorp. (PACW) and Zions Bancorp. (ZION) have been under pressure since the beginning of the year.
Since last March, the Federal Reserve has raised interest rates at the fastest rate in four decades, raising the benchmark federal funds rate by a cumulative 5% to the highest level since 2007. Higher interest rates have led to higher borrowing costs, cooling the demand for new investments and this leads to a drop in real estate prices in recent months.
At the same time, enduring remote and hybrid work arrangements mean workers haven’t returned to the office in large numbers. The U.S. office vacancy rate stood at 12.9% at the start of the second quarter, down from a pre-pandemic low of 9.4%. That’s just above the level it was in 2010, the year after the global financial crisis. Meanwhile, the percentage of office space available for rent, a measure of availability tracked by CoStar Group Inc., hit an all-time high of 16.4 percent.