How empty are offices in major cities? Not everyone agrees on the exact numbers, but vacancy rates fall between 15% and 19% nationally. Numbers from JLL Research pegged the national office vacancy rate for metro cities at 18.7% at the end of 2022. San Francisco’s was the highest at 26.4%. (See chart.)
The weekly worker occupancy report from Kastle Sytems, a building-access swipe card provider, shows the number of workers in offices in the 10 largest U.S. cities plateauing at about 49% the past few weeks.
All this matters because it reveals and affects the economic health of major U.S. cities, work location trends, and, given recent regional bank problems, the state of commercial real estate financing.
Of particular concern are the commercial real estate (CRE) loan books of regional and smaller banks. Banks financed about 46% of office and retail CRE credit in the last few years, amounting to about $714 billion, according to data from the Mortgage Bankers Association. Bank lenders are behind more than 50% of the loans scheduled to come due in 2026 and 2027, according to data from Alexis Maltin of MSCI.
Will there be a sudden collapse in office real estate that prevents refinancings and leads to massive liquidations and severe market stress?
How these problem loans are resolved will depend on the idiosyncratic condition of the properties, the economic condition of their locations, and the interest rate environment down the road. — Tracy Chen, Brandywine Global
The level of distress will depend on where things go from here, experts say.
In BofA Securities’ first quarter property sector review published on May 19, the research team said recession fears could accelerate workers’ return to offices. However, a recession could also reduce the need for a large office footprint, causing rent growth to stagnate as “leases are not renewed … or are renewed for less space.”
There is a moderating effect, however, according to JLL Research’s first quarter 2023 Office Outlook report. A typical office tenant’s rent obligations [comprise] 10% to 15% of employee payroll costs.
While firms can limit space needs by instituting hoteling or desk sharing, “there are limits to how much space can be saved and tradeoffs for the employee experience and benefits of in-office attendance when these policies are implemented,” according to the report. “Many companies may be compelled to continue investing in premium office space and resist hoteling employees to promote recruitment and retention.”
Undoubtedly, the shift to work-from-home and hybrid work arrangements will produce losses for credit providers in the CRE market.
To estimate base-case losses in the office loan sector, Tracy Chen of Brandywine Global Asset Management assumes office vacancy rates will increase another 10% to 20%. In an April 12 report, she projected potential losses would fall in the range of mid-to-high single digits over the next three to five years. (See chart, above.)
But they will not reach the 9% to 14% experienced during the global financial crisis (GFC) due to the better underwriting on current loans, price appreciation, and lack of distressed sellers.
Chen expects to see loan extensions, modifications, and debt restructurings, noting that during the GFC, “ servicers granted many loan extensions to borrowers facing difficulty refinancing.”
Ultimately, however, “how these problem loans are resolved will depend on the idiosyncratic condition of the properties, the economic condition of their locations, and the interest rate environment down the road,” according to Chen.
According to BofA Securities, “newer, trophy buildings are likely to continue to garner the majority of tenant interest in most markets, cannibalizing demand for older, lower quality buildings. … While some better-located buildings may be able to be successfully repositioned or liquidated with a minimal loss, others will suffer considerably greater degradations in value.”
