The current vulnerability of Commercial Real Estate is much more of a classic bank credit problem, than what brought down SVB, Signature, et. al. There are two parts to it.
The first problem is rising interest rates.
Many (not all) loans on income-producing commercial real estate have maturities substantially shorter than their amortization schedules. For example, 25-year amortization / 5 year maturity. So on day one, both the borrower and lender expect to refinance at the 5-year maturity.
Also, most (not all) of these loans are floating rate. Used to be based off LIBOR. Say, for example, 90-day LIBOR + 2.5%. But that's out now, and it's another consensus rate not as prone to manipulation as LIBOR was.
Regardless of the base rate, if the banks were smart, they'd have been working hard to sell the borrower on purchasing fixed-for-floating interest rate swaps to hedge the risk of rising interest rates. During the unusually long reign of unusually low interest rates, these swaps were cheaper than ever before in history.
So contrary to popular belief, derivatives are not inherently evil. This is a great example of how, used correctly, derivatives can reduce the risks faced by both banks and borrowers.
Sadly, that window of really cheap risk management has closed. While interest rate swaps are still available, they're now much more expensive. And with interest rates on the renewal being materially higher than for the original loan, the debt service is going to be a lot higher, putting stress on the landlord that is compounded by the second problem....
The second problem is a bit stickier: Vacancy rates, especially in the Class A Office Space / Central Business District arena, are high and rising. This troubling trend got its start in the work-from-home arrangements that started during the pandemic.
It has, however, continued after the pandemic waned for a variety of reasons:
- People like working from home and employees are resistant to going back to the office.
- In many cities, the CBDs are no longer as attractive to workers due to the perception of elevated rates of crime, homeless camps, open drug use, etc. I don't know if those perceptions are accurate or not. But it really doesn't matter. A lot of office workers are really resistant to going back to the office, and it's a factor in the resulting vacancy rates.
- Technology allows not only work-from-home, but also so-called "hoteling." That's where you no longer have an assigned office, but rather a floor full of work stations where you come in a couple of days a week. You just grab one that's open that day, and work away.
Since because only 40% of employees are in the office at any one time, the employer needs less than half of the space it once did. And it doesn't necessarily need the quality of finish. End result? More vacancy.
Right now, a lot of employers are operating under leases signed before the pandemic, and so before work-from-home and hoteling changed their needs. They still have to pay for the contracted space even if they don't actually occupy it.
But commercial leases are typically 5 years. Maybe longer if the tenant does some extensive build-out. Regardless, those things are going to be expiring soon, and the lessees won't likely renew for the amount of space they currently have.
Technology was already reducing demand for this space. But it was a slow wave, and the industry was adjusting just fine.
Then the pandemic and resulting domino effects created a massive and totally unforeseeable acceleration in the rate of disruption for the Class A CBD Office Space market...kind of like what the cell phone did to land lines. It's going to take a while for that to shake out, and it's likely to get ugly.
I'm a bit concerned about some other types of CRE (retail), but not nearly to the degree I am for Class A CBD office space. As other posters have said, there's a reckoning coming for that.
