Commercial Real Estate is starting to show cracks, as a number of negative factors converge. A rapid increase in rates came at investors fast and now the bill is coming due.

What that amounts to is a $1.5 trillion “Wall of Debt” is coming due by the end of 2025. $270 billion is maturing in 2023, an all-time record year for loan maturations.[1]

For context, $1.14 trillion was invested in commercial real estate in total in 2022.[2]

The beginning of that “wall of debt” is starting to come due this October and it will need to be refinanced at far higher interest rates.

The interest rates on these loans varied, based on the amount and the balance sheet of the borrower, but they were all taken out during a ZIRP environment. For example a 10 year commercial SBA loan taken out for out in September 2013 at 4.8% is now over 7%, and rising.[3]

So refinancing is going to take place at rates upwards of 50% higher. Compounding these problems for borrowers, vacancy rates have sky-rocketed in office buildings as Covid transformed the way we work.

San Francisco, New York, and Austin, have seen office vacancy rates go up 19.8 percentage points (up to 24.8% vacancy for SF office space), 14pp, and 14pp respectively from 2019 to 2023. Nationwide, the office space vacancy rate is just below 20%, compared to 11% in 2019.[4]

It all goes back to supply and demand

Commercial real estate investors are getting squeezed by both sides - interest payments and revenues.

This double squeeze has implications across the board:

• Defaults may go up as lower revenues dip below higher interest payments, increasing supply in the market
• Real estate investors may pull back on new investments/developments as they become increasingly strapped for cash, decreasing demand
• Banks reeling from potential loan losses, and worried about a higher risk of default, will tighten their criteria for lending meaning fewer loans and/or increase risk premium, decreasing demand further

So there is a scenario where demand decreases and supply increases dramatically.

We’ve already seen a slow down in commercial real estate loans since rates have moved up.

Demand has slowed dramatically since 2021 but still isn’t far off the past decade mean.

As factors converge, the change in supply and demand could depress commercial real estate prices dramatically. Morgan Stanely “estimates office and retail property valuations could fall as much as 40% from peak to trough.”[5]

We’re already seeing delinquencies uptick slightly since the Fed began raising interest rates (from .65% in Q3 2022 to .84% Q1 2023), but we haven’t seen an uptick in delinquencies anywhere near the debt-driven real estate crisis of 2008 or the overbuild-driven pop of the early 90s. There are cracks, but we haven’t yet seen a shattering.

Thinking about the broader risks

Increasing defaults, tightening credit, falling real estate demand, and ultimately a lowering in real estate prices are all risks to the economy. Kalshi has recently listed a number of economic markets directly related to real estate, ranging from will commercial real estate defaults go up to what rental prices will be to what interest rates will be, to help hedge the many risks this dynamic represents. In addition, there may be some distant-but-connected second and third-order risks that may impact the economy at large.

A real-estate-driven contraction could have significant impacts on the broader economy. For example, local and regional banks have increased their investment in commercial real estate, while government agencies have proportionally decreased their investments in recent years.[6] What will those banks do if they need to take over commercial real estate properties that are 60% of the value of the loan? Banks are already trying to sell their loans as pressure mounts.[7]

It’s important to bring up the counterarguments here. There are some who bring up the valid point that this debt wall has been known about for a while, and there are investors waiting to jump at the opportunity to purchase distressed real estate. The replacement costs of these buildings are also extremely high, as there’s a nationwide dearth of construction workers[8] and inflation raises the cost of raw materials, meaning the chance of being undercut by new builds is lower. Those who have a healthy balance sheet and a long time horizon may be able to take advantage of the opportunity, and potentially help the economy stave off a true real estate crisis.

It’s hard to know how the chips will fall. If there is a true commercial real estate debt crisis, the second-order effects will ripple through an already over-indebted economy.

1. https://www.bloomberg.com/news/articles/2023-04-08/a-1-5-trillion-wall-of-debt-is-looming-for-us-commercial-properties // https://www.costar.com/article/1420057123/next-12-months-pivotal-for-commercial-real-estate-debt-maturities // https://rebusinessonline.com/turmoil-in-bank-sector-causing-frayed-nerves-as-banks-approach-debt-wall-says-trepp/
2. https://www.fool.com/research/commercial-real-estate-investing-statistics/#:~:text=The%20total%20dollar%20volume%20of,from%20%241.43%20trillion%20in%202021.
3. https://nedcoloans.org/historical-rates-year/
4. https://www.nytimes.com/2023/05/05/nyregion/nyc-office-space-vacancy-rates.html // https://www.statista.com/statistics/194054/us-office-vacancy-rate-forecasts-from-2010/
5. https://www.bloomberg.com/news/articles/2023-04-08/a-1-5-trillion-wall-of-debt-is-looming-for-us-commercial-properties
6. https://www.bloomberg.com/news/articles/2023-04-08/a-1-5-trillion-wall-of-debt-is-looming-for-us-commercial-properties
7. https://www.bloomberg.com/news/articles/2023-07-14/jpmorgan-eyes-sale-of-loan-on-struggling-manhattan-office-tower#xj4y7vzkg // https://markets.businessinsider.com/news/stocks/commercial-real-estate-debt-crisis-credit-crunch-bank-loans-default-2023-8
8. https://www.nccer.org/newsroom/the-greater-impact-of-the-construction-labor-shortage-examined/

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