Inflation Eases, but Is the Damage Done for Commercial Real Estate?

What you'll learn in this article:

• Easing inflation contrasts with declining commercial real estate values.
• Significant property value drops and high debt levels are impacting landlords.
• Rising vacancy rates and increased borrowing costs are stressing the sector.
• Tenants should review leases as market conditions and property management may worsen.

In June 2024, the U.S. Consumer Price Index (CPI) came in lower than expected at 3.3% year-over-year, compared to the anticipated 3.4%.

The monthly CPI saw a modest increase of 0.2%. This marks a dramatic reduction since the surge in 2022, which reached generational highs above 9%. The dropping numbers reflect a continued easing of inflationary pressures.

At the same time, the Federal Reserve's ongoing efforts to stabilize prices occur against a backdrop of widespread instability and distress in the commercial real estate sector.

By the end of 2024, $900 billion worth of real estate loans and securities, primarily issued at rates much lower than current ones, are set to mature.

If sufficient recalibration isn’t taken, we could witness major trouble because, while inflation stands a 3.3%, commercial property values are in a complete and utter recession.

Learn how to survive a post-pandemic Office market in our new book, Surviving the Office Apocalypse.

Property Values Down

While inflation is sticking close to 3%, Green Street’s Commercial Property Price Index (CPPI) highlights that commercial property prices have fallen by 7% over the past year and by 21% since their peak in March 2022.

This significant disparity indicates that while inflation is somewhat under control, CRE values are in a severe downturn.

Of course, this varies by industry. While the office sector sits around a 19% average vacancy nationwide, the industrial sector is around 5%. 

Property devaluation in office space is rampant, reflected by several fire sales of major office towers and/or the prolonging of sales through extend and pretend.

Sales now often see the owner taking quite a significant loss from the building’s original purchase price. And what’s unfortunate is that often these sales can’t even take place because there are no buyers.

For example, major landlord, Shorenstein properties, which has accrued $19B in assets since 1992, was forced to relinquish ownership of Capella Tower to its lender, Metropolitan Life Insurance.

This comes after an unsuccessful search for a suitable buyer for the second-tallest tower in downtown Minneapolis last week.

In 2018, the company purchased the 58-story building for $255 million. However, a more recent assessment by the Star Tribune valued the tower at just under $197 million.

Massive Amounts of Debt

This situation is only the beginning. According to a Bisnow analysis of the Morningstar Credit securitized loan database, the San Francisco-based firm faces an additional $822 million in defaulted or at-risk debt associated with large office properties nationwide.

And this is only under the breadth of one landlord. With this context, the nearly $6 trillion in outstanding commercial real estate debt isn’t too hard to fathom. And just to make the image clearer, U.S. banks are holding approximately half of this total on their balance sheets.

The hurt of property devaluation is felt more acutely in some areas of the country. For example, in San Francisco, vacancy rates are currently up to 35%. However, with the current occupancy rate below 50%, it doesn't take a genius to see that vacancy rates will catch up, hitting the 50% mark. This is a catastrophic level of vacancy. 

And when we talk about the fall of San Francisco, we have to mention that the real estate royalty, Shorenstein controlled 25% of San Francisco's Class-A office space in the mid-1980s.

So as these cities fall, they take down the titans who most economists would bet are too big to fail. They are taking on unprecedented amounts of debt, along with them other notable landlords Charles Cohen, who has amassed $1 billion in defaults, and Aby Rosen, who is contending with a $2.5 billion debt obligation.

Not to mention that commercial loans are non-recourse. Landlords can default without additional financial obligation beyond the property itself, effectively passing the financial buck onto the banks.

Now, the decision by the FED to not cut rates significantly heightens borrowing costs, casting a shadow over an already struggling sector. As office property values plummet, the collateral supporting CRE loans weakens, drastically increasing the risk of further defaults.

This scenario complicates the refinancing process, with tighter lending conditions and escalating financial stress. This scenario not only threatens to unleash a wave of distressed assets but also could precipitate a broader financial instability, making the outlook for CRE pretty grim.

Bank Bailout on the Horizon?

It also puts us on the precipice of an environment where the broader economy has to shoulder the severe drop in commercial costs. Because small and regional banks are already holding more 2.7 trillion in commercial real estate debt, according to Columbia Business School.

Analysis by the Klaros Group underscores the gravity of the situation, finding that 282 out of 4,000 U.S. banks face the dual threat of CRE loans and potential losses tied to higher interest rates. Read: Is a Bank Bailout in Our Future?

Stable Labor Market

On top these other conditions, the contingency for the FED to only unleash one rate cut this year is that the labor market has to stay steady.

The June unemployment report, however, painted a more complex picture. With unemployment claims rising to their highest level in ten months and the jobless rate increasing to 4%, the labor market's stability is in question.

Higher-than-expected jobless claims, which reached 242,000 compared to the projected 225,000, suggest potential turbulence ahead. This uptick in unemployment claims could be an early indicator of broader economic challenges, which may complicate the FED's strategy to balance between promoting maximum employment and controlling inflation. If the labor market continues to show signs of weakness, it could derail any success the country has had with moderating inflation. Then a recession is more than just a possibility.

And in consideration to the office market, any layoffs will further complicate the low occupancy crisis.

Layoffs exacerbate low occupancy issues in commercial real estate by reducing demand for office space as companies downsize and shift to remote work models. Financially strained businesses are less likely to invest in or maintain large office spaces, and economic uncertainty makes firms cautious about long-term leasing commitments.

Simultaneously, with fewer employees requiring physical office space, companies may reduce their real estate footprint. his results in higher vacancy rates and diminished demand for office properties.

So, when the uptick in unemployment claims not only threatens the stability of inflation but will undoubtedly ripple through other sectors, it is certainly something to keep an eye on.

Takeaways for Tenants

While the FED has maintained a wait-and-see, data-dependent approach, the only thing for the country to do is watch to see how the situation evolves.

But for corporate tenants, there has never been a more important time to review your leases. 500 million additional square feet of net rentable area (NRA) in office and mixed-use properties backed by commercial mortgage-backed securities (CMBS) are expiring over the next five years. And with low office demand, it’s unlikely that they will all be renewed.

If landlords can’t maintain occupancy rates, they aren’t maintaining the same level of income. This will undoubtedly lead to a drop in services, whether it’s still under their ownership, or if the property goes into receivership. Because the first priority of the owner is to pay the taxes and the mortgage. All other bills come in secondary. Unfortunately, this usually negatively affects the tenants most.

So, this is where due diligence comes in as a critical tool. There are techniques to survive this new leasing environment. To learn all the tips are tricks taken by True Tenant Reps to safeguard the leases of the corporate tenants they represent, download Surviving the Office Apocalypse. You will receive invaluable insight on how to navigate a commercial real estate sector on the brink of a recession from the tenant’s optimal point of view.