Related Links

• Out of the Office, Into a Financial Crisis?, Econ Focus
• Financial Stability Report, Federal Reserve Board of Governors

Transcript

Tim Sablik: Hello, I'm Tim Sablik, a senior economics writer at the Richmond Fed. My guests today are Borys Grochulski, a senior economist at the Richmond Fed, and John O'Trakoun, a senior policy economist at the Richmond Fed. Borys and John, thanks for joining me.

Borys Grochulski: Hello, Tim. Thanks for having me on the podcast. I'm a longtime listener, first-time caller.

John O'Trakoun: Hi, Tim. Great to be here as always.

Sablik: Today, we're going to be discussing what's going on in the commercial real estate market, particularly when it comes to offices.

Offices have gone through a tumultuous few years. The pandemic shifted many workers out of the office to the home. While companies have been gradually bringing workers back to the office, overall occupancy levels in office buildings remains below where it was before the pandemic.

This has raised a lot of questions about the future of the office. Will companies permanently reduce their office space needs? If so, what does that mean for the owners of empty office buildings? I wrote a piece about this in our latest issue of Econ Focus magazine. We'll include a link to that on the show page.

One thing that struck me as I was writing that story is that it's tricky to get a clear picture of office demand. John, what indicators are you looking at, and what picture do they paint for offices and the commercial real estate sector in general?

O'Trakoun: Well, Tim, I've also got to put in a plug for your Econ Focus article. Great stuff.

Sablik: Thank you.

O'Trakoun: In it, you cover some of those office demand indicators being produced by a number of different organizations.

One of the big ones we look at is the office vacancy rate. That's the share of office space that's available to rent in any geographic market. There are several sources producing these indicators, but one measure from REIS puts the national office vacancy rate at 19 percent in the first quarter of 2023. That's the highest in data that goes back to 2005. Higher vacancy rates indicate lower demand, so this recent rise in vacancy is discouraging. Also, it could be understating how bad things actually are because some of the office space currently being rented out might not actually be fully utilized.

Commercial real estate investors will also look at net absorption, which is the difference between the square footage that people are moving into and the square footage that people are moving out of. When this measure is negative, it means that people are downsizing their office space or moving out of offices altogether. In the worst-case scenario, that could be a signal that some companies are going out of business or laying off workers. As of the first quarter of this year, net absorption has been negative for two quarters in a row.

Another measure you can look at is new office completions, which relates to the pace of building and the supply of office space coming online. This kind of activity represents a long-term investment, so it reflects how optimistic office builders are about the future. In the first quarter of 2023, we saw just under 4 million square feet in office completions across U.S. metro areas. That's the lowest it's been since the first quarter of 2013.

Altogether, these indicators are pointing to a gloomy picture for office demand and its near-term prospects.

But office is just one part of the commercial real estate sector, which includes things like apartments, retail space, industrial, storage, and hotels. It's not all terrible news across the board. Some of those segments like industrial still look like they might be doing okay, based on what these indicators look like in those segments.

One of the things a commercial real estate lender would be tracking is the capitalization rate or the "cap rate" for short. It's the rate of return that you could expect to get from owning a commercial real estate property. Although it sounds like a higher cap rate would always be better, the cap rate can also go up if the investment becomes really risky. That might be what we're seeing now. In data from Real Capital Analytics, the three-month average cap rate was 7.5 percent, the highest since the second quarter of 2011.

Sablik: Thanks for that overview.

Another issue that's part of this is the fact that, like most residential homes, offices are typically financed through loans. Office building owners are potentially facing a double whammy of the reduced demand from tenants, which you talked about, and higher interest rates to refinance loans.

John, what does the office loan market look like right now? Are you seeing any signs of increased distress?

O'Trakoun: Yeah, lending for office developers has been harder to come by. Borrowing rates have risen in line with the Fed's rate hikes and we hear stories from our District's business contacts that some loans for construction and development are just impossible to get.

Banks are becoming stricter in their lending standards. In the Fed's Senior Loan Officer Opinion Survey for the third quarter, a net 68.3 percent of respondents said that they had tightened credit standards for non-farm, non-residential properties. (That includes office.) That's the second-highest tightening score in the data, just under the COVID crisis in the third quarter of 2020.

These banks are also reporting that demand for loans backed by non-farm, non-residential properties is shrinking. With quarterly loan demand shrinking for five straight quarters now, the sharpest demand contraction happens just last quarter, the second quarter of 2023.

The good news is that, so far, across all commercial banks, delinquency rates of commercial real estate loans are still low and borrowers are still making payments. According to Fed data, the delinquency rate was 0.76 percent at the first quarter of this year. That's historically low, especially when you compare it to the almost 9 percent delinquency rate we saw following the Great Recession.

However, we have been seeing a rise in delinquencies for the office segment of commercial mortgage-backed securities. So, we still have to be vigilant about rising fragility.

Sablik: Yeah. On that topic, banks are often the ones making commercial real estate loans. Some market observers worry that if defaults on office loans start to rise, that could trigger a broader financial crisis. Borys, how important are commercial real estate loans — and particularly office loans — for bank balance sheets?

Grochulski: CRE [commercial real estate] lending does make up a significant portion of bank credit. In Federal Reserve data as of July, the total amount of credit extended by banks was approximately $17.25 trillion. CRE loans stood at a bit less than $3 trillion, a bit less than 17.5 percent, which is significant.

But CRE loans backed specifically by office buildings made up only about 11 percent of all CRE bank lending. That's approximately $330 billion, which is less than 2 percent of all outstanding bank credit. For comparison, commercial bank funding for residential housing — directly through mortgages and home equity lines of credit as well as indirectly through holdings of mortgage-backed securities — amounts to $5.1 trillion. That's 39 percent of all outstanding bank credit.

So, overall, I'd say the banks' exposure to office credit is small, which is not to say that some small or regional banks may not have significant exposure, particularly if their lending is concentrated in some of the more distressed locations like downtown San Francisco at the moment.

I think non-bank lenders are also worth mentioning here. They actually extend a bit more mortgage credit to office buildings than banks do. Non-bank lenders here include life insurance companies, mortgage REITs or real estate investment trusts, private debt funds, as well as investors holding mortgage-backed securities.

Sablik: Commercial real estate has been at the heart of some financial crises in the past, such as the S&L crisis in the late 1980s and, to some extent, the financial crisis of 2007 and 2008. Borys, how does the current situation compare to those past episodes? Has the banking system become more resilient to these kind of shocks?

Grochulski: To a large extent, Tim, both these crisises were driven by distress in the residential mortgage markets. At present, residential credit quality and funding stability are good. So, the scenario in which we see a negative spillover from residential to commercial lending is, in my view, unlikely.

As far as the negative impact of lower office valuations on banks, I don't think that impact is significant in the aggregate right now because of the small share of office bank lending in overall bank credit. It is also worth mentioning that the loan-to-value ratios in commercial lending are, on average, 65 percent. So, it would really take a huge devaluation of office buildings — 35 percent on average — for these properties to go underwater.

I think the probability of a recession in the next year or two — an overall decline in real GDP activity — is the most important factor for the banking sector right now. The market measures of that probability, although still elevated, appear to have been easing over the last few months.

Beyond banks, however, lower occupancy rates and valuations in office and other commercial real estate have a negative impact on local government tax revenues, and on cities in general. In the scenario in which large businesses move their office locations out of central business districts into suburban areas — which is what we see a lot of right now with the hybrid, work-from-home model — smaller businesses like restaurants follow. This movement of activity out of city centers erodes the tax base in some cities like San Francisco, to use this example again, which is certainly a concern for these localities.

Sablik: Do we have any sense yet of where the office market is heading? Do things seem to be getting worse or better?

O'Trakoun: Well, things are certainly in flux now and there's a lot of uncertainty. My best guess is that office will continue to be under a lot of pressure in the near term as borrowers try to figure out with their banks how to get these financing deals that get them through this rough patch.

But I believe these pressures are going to ease over time. Once inflation gets back to target, for example, the Fed can bring back interest rates down to their long-run normal levels. And, office fundamentals will become more favorable as companies reach an equilibrium on what their hybrid work environments look like. We're even seeing Zoom bring its employees back to the office on a part-time basis.

Grochulski: I agree with John. In the meantime, we can expect some losses to be absorbed by equity positions. But I don't expect a huge wave of defaults on CRE loans.

Sablik: In the meantime, what is the Fed doing to ensure that the financial system is prepared for any additional or unexpected shocks in this space?

O'Trakoun: As part of the monetary policymaking process, the Fed regularly conducts a thorough assessment of vulnerabilities in the U.S. financial system. The staff of the Board of Governors gauges the level of risk coming from areas like valuation pressures, business and household leverage, financial sector leverage, and funding risk.

Commercial real estate and office risks feature prominently in these assessments. Part of the evaluation process involves running various risk scenarios of what might happen if office prices and commercial real estate prices more generally are hit with large negative shocks. This helps the Fed understand how prepared the U.S. financial system is to these potential downsides materializing and whether or not any actions or contingencies have to be put in place.

The Fed also produces a public Financial Stability Report, where it publishes these findings twice a year so that the public understands the Fed's views on the topic and can hold the Fed accountable. The latest report was released in May and another one's coming in November. They can be found on the Board of Governors website at www.federalreserve.gov.

Sablik: John and Borys, thanks so much for coming on to talk with me today about commercial real estate.

O'Trakoun: Thanks. It's been a pleasure.

Grochulski: Thanks very much, Tim.

Sablik: Listeners can find a link to my recent article on this topic as well as other related links on the show page. And if you enjoyed this episode, please consider leaving us a rating and review on your favorite podcast app.