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Signs of stress in the commercial real estate sector are now coming thick and fast. This month investors have been spooked by exposures on CRE loan books at lenders including America’s New York Community Bank, Japan’s Aozora and Germany’s Deutsche Pfandbriefbank. The US Treasury secretary Janet Yellen also last week raised concerns over the impact of falling property valuations on the banking system.
Although interest rates are expected to come down this year, the sector remains in a tight spot. An estimated $1.2tn of US CRE debt is maturing in the next two years, according to the Mortgage Bankers Association. Commercial property values have already fallen steeply, and since rates are unlikely to return to previous lows any time soon, developers will still face higher refinancing costs. Meanwhile, increased remote working has hit demand. Office vacancy rates remain well above pre-pandemic levels in cities across the US, Europe and Asia. Loan delinquencies and distressed sales are set to climb.
Regulators are right to monitor the ongoing risk of fire sales and hidden exposures among private lenders. But a widespread contagion through the global banking system seems unlikely. Capital buffers, oversight and loan transparency, while far from perfect, have all improved since the 2008 financial crisis. Some forbearance in contract negotiations and opportunistic investors looking for discounts will also provide a cushion. Instead of a short, sharp shock, a long period of painful adjustment is in store.
As homeworking patterns persist, retail and office buildings in big urban centres will be hit particularly hard. Projections by McKinsey suggest demand for office space will remain below pre-pandemic levels for decades, with at least a 26 per cent drop in the value of office space by 2030 across major global cities. Businesses are already downsizing into higher-quality spaces, and are also redesigning offices. Vacant buildings may lay idle for long periods, and others could be abandoned entirely. Economic activity in some city centres, such as San Francisco — which has a concentration of tech workers — risks being hollowed out.
Urban authorities are not powerless. They can help extract more value from buildings by supporting their repurposing. Office-to-residential conversions are one option, which can also help offset national housing shortages. Mixed-use spaces are another. One Wall Street, in Lower Manhattan’s financial district, for instance, has been redeveloped into condos.
Flexing building use can help revamp cities, cushion price falls and reduce the risk of stranded assets. By avoiding the destruction of entire structures, it is environmentally friendly too. But even with falling prices, it remains costly. Real estate businesses also often cite complicated planning systems, strict zoning laws and building regulations as other factors hindering redevelopment across cities. This is where city authorities can play a facilitating role.
Planning rules and processes should be made more flexible to encourage and speed up repurposing efforts, without compromising building standards. Municipalities can also help by convening with developers, architects and planners to ascertain what is possible, and what additional infrastructure may be needed. The City of London told the Financial Times this week that it would be “flexible” in supporting developers to meet requirements. Imagination is important too: a corporate auditorium could become a cinema by night, while urban labs can support new research districts.
Many buildings will remain unconverted. There are architectural obstacles, and demand depends on neighbourhood quality. But opportunities to eke out affordable living spaces and other commercial activities should form part of urban regeneration plans.
If authorities want to sustain the dynamism of their cities, they must become more agile. The CRE market is resetting. By enabling more buildings to be repurposed, that transition can be made less painful for lenders and investors — as well as urban areas themselves.
