Soaring commercial vacancy rates are looming threat to economy
Ask Americans how they feel about the economy, and you will largely receive uninspiring-to-sour responses. In fact, 63 percent believe that the economy is trending in the wrong direction. Meanwhile, the Biden administration is busily touting the purported successes of “Bidenomics.” Clearly, there’s a disconnect.
Sure, there are many triumphs to showcase—from the relatively low unemployment rates to the booming stock market. However, there are some growing financial storm clouds that are cause for concern, particularly related to the commercial real estate market: Landlords are struggling to repay their debts, which threatens overexposed lenders, but officials seem intent on burying their heads in the sand.
This reminds me of a popular internet meme in which a cartoon dog sits in a chair drinking coffee, while surrounded by mounting flames. As the fire consumes the room, the dog says, “This is fine.” Things were obviously not fine, and similarly, disregarding economic indicators and claiming things are fine is a disingenuous and possibly perilous policy.
The problem has been a long time coming. After years of over-construction, the United States has been left with a glut of commercial properties, but many remain empty due to technological and cultural changes. During the COVID-19 pandemic, employees began working from home in vast numbers—thanks to development of teleconferencing software and hardware.
When the pandemic lifted, many employees refused to return to the office—instead opting to continue teleworking. Further, economic circumstances have led some employers to forgo traditional big offices. Why shouldn’t they? Workers have proven to be productive at home, and relying on virtual offices can save employers tons of rent money.
The combination of these factors represents a witches’ brew that is afflicting commercial landlords and lenders. According to Moody’s Analytics, “The national office vacancy rate rose […] to a record-breaking 19.6%, shattering the previous record.” Vacancies in metro Atlanta aren’t quite as high, but still sit at a troubling 18.8 percent. High vacancy rates mean lower revenue, which is leaving commercial property owners in dire straits. In fact, office-space giant WeWork filed for bankruptcy protection last year.
As is the case with residential properties, many are not owned outright. Rather investors secured loans to purchase the commercial real estate. Yet with flagging demand, investors are increasingly delinquent on loan repayments. “Fitch Ratings projects the delinquency rate of commercial mortgage loans that have been converted into securities will increase to 4.5% in 2024 and to 4.9% in 2025—more than doubling the 2.25% rate in 2023 as of November,” reported the Wall Street Journal. As of last year, delinquent commercial property debt held by the six largest banks surged to $9.3 billion.
This is incredibly worrisome and places an extraordinary amount of stress on lenders. “The average reserves at JPMorgan Chase, Bank of America, Wells Fargo, Citigroup, Goldman Sachs and Morgan Stanley have fallen from $1.60 to 90 cents for every dollar of commercial real estate debt on which a borrower is at least 30 days late,” according to the Financial Times.
Even worse, many commercial property loans are now maturing. “Unlike home mortgages, whose principal is paid off over time, most commercial mortgages are interest only,” reads the Wall Street Journal. “That means that when the debt matures, the borrower has to refinance or pay off the principal.”
There are no good choices here. Because of the Federal Reserve’s attempts to rein-in inflation, interest rates have shot through the roof. So borrowers with maturing loans have to either contend with higher than affordable rates, paying off underperforming properties or finding another path. Various negotiated settlements are on the table, but one of the more creative methods of coping with decreasing vacancy rates while also ameliorating the housing shortage involves converting commercial properties into residential. It’s not a cheap or easy fix, but it’s a novel one. In fact, California has a new bill that would promote such conversions in San Francisco.
Either way, there will soon be a spate on maturing commercial property loans. In 2023, about $540 billion of commercial real estate debt matured, but by the close of 2027, that number will be over $2 trillion. This could impact myriad banks given that they hold around 60 percent of non-residential loans. Considering their limited reserves, defaults could prove detrimental to lenders and the rest of the economy.
United States banking institutions faced a crisis last year resulting in five bank failures. While this was limited in scope and largely unrelated to commercial real estate loans, it demonstrates that despite all of the regulations, banks can and do still fail. It remains to be seen whether or not we are sleepwalking into the next financial crisis. If we are, then expect government officials to slowly sip their coffee and claim that things are fine as the economy languishes around them.