Commercial Office – What Happens Next?
Posted By: DBUSINESS on September 11, 2023. For more information, please click here to read the source article. Written by Peter D. Cronk & Jeanna M. Weaver, Partners at Plunkett & Cooney
Predicting the future of the U.S. commercial property market is never easy. Fortunately, research conducted by industry thought leaders provides key insights that should help lenders better position themselves for the murky future ahead.
The last Commercial Buildings Energy Consumption Survey conducted in 2018 by the U.S. Energy Information Administration found that 97 billion square feet of commercial real estate space existed in the U.S., approximately 16% of which is commercial office.
According to a recent article by J.P. Morgan Chase, $1.5 trillion of commercial real estate debt will mature before the end of 2025. In the CMBS market alone there is approximately $185 billion in commercial office debt, 20% of which is predicted to default.
It is hard to predict where the biggest trouble will lie, but since the pandemic, suburban office space has recovered at a faster pace than urban markets. In the third quarter of 2022, vacancy in suburban offices was 11% compared to 18% for Central Business District offices. In addition, Class A properties, which are often newer and may include energy efficiency enhancements, access to outdoor space, fitness facilities and state of the art technology are doing better compared to their Class B (or C) counterparts. According to the same J.P. Morgan Chase article, nationwide, Class A vacancy was 18% and Class B vacancy was 20.2% at the beginning of 2023.
Overall, the U.S. commercial office market is experiencing a 20% vacancy rate. Detroit is faring slightly better (19.3%) than cities like Chicago (23.5%), Indianapolis (22.4%) and Columbus (21.7%), but it’s likely vacancy rates will continue to increase due to several factors, including sublease expirations and “shadow space.” According to Michigan commercial brokers, available subleases have experienced a dramatic rise with available sublease square footage in 2023, which is anticipated to double the available square footage of 2022.
A statistic that hasn’t received much attention previously, but is important now, involves “shadow space,” space that is currently under lease, but not available for sublease, and is not being utilized by the tenant. According to research conducted by global real estate services provider Cushman & Wakefield, shadow space makes up approximately 20% of commercial office space. With a 20% vacancy rate, shadow space of 20% and fast-growing sublease availability, the commercial office market is at a significant turning point.
With higher capital costs, declining occupancy and a tight or nearly non-existence lending market for commercial office, many owners are reluctant to put more money into their properties.
Lenders are cautious to take assets back, preferring to work with borrowers and return the loans to performing status. But few borrowers have sufficient capital to contribute to obtain lender approval for an extension, loan modification or forbearance arrangement. While some lenders may return to the “extend and pretend” strategy from 2008, others are focused on declining office space values. These lenders, for example, may be willing to take a property back now and incur a $5 million loss rather than give the borrower a two-year extension and take the property back at a $15 million loss.
There’s also increased interest from investors considering loan or REO property purchases from lenders, but pricing expectations are not always aligned with investors seeking larger discounts than lenders are willing to offer. A recent study by Columbia University and New York University projected office values could decline over 40% of the pre-pandemic value by 2029.
What happens next is not going to be pretty for many property owners or lenders, but conditions might present an opportunity for those willing to invest at a discount or repurpose or improve their property.
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