WTF is going on with the Economy?!

WTF is going on with the Economy?! - The Commercial Real Estate Downrturn

WTF Economy Editors March 12 2024 · 6 min read
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Real estate is a massive part of the economy covering anything from land, to homes, to factories, warehouses, airports, shopping malls, you name it. For many of us, we most closely associate real estate with the housing market. This association makes a lot of sense since:

  • We live in some sort of home 
     
  • Many of us have “home ownership” as one of our financial goals 
     
  • In our lifetimes, we’ve experienced both the biggest housing crash and largest boom, all within a 15 year time span, and all while many of us were just getting our start in life.


Right now, if you’re only following the housing market, you’d think that real estate is an amazing asset with no weaknesses (put in something about wanting to buy) However real estate is more than just houses, and if you’re a commercial real estate investor, your view is likely far from rosy. Here’s why.

What is commercial  real estate? 


Commercial real estate (commonly abbreviated as CRE) encompasses any property where business activities take place. Some of the more common property types in this class include:

  • Office buildings
     
  • Coworking spaces 
     
  • Shopping centers
     
  • Business parks
     
  • Hotels and restaurants

Unlike with residential real estate where the majority of transactions are for owner-occupied houses (i.e. I buy my apartment to live in there), CRE depends on rents and leases to make returns. Renting commercial properties instead of buying them makes a lot of sense for businesses since:

  • Businesses can shrink and expand and will need to manage office or floor space efficiently. 
     
  • There’s a lot of volatility and uncertainty in private businesses, where companies can and do go out of business quickly.
     
  • Companies would rather spend their time and capital growing their business than purchasing the office or floor space.

The market for commercial real estate is enormous, only behind the bond and stock markets in terms of overall investment. Globally, CRE is worth 13.5 trillion USD as of the beginning of 2024.


How commercial real estate financing works 


Commercial real estate financing works differently than residential mortgages in a couple of different ways. First, CRE investors will borrow money for as little as a few of years up until two decades, whereas home buyers will take out loans for a minimum of ten years. This short cycle means that commercial real estate investors have to refinance their loans often, which exposes them to interest rate volatility.

Second, many of the loans in CRE function as “interest only.” Under this structure, the borrower only repays the interest due during the repayment period. However, once the loan ends, they’ll need to repay the entire amount borrowed (so the principal plus all remaining interest) in what’s called a “balloon payment.” 


Why is commercial real estate in trouble right now? 


Right now, CRE is in the middle of a “perfect storm,” brought on by a combination of the aftermath of the pandemic, new climate rules, and investors needing cash in other markets.

First, let’s look at the pandemic. COVID-19 had three major impacts on commercial real estate:

  • People stayed away from the office and many physical stores and restaurants for nearly two years, which created massive vacancies.
     
  • Work from home became culturally ingrained, with workers demanding at least a hybrid remote working policy, causing demand for office space to plummet. 
     
  • The economy rapidly went through a deep contraction followed by a robust expansion causing interest rates to drop and then climb at near unprecedented levels. 


As buildings emptied out, CRE investors were facing an existential crisis with rent income plummeting. However, as the economy came crashing down in March 2020, interest rates went down with it. Combined with government support, CRE investors were able to refinance their loans and renegotiate terms with tenants to stay afloat. 
 

That all changed in 2022 as inflation picked up, the economy grew, but workers stayed home and continued to shop online. The refinancing CRE investors made during the low interest period of 2020 started to expire. With demand for office space remaining flat and borrowing costs going up, the economics of owning and renting CRE started to show major cracks. These fissures only got wider in 2023, leading to the steepest price decline since the 2008 financial crisis. 
 

Second, real estate is a major contributor to global CO2 emissions, accounting for 37% of all output worldwide.  CRE in particular is carbon-heavy, with estimates that the sector is responsible for 20% of the United States’ overall CO2 pollution. Governments and policymakers are well aware of the threat CRE poses to the climate and have put strict standards in place for the sector to get to net-zero. Of course, getting there requires significant investment, particularly when it comes to renovating older buildings. The cost of doing so is only adding pressure to CRE’s already tense operating environment. 
 

Finally, there’s a sell off by some CRE investors right now who are in need of cash. As selling continues, prices go down, which harms valuations, making it even more expensive to refinance loans. 
 

What does that mean for the overall economy? 
 

With this news, it’s tempting to think we’re on the edge of a 2008-like event where the bottom falls out and the entire economy collapses. Thankfully right now, it doesn’t look like that will be the case.

For one, interest rates are likely to go lower in the coming months as inflation is back to near-normal levels. When interest rates go down, borrowing costs do, too, which will give prudent CRE investors some breathing room.

Second, the sector has priced in the decline in assets for a while now. Investors get into CRE through one of two ways: 
 

  • Private investment coming through private equity funds or other non-publicly-traded entities
     
  • Publicly-traded companies like Real Estate Investment Trusts (REITs) that trade on stock exchanges

The private side of real estate investment has likely weathered the storm already and have even started a new growth cycle. These firms can move relatively faster than their public counterparts due to a smaller shareholder pool and less reporting requirements.

Analysts believe that the publicly-traded sector is going through that adjustment now. They believe that as soon as interest rates decrease, they’ll be able to finish the bottom of the cycle and continue to grow again (since they depend in part on their share price for financing).

Finally, deal-hunters are on the prowl right now scooping up CRE properties at deep discounts. The Wall Street Journal recently wrote about how a former Warren Buffett protege is purchasing 3 million square feet (~ 278,000 m2 ) of office space in San Francisco for 30% of what it was worth just a few years ago. As CRE investors grab these deals, it will enable them to profitably ‘reset’ rents back to their current market rate.

To be clear, we’re not out of the woods yet. In the US alone, there’s nearly 1 trillion USD worth of CRE loans coming due this year with banks holding half of those on their books. 

Regulators in the US and Europe are watching the situation at banks closely to ensure that any bad loans on CRE won’t contaminate the banking sector and the economy as a whole. Commercial real estate still hasn’t figured out how to address the remote working revolution either. It’s perhaps no surprise that one of the biggest investors in CRE has sharply criticized remote workers for “not working hard.” 🙄

There’s also no guarantee that rates will go down soon, even if many economists believe that they will. Whatever happens,  CRE is going through a fundamental change; one that will impact everything from the cost of doing business to our investment accounts, pension plans, and beyond.