Commercial Real Estate in Focus

Commercial real estate (CRE) is navigating several challenges, ranging from a looming maturity wall requiring much of the sector to refinance at higher interest rates (commonly referred to as “repricing risk”) to a deterioration in overall market fundamentals, including moderating net operating income (NOI), rising vacancies and declining valuations. This is particularly true for office properties, which face additional headwinds from an increase in hybrid and remote work and troubled downtowns. This blog post provides an overview of the size and structure of the U.S. CRE market, the cyclical headwinds resulting from higher interest rates, and the softening of market fundamentals.

As U.S. banks hold roughly half of all CRE debt, risks related to this sector remain a challenge for the banking system. Particularly among banks with high CRE concentrations, there is the potential for liquidity concerns and capital deterioration if and when losses materialize.

Commercial Real Estate Market Overview

According to the Federal Reserve’s April 2024 Financial Stability Report (PDF), the U.S. CRE market was valued at $22.5 trillion as of the fourth quarter of 2023, making it the fourth-largest asset market in the U.S. (following equities, residential real estate and Treasury securities). CRE debt outstanding was $5.9 trillion as of the fourth quarter of 2023, according to estimates from the CRE data firm Trepp.

Banks and thrifts hold the largest share of CRE debt, at 50% as of the fourth quarter of 2023. Government-sponsored enterprises (GSEs) account for the next largest share (17%, primarily multifamily), followed by insurance companies and securitized debt, each with approximately 12%.Analysis from Trepp Inc. Securitized debt includes commercial mortgage-backed securities and real estate investment trusts. The remaining 9% of CRE debt is held by government, pension plans, finance companies and “other.” With such a large share of CRE debt held by banks and thrifts, the potential weaknesses and risks associated with this sector have become top of mind for banking supervisors.

CRE lending by U.S. banks has grown substantially over the past decade, rising from about $1.2 trillion outstanding in the first quarter of 2014 to roughly $3 trillion outstanding at the end of 2023, according to quarterly bank call report data. A disproportionate share of this growth has occurred at regional and community banks, with roughly two-thirds of all CRE loans held by banks with assets under $100 billion.

Looming Maturity Wall and Repricing Risk

According to Trepp estimates, roughly $1.7 trillion, or nearly 30% of outstanding debt, is expected to mature from 2024 to 2026. This is commonly referred to as the “maturity wall.” CRE debt relies heavily on refinancing; therefore, most of this debt is going to need to reprice during this time.

Unlike residential real estate, which has longer maturities and payments that amortize over the life of the loan, CRE loans typically have shorter maturities and balloon payments. At maturity, the borrower normally refinances the remaining balance rather than paying off the lump sum. This structure was beneficial for borrowers prior to the current rate cycle, as a secular decline in interest rates since the 1980s implied CRE refinancing generally occurred with lower refinancing costs relative to origination. However, with the sharp increase in interest rates over the last two years, this is no longer the case. Borrowers looking to refinance maturing CRE debt may face higher debt payments. While higher debt payments alone weigh on the profitability and viability of CRE investments, a weakening in underlying fundamentals within the CRE market, especially for the office sector, compounds the issue.

Moderating Net Operating Income

One notable fundamental weighing on the CRE market is NOI, which has come under pressure of late, especially for office properties. While NOI growth has moderated across sectors, the office sector has posted outright declines since 2020, as shown in the figure below. The office sector faces not only cyclical headwinds from higher interest rates but also structural challenges from a reduction in office footprints as increased hybrid and remote work has reduced demand for office space.

Growth in Net Operating Income for Commercial Real Estate Properties

SOURCE: CBRE Group.

NOTE: Data are from the first quarter of 2018 to the fourth quarter of 2023.

Apartments (i.e., multifamily), on the other hand, experienced a surge in NOI starting in 2021 as rental income soared with the housing boom that accompanied the recovery from the COVID-19 recession. While this enticed more builders to enter the market, an influx of supply has moderated rent prices more recently. While rents remain high relative to pre-pandemic levels, any reversal poses risk to multifamily operating income moving forward.

The industrial sector has experienced a similar trend, albeit to a lesser extent. The growing popularity of e-commerce increased demand for industrial and warehouse space across the U.S. in recent years. Supply surged in response and a record number of warehouse completions came to market over just the last few years. As a result, asking rents stabilized, contributing to the moderation in industrial NOI in recent quarters.

Higher expenses have also cut into NOI: Recent high inflation has raised operating costs, and insurance costs have increased significantly, especially in coastal regions.According to a 2023 report from Moody’s Analytics (PDF), insurance premiums for CRE properties have increased 7.6% annually on average since 2017, with year-over-year increases reaching as high as 17% in some markets. Overall, any erosion in NOI will have important implications for valuations.

Rising Vacancy Rates

Building vacancy rates are another metric for assessing CRE markets. Higher vacancy rates indicate lower tenant demand, which weighs on rental income and valuations. The figure below shows recent trends in vacancy rates across office, multifamily, retail and industrial sectors.

According to CBRE, office vacancy rates reached 19% for the U.S. market as of the first quarter of 2024, surpassing previous highs reached during the Great Recession and the COVID-19 recession. It should be noted that published vacancy rates likely underestimate the overall level of vacant office space, as space that is leased but not fully used or that is subleased runs the risk of turning into vacancies once those leases come up for renewal.

Vacancy Rates for Commercial Real Estate Properties

SOURCE: CBRE Group.

NOTES: The availability rate is shown for the retail sector as data on the retail vacancy rate are unavailable. Shaded areas indicate quarters that experienced a recession. Data are from the first quarter of 2005 to the first quarter of 2024.

Declining Valuations

The combination of elevated market rates, softening NOI and rising vacancy rates is starting to weigh on CRE valuations. With transactions limited through early 2024, price discovery in these markets remains a challenge.

As of March 2024, the CoStar Commercial Repeat Sales Index had declined 20% from its July 2022 peak. Subindexes focused on the multifamily and especially office sectors have fared worse than overall indexes. As of the first quarter of 2024, the CoStar value-weighted commercial property price index (CPPI) for the office sector had fallen 34% from its peak in the fourth quarter of 2021, while the CoStar value-weighted CPPI for the multifamily sector declined 22% from highs reached in mid-2022.

Whether overall valuations will decline further remains uncertain, as some metrics show signs of stabilization and others suggest further declines may still be ahead. The overall decline in the CoStar metric is now broadly in line with a 22% decline from April 2022 and November 2023 in the Green Street CPPI, an appraisal-based measure that tends to lead transactions-based indexes. Through April 2024, the Green Street CPPI has been stable near its November 2023 low.

Data on REITs (i.e., real estate investment trusts) also provide insight on current market views for CRE valuations. Market sentiment about the CRE office sector declined sharply over the last two years, with the Bloomberg REIT office property index falling 52% from early 2022 through the third quarter of 2023 before stabilizing in the fourth quarter. For comparison, this measure declined 70% from the first quarter of 2007 through the first quarter of 2009, leading the decline in transactions-based metrics but also outpacing them, with the CoStar CPPI for office, for example, falling roughly 40% from the third quarter of 2007 through the fourth quarter of 2009.

Meanwhile, market capitalization (cap) rates, calculated as a property’s NOI divided by its valuation—and therefore inversely related to valuations—have increased across sectors. Yet they are lagging increases in longer-term Treasury yields, potentially due to limited transactions to the extent building owners have delayed sales to avoid realizing losses. This suggests that further pressure on valuations could occur as sales volumes return and cap rates adjust upward.

Looking Ahead

Challenges in the commercial real estate market remain a potential headwind for the U.S. economy in 2024 as a weakening in CRE fundamentals, especially in the office sector, suggests lower valuations and potential losses. Banks are preparing for such losses by increasing their allowances for loan losses on CRE portfolios, as noted by the April 2024 Financial Stability Report. In addition, stronger capital positions by U.S. banks provide added cushion against such stress.Bank supervisors have been actively monitoring CRE market conditions and the CRE loan portfolios of the banks they supervise. See this July 2023 post. Nevertheless, stress in the commercial real estate market is likely to remain a key risk factor to watch in the near term as loans mature, building appraisals and sales resume, and price discovery occurs, which will determine the extent of losses for the market.

Notes

1. Analysis from Trepp Inc. Securitized debt includes commercial mortgage-backed securities and real estate investment trusts. The remaining 9% of CRE debt is held by government, pension plans, finance companies and “other.”
2. According to a 2023 report from Moody’s Analytics (PDF), insurance premiums for CRE properties have increased 7.6% annually on average since 2017, with year-over-year increases reaching as high as 17% in some markets.
3. Bank supervisors have been actively monitoring CRE market conditions and the CRE loan portfolios of the banks they supervise. See this July 2023 post.