Commercial Real Estate Market Faces Prolonged Recovery, Office Values May Not Reach Pre-Pandemic Levels Until 2040

The commercial real estate sector is grappling with tightening housing conditions and elevated mortgage rates, which could impede a full recovery until 2040, according to Kiran Raichura, Capital Economics Deputy Chief Property Economist. Raichura highlights that office values are not expected to regain their pre-pandemic levels for another two decades, raising concerns about the risk of default in the market.

The reluctance of lenders to provide financing has compounded the distress in the commercial real estate sector, and Raichura predicts that numerous office properties will be handed back to lenders. Some property owners have already decided to relinquish their assets due to the unfavorable economic conditions, especially in hard-hit cities. Additionally, distress is increasing among commercial mortgage-backed securities (CMBS) loans, with the delinquency rate for office CMBS surpassing 4%.

While there may still be buyers in the market, transactions are taking place at substantial discounts compared to pre-pandemic values. Buildings in cities like San Francisco are transacting at 50% to 80% lower than their previous valuations. The prolonged recovery timeline can be attributed to the structural impact resulting from reduced office space usage. Raichura draws parallels with the recovery following the Global Financial Crisis, which took 12 years for office values to regain their peak levels. Considering the structural changes and reduced demand for office space, the recovery this time could be even slower, potentially stretching into the mid-2040s.

Regarding office conversions, Raichura acknowledges that they can help cushion the blow, but there are challenges. Converting offices to multifamily units often faces hurdles due to building configurations and planning permissions. More support and action from cities and city planners are necessary to facilitate these conversions and ensure a continuous flow of people and businesses in central business districts.

The delinquency rate for CMBS loans is expected to increase, potentially reaching double digits by the end of the year. The gradual reduction in rent rolls over the next few years will contribute to the rise in delinquency rates. However, the impact will be slower than during the Global Financial Crisis when firms vacated spaces immediately due to bankruptcy. This time, landlords are still receiving rent, but the gradual reduction in occupancy will affect the average building’s rent roll.

While commercial real estate values are expected to decline across sectors due to increased interest rates, there are still strong fundamentals supporting the industrial and multifamily sectors. Industrial properties benefit from e-commerce growth, while multifamily units address the shortage of housing stock in the US. The retail sector, which has struggled in the past, is projected to have positive returns in the next few years.

The commercial real estate market faces significant challenges, particularly in the office sector. Investors and industry stakeholders should prepare for an extended recovery period and explore opportunities in other sectors with more favorable prospects.