I am Drew Demers and I joined Foster Graham Milstein & Calisher, LLP in January 2023 as a partner in the Land Use and Real Estate practice group. I come to FGMC with over 20 years of practice experience, and focus on representing clients in real estate financing, development, purchase and sale transactions, leasing, and related real property disputes. Thank you for this opportunity to share some thoughts about the current state of the commercial real estate market. I can be reached at 303-333-9810 or ddemers@fostergraham.com.
The press has given much attention to Fed’s ongoing rate hikes in 2023 and the chilling market for commercial property. The general sentiment among economists, industry professionals and pundits alike is that the office market is troubled, perhaps deeply so, as it continues to reel from the effects of the pandemic. The recent FDIC takeovers of First Republic Bank, Signature Bank and Silicon Valley Bank have added fuel to the fire of economic concern. This article starts with a data driven approach to the current state of commercial real estate and addresses some factors real estate professionals may want to consider during these interesting times.
First, the numbers:
- According to Morgan Stanley Wealth Management’s CIO, “more than 50% of the $2.9 trillion in commercial mortgages will need to be renegotiated in the next 24 months when new lending rates are likely to be up by 350 to 450 basis points.”
- Nationally, Cushman and Wakefield reports that office leasing activity declined by 23% in Q1 2023, citing to challenging factors like “inflationary pressures, increased interest rates, tight labor markets, economic uncertainty [and bank failures]”.
- Locally, Avison Young reports the greater Denver market had a 17.9% office vacancy rate and a 23% year-over-year decline in pricing per square foot for sale of office property in Q1 2023, with “move-outs vastly outpacing move-ins and hybrid working arrangements reigning supreme.”
- Avison Young also reports meaningful variances within our Denver market, from a healthy Cherry Creek sub-market (6.9% vacancy) to Denver’s struggling core business district (26.2% vacancy).
- Forbes reports that, by 2026, worldwide e-commerce sales are expected to grow over $8,000,000,000,000 (eight trillion dollars) annually, with nearly one in four retail purchases being online, and purchases by mobile phone doubling from their 2021 levels.
- Morgan Stanley analysts have likewise forecasted “a peak-to-trough CRE price decline of as much as 40%, worse than in the Great Financial Crisis”.
- In the 1980s, the U.S. had around 2,500 shopping malls. One expert predicts that number will dwindle by 95%, to 150 malls, by 2032.
These figures and forecasts clearly reflect big changes and tough times ahead for office and retail properties. Perhaps it’s somewhat reassuring that the numbers we’re seeing in Denver are consistent with reporting in other core business districts around the country. Many areas, like San Francisco and Manhattan, appear to be faring far worse, while Avison Young reports that certain other markets, like Miami, are showing “resilience”. But as a general matter, the sentiment nationwide is quite negative. Barbara Corcoran recently equated the commercial office market to an impending “bloodbath”, and she may very well be right as far as core urban markets are concerned.
The tough questions are 1) is this downward trend in CRE a cycle, or rather, a sea change, and 2) what are the broader economic implications for office and retail CRE, core downtowns, and the banks that finance these properties? While tech companies and Wall Street continue implementing return-to-office mandates, employees discovered newfound flexibility in the pandemic and continue to resist. Only time will tell whether this ideological struggle will produce a clear winner, or perhaps more realistically, whether a hybrid work model will become the new norm. The path forward isn’t clear on this issue, but it’s apparent that commercial office owners in core downtowns, like their retail shopping center counterparts, need to get ahead of the issues.
Despite the downtown exodus, there are some bright spots. Cherry Creek’s numbers appear to track other amenity-rich office submarkets like Chicago’s Fulton Street and Midtown Atlanta. These sub-markets attract the live-work-play crowd and are reaping the benefits of a systemic corporate exodus from their proximate downtown cores.
The failure of a small group of banks earlier this year has added another layer to the story. Truth be told, bank failures are not that uncommon, though the three banking failures to date in 2023 have received a healthy amount of coverage in the media. Historically, the federal government’s agency for regulating banks – the Federal Deposit Insurance Corporation (FDIC) – reports somewhere between five and ten bank failures in most years since 2000. In that respect, our 2023 year-to-date numbers are very much consistent with the FDIC’s historical record. In fact, no banks failed in 2005-06, 2018 and 2021-22. But if history teaches us anything, it’s that waves should be periodically expected and tsunamis will come every so often. During the Great Financial Crisis (2008-2014), a total of 507 banks failed. With office and retail at an inflection point, the question is whether a new wave is on the horizon.
Our economy today is undoubtedly different in terms of high inflation, higher interest rates, a surge in remote and hybrid work arrangements, and surging online retail, which factors were not necessarily on the radar in 2008. The explosion in e-commerce (and an even sharper uptick in “mobile commerce”) is a behavioral trend driven by convenience and efficiency that is taking over. And so may be the case for work from home or flex/hybrid work programs. These trends appear to have the same potential for major economic upheaval and financial strain as we saw in 2008. Other macro issues, like the short supply of affordable housing in reasonable proximity to core business districts, should also be top of mind for owners, developers and investors in the coming years.
Commercial loans and leases are generally 5-15 years in duration, and there’s undoubtedly a wave coming due. In Colorado, these challenges also converge with the State’s energy efficiency initiatives for commercial buildings over 50,000 SF and a rather aggressive 2030 energy reduction target which will require billions of dollars in future investment and upgrades. Given all of these factors, there is little doubt that existing office properties, retail brick-and-mortar operations, and lenders heavily weighted in these sectors will face some tough years ahead. It’s more likely to get worse for commercial office properties and downtown core business districts before it gets better. Some of these factors are fleeting and will turn around, but there’s no doubt that owners and developers need to think creatively and strategically with projects both existing and new. Opportunities can be plentiful in a downward cycle, and in the words of Albert Einstein, “We cannot solve our problems with the same thinking we used to when we created them.”
References:
Commercial Real Estate Prices May Crash 40% From Peak, Worse Than 2008 (businessinsider.com)
Denver Office Market Reports | Avison Young US
2023 Office Market Outlook: Optimal Space Utilization Is Key (forbes.com)
U.S. Office MarketBeat Reports | United States | Cushman & Wakefield (cushmanwakefield.com)
‘Mobile Commerce To Grow 68% By 2022 As More People Shop On Their Phones (forbes.com)
US Malls Are Dying and There May Be Just 150 Left in 10 Years (businessinsider.com)
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