The surge in remote work has triggered a significant transformation in the commercial real estate market, impacting building owners, lenders, and tenants. The global vacancy rate for commercial office space reached an all-time high of 15.9% in Q3 2023, with North America experiencing the largest increase, according to Jones Lang LaSalle. A study by CBRE highlighted a 22% decline in average square footage per person and revealed that 43% of organizations plan to reduce their office space by over 30% in the next three years.
The oversupply of commercial office space is expected to make it more affordable, with CBRE estimating a 3% to 4% decline in asking rents in 2024. Existing renters are benefiting from record landlord concessions, including tenant improvement allowances and an average of 10 months of free rent for top-tier buildings in 12 U.S. office markets.
CBRE's office occupier sentiment survey indicates that tenants are seeking shorter lease terms and smaller leases, especially those under 10,000 square feet. While these trends offer advantages to companies, they pose challenges for commercial real estate lenders, primarily banks.
The combination of high interest rates and declining rental income is causing difficulties for borrowers in making timely loan payments. As of Q3 2023, 5.1% of the balance of office property loans was delinquent, up from 4% in the previous quarter, according to the Mortgage Bankers Association. Fitch Ratings projects that U.S. commercial mortgage-backed securities (CMBS) office loan delinquencies will rise to 8.1% in 2024 and 9.9% in 2025.
Furthermore, approximately $150 billion of mortgages on U.S. office buildings are set to mature by the end of 2024, with over $300 billion maturing by the end of 2026. Properties in large central business districts are deemed highly vulnerable due to the structural shift to hybrid working, impacting valuations. Fitch emphasizes that properties with tenant rollovers or lower debt service coverage ratios are particularly at risk.
While banks have taken steps to address declining credit quality, selling assets, and stress-testing exposures, there are lingering risks in the commercial real estate sector. Projects underwritten based on assumptions made several years ago may require additional equity from borrowers or loan extensions to mitigate the risks associated with changing market conditions.
While the current distress in commercial real estate is not extreme, experts stress the need for lenders and borrowers to address potential risks. A misjudgment of assumptions, especially related to cash flow and interest rates, could impact the industry. If credit losses in commercial real estate portfolios escalate, there is a risk of contagion, potentially leading to the failure of smaller U.S. banks, according to Fitch.
