The sudden increase in interest rates has left many experienced commercial real estate owners gasping for air. It’s a tsunami of woe for landlords who own office and retail space and never saw it coming—and it threatens the nation’s entire real estate ecosystem.
Not only have mortgage interest rates ascended skyward, with no easing in sight, but remote work and e-commerce have meant former tenants have vacated buildings with no sign of return. Big cities like New York have been especially hit hard.
“You literally have trillions of dollars of investment that are suddenly just massively impaired,” Dan Zwirn, chief executive of Arena Investors, a New York-based asset manager and real estate investor, told the Wall Street Journal. “People thought of these office buildings as forever because, of course, it’s going to be 98% leased forever.”
Property Owners Are Living on Borrowed Time
According to real estate consulting firm Colliers, the vacancy rate in U.S. commercial buildings was at 17% as of the fourth quarter of 2023, higher than it was during the financial crash of 2008. Forgiving lenders don’t want to be saddled with foreclosed properties they can’t sell, and so are holding off on court proceedings. Remaining tenants who are current with rents are holding on, allowing buildings to stay afloat—for the time being.
However, without fully rented buildings, limping along on borrowed time means maintenance issues will mount, and finding insurance on an almost insolvent building is challenging. Many landlords who can see the writing on the wall have decided to cut their losses. The New York Times reported that many commercial buildings around the country are being sold at a 50% to 80% discount.
As the cycle continues, it’s not just commercial landlords of skyscrapers who are feeling the pinch. Landlords and businesses throughout major cities are hurting as workers move, and municipal budgets that rely on taxes associated with valuable commercial property face shortfalls as lower property tax assessments cut revenue.
How Empty Offices Affect Cities and Small Residential Landlords
When people no longer need to live in cities to work, the entire infrastructure of that city suffers, including smaller landlords who provide housing. Although the lack of inventory and high interest rates have forced people to keep renting instead of buying, it’s not surprising that there has been a huge movement away from expensive Northern cities since the pandemic.
According to census data, New York City has been most affected, with 78,000 people leaving in 2023. Overall, the state of New York lost 102,000 people. Most people leaving New York were not millionaires but the lower and middle class, earning between $32,000 and $65,000 who, without the need to be tethered to a costly city, were happy to give up high rents and cold weather.
How Empty Offices Could Impact Banks and Loans for Other Smaller Investors
According to Moody’s Analytics, the national office vacancy rate reached a record 19.6% in the fourth quarter of 2023. Not since 1979 had offices been so empty.
If landlords foreclose or sell for less than they owe, that could spell big problems for banks that hold a lot of commercial real estate debt. The aftershocks could be felt throughout the whole lending industry, affecting smaller landlords seeking real estate loans.
“We saw this play out last year: A bank gets in trouble, and that creates uncertainty in the market,” Dan Roccato, a clinical professor of finance at the University of San Diego, told CBS. “That uncertainty ripples through the stock market, that uncertainty ripples through the real estate market, and that uncertainty then shows up in your 401(k) plan at the end of the month.”
The result could be cities looking to make up the tax income shortfall from distressed and discounted commercial building sales by increasing revenue from residential property or sales taxes.
The Waiting Game Gets Harder
“Survive until ‘25” is not a phrase any landlords struggling with high interest rates would have expected to hear at the start of the year when the Fed first touted a series of rate cuts. However, inflation‘s stubborn grip on the U.S. economy and Fed Chairman Jerome Powell’s steadfast position on refusing to cut rates until it falls has investors, homeowners, and many politicians wringing their hands in despair.
As we have seen from distressed commercial real estate sales and syndications with floating-rate mortgages, holding on to underwater debt has become increasingly difficult. Banks, too, are feeling the heat, having to carry debt expected to be paid off. On average, commercial real estate loans make up more than a fifth of U.S. banks’ overall loan portfolios. Many commercial landlords cough up borrowed cash to extend their loans until rates drop.
According to CRED iQ analysis, New York landlords SL Green and Vornado had to find around $100 million to extend a $1.08 billion loan on an office building at 280 Park Avenue in April. Other owners have decided they can no longer afford to keep servicing the debt and would do better to deploy their money elsewhere. This is similar to what happened in the financial crash of 2008. Waiting in vain has its limits.
“Last year, borrowers were saying, ‘I just need three months for rate cuts to kick in,’” Alex Killick, a managing director at real estate services company CWCapital Asset Management, told the Wall Street Journal. “We aren’t hearing that anymore. Powell sounded pretty clear that this is the new normal.”
Final Thoughts
Letting properties go is always the last option for investors when the financial strain becomes unbearable. What frustrates many commercial property owners is that the Fed teased rate cuts and then backed off. They will inevitably happen, but when is the all-important question?
In the meantime, the ropes tethering commercial buildings, lenders, owners, and an entire real estate infrastructure are starting to give, threatening businesses, livelihoods, and cities.
Although no one saw the pandemic coming, the aftershocks must make politicians and landlords better prepared to handle other black swan events. At the root of it all are interest rates, fueling rampant inflation caused by the Fed’s easy money policy.
Other countries have recovered more quickly from the pandemic than the U.S., without the inflation and rate hikes. Lessons must be learned.
In the meantime, Jerome Powell needs to offer the nation some hope. Quoting solid economic data is not enough for landlords about to lose their buildings and residents’ homes.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
