A Fed-induced recession could hurt commercial property values and rents … [+]
The Federal Reserve’s announcement of another 0.75 percentage point rate hike continues the central bank’s bitter fight against inflation. Higher interest rates hurt the entire economy, which never stabilized after the Covid-19 shock. But commercial real estate, which is vital to the economic and fiscal well-being of cities, has not yet met with much success.
Ever-higher interest rates are slowing the economy, and if the Fed continues like this, it will bring about a recession (which seems to be its goal). Though some noted a softening in Chairman Jay Powell’s comments on today’s rate hike, stock markets fell sharply as Powell said it was “premature” to consider suspending hikes, saying: “We have a long way to go.” Ahead.” That doesn’t bode well for the economy, for jobs and demand, or for commercial real estate.
Cities and city experts are particularly concerned about the impact on commercial real estate, which has still not recovered from the Covid-19 pandemic. This has led to an increase in home working (WFH) and a parallel decline in office occupancy, and there are signs that these effects are becoming somewhat permanent. The well-regarded Kastle Office Occupancy barometer, which measures keycard swipes in 10 major real estate markets, is slowly trending higher, but the 10-city average has still not surpassed 50%.
Forbes’ Jonathan Ponciano points out that the Fed has now pushed interest rates to their “highest levels since the Great Recession”. The Fed is reacting to persistently high inflation, although many economists argue that inflation is being driven by factors beyond the Fed’s control, including food and energy price hikes caused by Russia’s aggressive war in Ukraine.
The Fed-induced slowdown has put office building rents under pressure and also cast a shadow over future office construction. Cities rely on clerical work to create jobs, both directly and for lower-paid workers who provide services like restaurants, security, and cleaning. The office sector also pays taxes, rents to landlords and interest payments to banks.
This pressure on trade offices worries many observers. Some scholars are predicting a commercial real estate “apocalypse,” seeing downward pressure on property values and cheaper and shorter leases reflecting lower demand as landlords scramble to find tenants. Their analysis for New York City forecasts “long-term office valuations 39.18% below pre-pandemic levels,” which could spell a “fiscal doom” for city budgets.
Not only scholars are concerned. In August, the Federal Deposit Insurance Corporation (FDIC) raised concerns about banks with concentrations in large commercial real estate (CRE) and said examiners would “increase their focus on reviewing CRE transactions,” particularly new loans and exposures to the bank balance leaves.
So far we do not see any CRE collapse. On the one hand, there is downward pressure on home prices as, as Cushman & Wakefield’s Eliot Kijewski points out, “the inability of buyers to access credit at what were once historically low interest rates is cooling the investment market.”
But loan repayments are not collapsing. The Mortgage Bankers’ Association reports that third-quarter arrears on commercial and multifamily loans actually declined slightly, part of a downward trend in 2022. Retail and lodging loans continued to be the worst, but even there, arrears are falling.
The arrears aren’t getting worse because tenants’ rent payments haven’t collapsed, allowing landlords to pay their loan fees. CommercialEdge reported that average office rents fell “2.4%” year over year in September, with many geographic and sectoral variations — not up, but not down.
There is anecdotal data that clients are seeking high-end Class A office space, despite the fact that they may be moving from existing, less desirable offices. Those older, less modern offices that they are leaving are the big worry hanging over the industry and cities.
Commenting on some positive moves by major New York corporations into expensive new Class A offices, the New York Post quoted Savills’ Jeff Peck as saying, “The subtext is, who’s going to absorb the spaces they leave?” Peck noted that economic woes for less affluent tenants will lead to demand for reduced rents and that “these class B minus buildings will cause real pain”.
That’s the main commercial real estate and city budget problem emerging from the Fed’s recession. Smaller businesses and nonprofits will stop growing or shrink (or go out of business) in a recession, reducing their demand for office space. Some of these older buildings can be converted into apartments, but this process takes time and requires more flexible policies from cities to encourage the transition.
And as Powell noted, the Fed is probably not done raising rates and pushing for a recession. This will result in losses to jobs, businesses and general well-being, with the impact on low-income and vulnerable workers being felt most severely and disproportionately among people of color.
So we don’t have a commercial real estate “apocalypse” yet. But the Fed’s push for a recession means cities and the commercial office sector are likely to fall further.
