Office closures during the COVID-19 pandemic made it clear that productivity continues to flourish in many white-collar industries, even when employees aren’t directly observed under the same roof. For many companies, that meant a permanent shift to remote or hybrid work models. As of April, people worked remotely about 39% of the time, according to Pew Research. Data from a McKinsey survey shows that 58% of workers are allowed to work remotely at least once a week, while 35% have the option to work from home all the time.
For many employees, this change is welcome. It means the opportunity to stay in pajama pants, spend more time with pets, skip the hassle of a commute, and claim the home office tax deduction. 87% of workers take advantage of the opportunity to work remotely. But for many commercial real estate investors, the change means higher vacancy rates in office buildings, less rental income, and debt concerns. What’s more, a decline in commercial real estate prices hurts cities and the broader economy.
The Varied Impact of COVID-19 on Commercial Real Estate
Commercial real estate prices decreased globally with the onset of the pandemic and is now exhibiting a strong recovery in general. But outcomes have looked different across segments and markets. The International Monetary Fund found that the trajectory of recovery was most impacted by factors specific to the pandemic, including:
- The aggressiveness of virus containment strategies
- The effectiveness of fiscal support
- The aggressiveness with which financial conditions were loosened
- The vaccination rates in the area
- Local and segment-specific changes in consumer behavior
Some segments of commercial real estate boomed during the pandemic. Stalled multifamily new construction starts combined with rising home prices increased the demand for multifamily units, and, consequently, rent prices and occupancy rates. And as e-commerce heated up due to retail closures, the industrial sector experienced increased rents due to high demand for distribution warehouses.
But retail and office space segments were harder hit by the impact of the pandemic. 71% of workers worked remotely in 2020, and that left office spaces empty. This had a negative effect on urban retail, as foot traffic for downtown restaurants and shops declined. Suburban retail saw improved performance accordingly.
As offices reopen, office vacancy rates are declining overall. In fact, of 139 metro areas, only about one-quarter have office vacancy rates that are lower than pre-pandemic levels. Some cities have even seen increased occupancy rates since before the pandemic. But for other cities, the situation is far more dire. The metro areas in the chart below have the highest vacancy rates currently.
Metro | Pre-Pandemic Vacancy Rates | Q3 2022 Vacancy Rate |
---|---|---|
Houston, Texas | 16.36% | 18.89% |
Dallas-Fort Worth, Texas | 15.14% | 17.57% |
San Francisco, California | 6.28% | 15.45% |
Washington, D.C. | 12.77% | 15.2% |
Chicago, Illinois | 12% | 15.08% |
Phoenix, Arizona | 12.07% | 14.69% |
Los Angeles, California | 10.22% | 13.81% |
Austin, Texas | 9.08% | 13.58% |
Atlanta, Georgia | 11.55% | 13.52% |
New York City | 7.69% | 13.43% |
San Francisco saw a particularly vast increase in vacant office space compared to before the pandemic. The city has a high concentration of office buildings, many of which host major tech employers that have embraced the future of remote work. Experts believe the San Francisco commercial real estate market is headed for a devastating crash.
And vacancy rates could worsen in areas most impacted by remote work since office leases are generally for three years or longer. As leases signed prior to the pandemic expire and tenants choose not to renew, vacancies may edge higher, further deflating the value of commercial real estate.
Landlords of Older Office Space Buildings Are Hurting the Most
Leasing activity has increased since 2021, driven mostly by businesses seeking top-tier office space. In anticipation of employees’ return to the office, many companies are relocating to new buildings with amenities designed to draw workers away from their couches—think expansive rooftop lounges with gorgeous views, fitness facilities, other wellness-oriented features, media centers, and restaurants.
Therefore, the buildings most vulnerable to high vacancy rates are older office buildings that haven’t been updated. On part of Manhattan’s Third Avenue, for example, a cluster of buildings erected between the 1950s and the 1980s has more available space than the rest of the city’s office buildings, with a vacancy rate of 29%. And in San Francisco, owners of lower-tier buildings face foreclosure. Some of these buildings have lost as much as half of their value, which is prompting landlords to request lower tax bills.
Tenants Now Have the Power to Make Demands
Real estate agents say that empty space in central business districts across the country has turned commercial real estate into a tenant’s market. While Class A office space may still be attracting rents on par with pre-pandemic times, owners of older buildings are offering office space at a discount, sometimes up to 25% for creditworthy applicants in certain areas.
It’s also common for tenants to ask for flexibility in lease arrangements. For example, leases can include clauses that allow for subleasing or an extended lease in case of business interruption. Concessions such as tenant improvement allowances are also becoming more common. Before the pandemic, landlords held all the power, but the market has shifted into the hands of the tenant.
Rising Interest Rates Add Pressure on Investors
In addition to struggling with reduced rental income, commercial real estate investors face financing issues associated with tighter financial conditions. The Fed will continue to raise the federal funds rate in an effort to control inflation. The resulting high-interest rates make it difficult for investors to finance new real estate transactions or refinance existing loans.
In markets with relatively low-interest rates, commercial real estate prices have been more resilient. This shows the direct impact of higher rates on property values. Additionally, slowing economic activity and fears of an upcoming recession may limit the demand for commercial real estate as more people cut back on shopping and dining out.
It’s bad enough that commercial real estate investors are losing money as their properties depreciate. But declining commercial property prices also pose a threat to the stability of the financial system and the broader economy.
How Commercial Real Estate Impacts the Broader Economy
Local governments in most states get the vast majority of their revenue from property taxes. As property values decrease and tax obligations are reassessed, budget cuts will be necessary in affected cities. This will have a detrimental impact on the availability of social services and spending on education. State and local governments spend about one-third of their money on elementary and secondary education. If commercial property values decline enough, schools could be starved of resources. San Francisco could be poised to collect 15% less in property tax revenue, equating to about a 4% dip in total revenue, according to economists.
The second problem is the impact on the financial sector, particularly small banks. Soon after the pandemic began, banks saw elevated delinquencies on commercial real estate loans. And declining property values impact how much banks can recoup when they foreclose. Banks hold about 38% of outstanding commercial real estate debt on their balance sheets, and community and regional banks tend to be more exposed to commercial real estate loans than larger banks, according to The Chicago Fed. That puts these banks at a higher risk of failure.
When banks fail, it limits the availability of financing to businesses and individuals. This has a ripple effect, causing unemployment as businesses can’t afford to hire staff. With more people unemployed, economic activity slows, creating less demand. Businesses slow their production, creating further unemployment. U.S. bank failures rose sharply during the Great Recession. Though we haven’t seen any bank failures in the last two years, there’s reason to be concerned about commercial real estate loan loss.
Predictions for the Future of Commercial Real Estate
Some analysts are calling the outlook for commercial office real estate “apocalyptic,” while others are more optimistic. Research from professors at NYU and Columbia puts the potential loss in value of offices nationwide at $456 billion. Data from CommercialEdge only shows a small dip in office listing rates, which are down 0.1% year-over-year. But as leases expire and vacancy rates increase, investment in the sector could further decline, pushing property values down.
However, Lawrence Yun, chief economist at the National Association of Realtors, expects the market to grow overall. He notes that some midsize markets are improving as businesses opt for more affordable office space away from central hubs. And other sectors are faring even better. Both industrial and residential rents are expected to continue rising in the future. And hotels and retail properties are recovering as well.
How Investors Can Adapt
Investors can pivot to find deals in areas with booming economies or sectors that are exhibiting strong growth, such as multifamily housing and industrial space. Those who still want to buy office space in the largest metro areas will need to be prepared to make updates that accommodate companies’ evolving needs.
Land is also a viable opportunity. Yun asked local governments to loosen regulations and zoning requirements to encourage investment in residential developments, which would address the shortage of homes. But there’s another option as well—e-commerce businesses seek land for delivery truck storage. Commercial banks may be more willing to offer financing for these deals because they can quickly become profitable.
What’s clear from the outcome of the pandemic is that cities and sectors are typically not unilaterally affected by economic disruption. Therefore, diversification is the best defense against negative returns. Commercial real estate investors need to start somewhere, and right now, the multifamily and industrial sectors have the advantage, but ultimately it’s wise to have your hands in multiple sectors and markets.
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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.