Investment in commercial real estate is at its lowest levels since 2013, office buildings are selling at steep discounts, and commercial construction is slowing dramatically, aside from apartments.
Lenders and the larger economy should be able to weather the real estate downturn, provided multi-family doesn’t follow down the same path that office space has, according to a leading commercial real estate economist.
“It is a period of pause in real estate, but no doom loop is at play,” said Richard Barkham, global chief economist with CBRE, the world’s largest commercial real estate services and investment firm, during a mid-year update for the National Association of Real Estate Editors in Austin on June 19.
Tenants are now requiring only 60% to 70% of the office space that they needed in 2019 because of the shift toward remote work that accelerated during the pandemic. Although more companies want staff to return to the office, it typically is only for a few days a week, reducing the amount of overall space needed.
“I expect that by 2025 we will have a 20% vacancy rate and not enough space,” Barkham predicted.
How is that possible? The office vacancy rate nationally was 17.5% and metro Denver’s rate was 23% at the end of May, according to Commercial Edge.
With abundant space available and lease rates falling, tenants are shifting toward higher quality Class A space, represented primarily in buildings constructed after 2010. Newer buildings are still seeing net positive absorption, meaning they are filling space, while older buildings are continuing to empty.
Barkham said new office construction is slowing sharply given the difficult market. At the end of May, there were 83.8 million square feet of office space under construction representing 1.2% of the existing stock, according to a report from Commercial Edge.
That number includes about 2.12 million square feet in Denver, with nearly a third of that coming in a single project, 1900 Lawrence St., a 720,000-square-foot building near the old Greyhound bus station, which is expected to open soon.
Riverside Investment & Development Co., along with Convexity Properties and Canyon Partners Real Estate, are the developers behind Denver’s largest office project in 40 years. Their argument for building the 30-story tower in an otherwise glutted market is precisely the one Barkham lays out — more high-end space is needed to lure workers back to the office.
Once the current pipeline is built out, Barkham argues the strategy will shift to rehabbing slightly older buildings. A separate CBRE study found that only 10% of office space is “prime,” or the kind that tenants currently desire.
“The game will be converting Class B space to what people want,” he said.
Through the first five months of the year, the U.S. office market has had $10.2 billion in transactions, with an average price per square foot of $165, according to CommercialEdge. In metro Denver, there have been $99 million in sales this year, at an average price of $103 a square foot, the lowest among the major Western cities.
A little more than $900 billion in debt tied to commercial real estate is coming due this year and needs to be refinanced. Next year that total drops below $600 billion and the year after to around $450 billion.
Large banks have built up their reserves to cope with potential losses, and while some smaller regional banks may still fail, it likely won’t trigger a larger financial crisis.
Right now, it looks like the banking system can handle the drop in demand for office space and the defaults that have resulted. But add in a double-whammy of a glut in apartment construction, and the story could change.
“If we get a similar drop in multi-family, we have a different situation,” Barkham said.
But how likely is that to happen? Elevated interest rates are leaving more would-be homebuyers renting rather than owning. The typical new mortgage payment in the U.S. is $3,153 a month, compared to an effective monthly rent of $2,163, according to CBRE.
That means more absorption, or people moving into new and vacant apartments once they hit the market. But the market’s ability to continue to fill new apartments will be tested in 2024 and 2025 as even more supply comes online.
The wildcard is how much demand exists to fill high levels of completions in the coming months, and if a glut emerges, how much will rents fall and what will those declines do to the finances of landlords and developers, not to mention the balance sheets of their lenders.
Most economists argue the nation continues to face a housing shortfall. Caitlin Sugrue Walter, vice president of research with the National Multifamily Housing Council, said the nation needs to build 4.3 million apartments at a variety of price points by 2035.
That total includes covering a shortage of 600,000 units from underbuilding during the Great Recession, Walter said during a presentation at NAREE. Dallas, Houston, New York, Phoenix, Austin and Atlanta face the greatest shortfalls.
According to the U.S. Census Bureau, developers added 438,500 new apartment units last year, up 22.1% from 2022 and the highest rate of completions since 1987.
Although apartment completions are at high levels, the number of permits and starts has fallen off as developers struggle with higher interest rates, Walter said. A correction is coming.
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Zillow, in a study released in late June, found that the country’s housing shortfall worsened despite a residential construction boom set off during the pandemic. Zillow estimates the U.S. has 4.5 million households doubled up with non-relatives. Those individuals and family units aren’t counted as separate households and are prime candidates to soak up the supply of new homes and apartments.
A contrarian study from the University of Kansas, however, argues the country created a surplus of 3.3 million homes between 2000 and 2020, with most of that coming during the housing boom between 2000 and 2010. The country’s problem is more about affordability, and not supply, the study’s authors argue.
“There is a commonly held belief that the United States has a shortage of housing. This can be found in the popular and academic literature and from the housing industry,” said Kirk McClure, professor of public affairs at the University of Kansas in a release. “But the data shows that the majority of American markets have adequate supplies of housing available. Unfortunately, not enough of it is affordable, especially for low-income and very low-income families and individuals.”
If NMHC, Zillow and others are correct, then the current surge in apartment construction should be absorbed. If the KU study is correct, then that new supply, which skews more toward luxury apartments with more expensive rents, is too much of what the market already has.
That could leave apartment developers and their lenders, many already strained by the collapse in the office market, vulnerable.
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