Wednesday’s announcement by the Federal Reserve of another ¾ point interest rate hike continues the central bank’s grim war on inflation. Higher rates are hurting across the economy, which has never stabilized after the COVID-19 shock. But commercial real estate, vital to cities’ economic and fiscal well-being, has yet to take a major hit.
Higher and higher interest rates are slowing the economy, and if the Fed keeps it up, it will cause a recession (which seems to be its goal.) Although some saw a softening in Jay Powell’s comments about today’s rate hike, stock markets fell sharply in response to Powell saying it was “premature” to consider suspending hikes, saying “we have a way to go.” This does not bode well for the economy, or for jobs and demand, or for commercial real estate.
Cities and urban experts are particularly concerned about the impact on commercial real estate, which has still not recovered from the COVID-19 pandemic. This has caused an increase in work from home (WFH) and a parallel decrease in office occupancy, and there are signs that this impact is becoming somewhat permanent. The much-watched Kastle Office Occupancy barometer, which measures key card sweeps in ten major real estate markets, has been slowly trending upward, but the ten-city average still hasn’t broken 50%.
Forbes’ Jonathan Ponciano points out that the Fed has now pushed interest rates to their “highest since the Great Recession.” The Fed is responding to continued high inflation, even though many economists argue that inflation is driven by factors beyond the Fed’s control, including food and energy price increases caused by Russia’s aggressive war in Ukraine.
The Fed-induced slowdown has put downward pressure on office building rents and also cast a shadow over future office construction. Cities depend on office work to provide jobs, both directly and for lower-paid workers who provide services such as restaurants, security and cleaning. The office sector also pays taxes, rents to landlords and finances interest payments to banks.
This pressure on commercial offices worries many observers. Some scholars are predicting a commercial real estate “apocalypse,” seeing downward pressure on property values and cheaper and shorter-term leases reflecting reduced demand as landlords search for tenants. Their analysis for New York City predicts “long-term office valuations that are 39.18% below pre-pandemic levels,” which could lead to a “fiscal doom” for city budgets.
It’s not just scholars who are concerned. In August, the Federal Deposit Insurance Corporation (FDIC) noted that it was concerned about banks with large commercial real estate (CRE) concentrations and said examiners would “increase their focus on CRE transaction testing,” particularly on new loans and risks to banks. balance sheet.
So far we are not seeing a CRE crash. On the one hand, there is downward pressure on property prices, because as Eliot Kijewski of Cushman and Wakefield points out, “buyers’ inability to access credit at the once historically low interest rates is cooling the investment market.”
But loans are not collapsing. The Mortgage Bankers Association reports that third-quarter delinquencies on commercial and multifamily loans actually fell slightly, part of a downward trend in 2022. Retail and lodging loans were still the worst, but even there delinquencies are trending down.
The arrears are not increasing because rents have not collapsed, allowing landlords to pay their borrowing costs. CommercialEdge reported that average office rents fell “2.4% year-on-year” in September, with a lot of geographic and sectoral variation.
There is anecdotal data that clients are looking for high class A office space, although they may be moving from existing, less desirable offices. Those older, less modern offices are the major concern hanging over the sector and over cities.
Commenting on a positive move by major New York companies to expensive new Class A offices, the New York Posted quoted Jeff Peck of Savills as saying “the subtext is who is going to absorb the spaces they are leaving?” He noted that economic problems for less affluent tenants will lead to demand for reduced rents and that “will cause a lot of pain for these Class B minus buildings.”
This is the essential commercial real estate and city budget problem of the Fed’s recession. Smaller businesses and non-profit organizations will stop growing or shrink (or go out of business) in a recession, reducing the demand for their office space. Some of those older buildings can be repurposed into residences, but that process takes time and requires more nimble policies from cities to encourage the transition.
And as Powell noted, the Fed probably isn’t done raising rates and pushing for a recession. This will result in losses in jobs, businesses and overall well-being, with the impact falling hardest on low-income and vulnerable workers, and disproportionately on Blacks and other minorities.
So we don’t have an “apocalypse” for commercial real estate yet. But the Fed’s push for a recession means cities and the commercial office sector are likely to fall further.