Property Investors Flee as Rates Rise, `Zombie' Office Buildings Lose Tenants

Commercial real estate investors are heading for the exits -- or trying -- as rising interest rates and worries about a looming recession turn office properties into zombies, and real estate funds are responding with limits on withdrawals.

Blackstone Inc. said its flagship $69 billion fund, Blackstone Real Estate Income Trust (BREIT), would cut how much money investors can redeem after a surge in requests. 

"It's not a surprise that you would see a deceleration in flows from individual investors when you've had this kind of market decline," Blackstone President and Chief Operating Officer Jonathan Gray said on an investor call.

Rising borrowing costs, along with cutbacks by office tenants whose employees are working from home part or all of the time, mean falling profits for landlords. With inflation hovering at a 40-year high, the Federal Reserve set its benchmark interest rate target at 3.75–4%. While that's not as high as the 6.5% rates of the 2000s, rates are rising at the fastest pace in a decade and show few signs of slowing. That, combined with supply chain woes and work from home trends, has taken a toll on the real estate market that's set to worsen in 2023.

Bob Knakal, chair of investment sales at JLL, sees a growing horde of “zombie” office buildings in Manhattan that are still alive but have no obvious future, the Financial Times reported. The typical zombie may have been purchased generations ago and supplied monthly checks to an ever-expanding roster of beneficiaries.

“Now the building is not competitive from a leasing perspective because it needs a new lobby, and new elevators and windows and bathrooms. And if you went to those 37 people and said: ‘You know what? You have to write a check for $750,000 so we can fix the building up.’ These people would have a heart attack,’” said Knakal.

Blackstone's BREIT said last week that redemption requests had exceeded the cap it had set, with some investors unable to cash out until next year. Blackstone isn't the only group trying to slow down withdrawals. Starwood Capital Group also notified investors that it would be restricting withdrawals from its $14 billion fund.

The rise in redemption requests has come from both individual investors and institutional investors like pension funds. In 2020, there was also a short-lived rise in these requests that was squashed when it appeared that office tenants weren't leaving or cutting back. However, many businesses didn't shed their offices, and the rise in e-commerce meant that warehouses were a solid investment, so investors remained in place.

Now, as interest rates keep rising, companies are begging to ditch their office spaces. New York City, the world's largest office market, is taking a particularly strong hit. 

Since January, the shares of SL Green and Vornado, two publicly traded REITs for New York's largest office owners, have fallen by half.

Increased interest rates have made it more expensive for owners and developers to remain in New York. 

“If you have debt coming due, all of a sudden your rates are doubled and the bank is going to make you put money into the asset,” one developer said to the Financial Times.

When interest rates were low, investors looked to commercial real estate for higher yields than they could get from owning low-risk bonds or treasuries, and BREIT was able to give individuals 13% annualized returns. Blackstone remains optimistic the fund will still yield high returns.

“Our business is built on performance, not fund flows, and performance is rock solid,” a Blackstone spokesperson said after the firm announced the redemption limits.

Layoffs have also been hitting the real estate market. Wells Fargo & Co., the biggest home loan originator among U.S. banks, said last week that it would cut hundreds of mortgage employees.

The  FTSE NAREIT All Equity REITs Index, which tracks all publicly traded landlords, is down more than 20% this year.