Rising interest rates, a banking crisis, and the enduring impact of the pandemic on work arrangements have produced a triple whammy for the commercial real estate industry, leading some economists to believe the $5.6 trillion industry could become the next trigger for a financial crisis.
Commercial real estate transaction volumes were down 65% year-over-year in the first quarter of 2023, Goldman Sachs wrote in its latest report on CRE lending conditions. Yield spreads on commercial mortgage-backed securities (CMBS), a proxy for financing costs and ease of obtaining credit, are at their widest in years and now far exceed the spreads on high-yield corporate bonds.
The report’s authors forecast a challenging environment for the commercial real estate industry for the remainder of 2023, and expect further declines in transaction volumes as "overall financing conditions will remain challenging."
Already, the loss of access to credit can be seen in landlords' struggles to service their CMBS debt. The Trepp CMBS Special Servicing Rate, which tracks delinquent CMBS debt transferred to special servicers, rose for a third straight month, to 5.62%. Six months ago, it was at 4.97%. Office properties and a lodging portfolio were among the biggest transfers in April, Trepp said.
Meanwhile, banks have also grown more conservative in their lending practices amid the recent turmoil in the banking sector following the collapse of Silicon Valley Bank, Signature Bank and First Republic Bank, the last of which was subsequently sold to JPMorgan Chase (JPM).
Small and regional lenders, which have been the most severely impacted by the recent crisis, account for a disproportionate share of CRE lending and have the greatest exposure to the industry. Lenders with less than $250 billion in assets account for 80% of commercial real estate lending, according to Goldman Sachs.
Shares of banks such as Western Alliance (WAL), PacWest Bancorp. (PACW) and Zions Bancorp. (ZION) have been under pressure since the start of the year.
Since March of last year, the Federal Reserve has hiked interest rates at the fastest clip in four decades, raising the benchmark federal funds rate by a cumulative 5% to the highest level since 2007. Higher interest rates have led to higher borrowing costs, cooling demand for new investments and causing real estate prices to fall in recent months.
At the same time, enduring remote and hybrid work arrangements have meant that workers haven’t returned to the office in large numbers. The office vacancy rate in the U.S. stood at 12.9% early in the second quarter, compared with a pre-pandemic low of 9.4%. It’s just above where it stood in 2010, a year after the global financial crisis. Meanwhile, the percentage of office space available for rent, a measure of availability tracked by CoStar Group Inc., hit an all-time high of 16.4%.