In this episode of the REconomy Podcast™ from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi discuss how underutilized office space may impact the commercial real estate industry with special guest Senior Commercial Real Estate Economist Xander Snyder
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“All of this is to say that impaired office cash flows will likely translate into lower prices for office buildings. And, due to the limited transaction activity going on right now, we probably haven't witnessed a lot of this price decline quite yet. And this issue is compounded by a lot of office debt that will be maturing soon in 2023 and 2024 in a higher interest rate environment.” – Xander Snyder, senior commercial real estate economist at First American
Odeta Kushi - Hello and welcome to episode 62 of the REconomy podcast, where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American and here with me is Mark Fleming, chief economist at First American.
Mark Fleming - Hello Odeta. Commercial real estate has been in the news a lot lately following the failures of Silicon Valley Bank and Signature Bank. To talk about what's going on and why commercial real estate is getting so much attention, we're joined again today by our favorite podcast-voiced friend from First American, senior commercial real estate economist Xander Snyder. Welcome back to the podcast, Xander. Hi, Mark. Hi, Odeta. Glad to join you both again on the show.
Odeta Kushi - That was a heck of a welcome, Mark.
Mark Fleming - I have voice envy, clearly.
Odeta Kushi - Yeah, I think I do too. Welcome back, Xander. You joined us a few episodes ago to chat about shadow vacancy in office buildings, which is a measure of under-utilization for office buildings that are much emptier today than they were pre-pandemic. Today, we're going to pick up where we left off and talk about some of the consequences of that emptiness, right?
Xander Snyder - Yes, exactly. There are all sorts of metrics that I could throw around about price declines and transaction volumes and interest rates. But, on a more fundamental basis, the pandemic changed how we use and interact with space, especially office space and residential space. In the pre-pandemic world, very few people worked remotely, and even fewer people would have imagined a world where work habits would shift all at once, but they did. And now there's less demand for office space. And I think some of that decline in demand is probably going to be permanent.
Mark Fleming - Wow, an economist making such a declarative statement. Xander, no, on the one hand or on the other here. Could you tell us a little more about the courage of your conviction and what some of the consequences would be?
Xander Snyder - Well, maybe I'll grow my third hand by the end of the podcast episode, we'll see. Yeah, throughout the pandemic, as we all remember, there were different waves of outbreaks. And a recurring pattern developed where at the end of each wave, employers would push to get employees back to the office, only to have their plans foiled time and time again by the onset of another wave. So high-frequency data on physical occupancy and office buildings let everyone track how busy these buildings were on a day-to-day basis compared to pre-pandemic benchmarks. And, as time went on, I think a lot of us were expecting that those physical occupancy numbers would eventually go back up and return to pre- pandemic norms.
Odeta Kushi - And yet, here we are three years on from the pandemic's onset and the latest Kastle data shows that the average physical occupancy rates across the 10 metros it covers compared to pre-pandemic is still under 50%.
Xander Snyder - That's right as time went on, and as we dug ourselves out from wave after wave of COVID, many kept expecting that the return to office would eventually kick into full swing, and we'd see those physical occupancy numbers go up, but they haven't. So the technology that enables remote work exists. It's out. It can't really be put back in the box. And from my perspective, all that does is add another knob that can be turned when employers and employees are negotiating contracts. Some people will value money above all else, and others will value remote work above money. As long as some people in the economy prioritize remote work over other forms of compensation, there will probably be reduced demand for office space compared to those pre-pandemic levels.
Mark Fleming - As you're saying this, I'm sitting here thinking, wow, like here we are on a Teams' call, the three of us doing this from three different locations all in our home offices. But, because employee preferences more broadly than basic compensation are more easily met by employers with the prevalence of remote work technology, there will be more remote work than before, at least for those employees that have the negotiating power. I think that's an important point. Not everybody necessarily gets to choose. I see that this gets to the issue of the permanence, or at least the persistence of weaker office demand. The demand for office space has fundamentally decreased and future demand is going to remain lower than pre-pandemic levels. Do you have any sense for how much less space may be demanded?
Xander Snyder - Lower demand for office space is already translating into higher vacancy rates. Fewer tenants means the cash generated by an office building is reduced and, like any business, if you're struggling to bring in enough income to offset your expenses, the business is going to face the risk of distress. And this is essentially what's happening to office real estate right now.
Odeta Kushi - Let me drill into the issue of cash flows a little bit. One way in which commercial buildings differ from residential buildings is that commercial buildings are often valued based on the amount of cash flow they generate. So does this imply that a long-term permanent reduction in cash flows could result in a long-term impairment in office building prices?
Xander Snyder - Yes, unfortunately, I do think that's the right way to interpret what's going on here and where we're heading. Right now, in the commercial real estate market, there aren't a lot of transactions happening. Transaction volume or deal activity is quite muted. And this is a function of several things, but certainly higher interest rates and scarcer debt are part of it. Fewer transactions means that there are fewer comparable transactions, and fewer comparable transactions means fewer benchmarks to assess the true value of properties. That's generally how it's done. In commercial real estate, you use comparable transactions, or comps, to figure out what a property is worth. And a true price for a commercial property doesn't really exist until that property is sold. And, until then, you're just relying on these estimates, like appraisals or comps. And all of this is to say that impaired office cash flows will likely translate into lower prices for office buildings. And, due to the limited transaction activity going on right now, we probably haven't witnessed a lot of this price decline quite yet. And this issue is compounded by a lot of office debt that will be maturing soon in 2023 and 2024 in a higher interest rate environment. It's not a great combination.
Odeta Kushi - No, it sure doesn't sound like it.
Mark Fleming - Well, if you ever wonder why economics is called the dismal science, there you go. Let me try and play devil's advocate, though for a second here, and maybe inject some optimism, hopefully, back into this conversation. Today, we demand less office space than we used to due to the greater prevalence of remote work. But doesn't that also mean we demand more residential space since it acts both as a shelter and workspace? Not to mention the fact that residential real estate is already in very short supply? Couldn't we take that underutilized office space and just miraculously turn it into more residential space? Why not convert all these office buildings into apartment buildings and solve both problems at once? Okay, that's really just a little tiny, tiny drop in the proverbial bucket then. It's certainly not enough to meaningfully remove old or obsolescing office stock. I'm really proud. I got that word right... obsolescing.
Xander Snyder - Yeah, in theory, office conversions are a great idea. In practice, it's one of those situations where it's much easier said than done. Office conversions are happening, and they are currently happening at a faster rate than they were before the pandemic. But they're still not widespread. According to a recent report from CBRE, only about 42 office conversions took place in 2022, all across the country. And there are currently about 220 more conversions either planned or underway. So, if you add all that space together, it comes to a little bit more than 80 million square feet. And, just as a point of comparison, to put that number in perspective, CoStar estimates that there's approximately 8.4 billion, with a B, square feet of office space in the country. So, in other words, all office conversions last year, plus all office conversions currently underway account for less than 1% of the total office stock.
Mark Fleming - Exactly. And repurpose it to productive residential use. But why easier said than done? Like, why is this so difficult?
Xander Snyder - The short answer is they're just costly and difficult to do. Estimates vary widely since conversion projects are all unique. But some data indicates that office to multifamily conversions can be completed at about a 15-to-25% discount to ground-up development. So, on average, that means that conversions may be cheaper than building a building from scratch, but not by a lot. And that doesn't leave a huge margin of error for unanticipated cost overruns. And, you know, whenever you're opening up the walls of a building, there's always the risk of finding a problem that you didn't plan for that will cost more money to fix. So, the economics of these conversions, at least today just don't really seem to pencil out frequently enough to meaningfully reduce that existing office stock.
Odeta Kushi - So you said these deals don't pencil out today, but could they in the future? What would have to happen for there to be more office conversions?
Xander Snyder - Well, prices would have to decline enough to make the discount relative to ground-up development bigger.
Odeta Kushi - I see. And we haven't seen a lot of those discounts in part because office owners are hesitant to sell, which is contributing to the low level of transaction volume.
Xander Snyder - Yes, that's exactly right. Now, a lot of office building loans are coming due soon. And this is also forcing the issue for a lot of owners. So the question you need to ask yourself is, what do you do if you have a large loan on a class B office building coming due? Interest rates today are twice as high as the rate that you had on your existing loan. And, on top of that, your building is half empty. There are going to be office owners that can't afford to make loan payments using the cash generated by their building, if they can even find a lender willing to lend to them at all.
Odeta Kushi - A little reminder that a class B office building just refers to a building that might not have the same pizzazz of a class A building with its impressive aesthetics and amenities, but is, instead, a little bit older, still functional and elegant, but just not the same level as a class A.
Mark Fleming - Pizzazz...Who would have thought we would get that word into a podcast episode about commercial real estate? But I do digress. It's important to understand how different commercial real estate loans are from residential loans. With residential loans, each payment is composed of an interest portion and a principal portion. The rate at which you repay this principle is called the amortization schedule. And for typical fixed-rate mortgage loans, you gradually repay your principal over the course of 30 years, hence the 30-year, fixed-rate mortgage.
Odeta Kushi - With commercial loans, that amortization schedule is different. Commercial loans often have a term of five-to-10 years, instead of 30 years. And the principal is usually paid back in smaller increments, if at all. For example, some commercial loans are interest only, which means that for the life of the loan, you're only paying interest payments. For other loans, there is amortization, but by the time the loan comes due, you may have only paid off a small fraction of the principal. This is where refinance risk comes into play with commercial loans. When you need to refinance, you maybe have 90-to-95% of your principal outstanding. This amount that needs to be paid off or refinanced when the loan comes due is called a balloon payment.
Mark Fleming - Right. So back to that class B office owner with a loan balloon payment due later this year. If I'm that owner, I need to pay the balloon payment from cash, which I likely don't have, or refinance, but I can't find a new loan because the new higher interest rate based monthly payment is less than the cash flow I'm earning from that half-empty office building. Or the bank simply won't give me the loan, even if I wanted to pay more than I earn from that office, because that's just too risky in their mind. What are my options in that situation? And what are the bank's options in that situation?
Xander Snyder - Unfortunately, there aren't a lot of great options. You can try to work with the bank to restructure the existing loan, which is sometimes referred to as amend-and-extend, or somewhat more commonly, extend-and-pretend, kicking the can down the road and more wonky jargon. Now, loan restructurings like this are usually viable options if a company or building is facing a short-term cash crunch, but is likely going to be able to get back to some normal state of operations afterwards, which, as we've already talked about, doesn't really appear to be the case with a lot of office properties. So, another option would be an equity injection, which is just kind of a fancy way of saying a bigger down payment. Now, this may well be required by some lenders in order to refinance on terms that borrowers can afford to pay. But it also puts office owners in the unenviable situation of having to invest more of their own money in a potentially distressed situation, chasing bad money with good, so to speak. And this is something that a lot of investors would prefer to avoid. And they might, at that point, even choose to cut their losses and just walk away, handing their keys back over to the bank.
Mark Fleming - Oh, to use a term from the Global Financial Crisis, which I haven't used in quite a long time, you mean a strategic default?
Odeta Kushi - Whoa, that is not a term we like to hear. It sure doesn't sound like great news. If more banks end up owning office buildings that have lost a lot of value, that would mean that those bank-owned buildings would be some of the most challenged and have a small prospective buyer pool as well. If I'm a bank that owns an office building that was taken as collateral, who can I sell that building to, and if the bank does sell, it might likely be at a big discount, But just how big?
Xander Snyder - Those are the questions facing commercial real estate right now and, unfortunately, there are no easy answers. This though, is the dynamic and concern that is driving a lot of the widespread concern about commercial real estate lending that you may have been reading in the news following the failures of Silicon Valley Bank and Signature Bank.
Mark Fleming - This just seems so dire. Is there any data we can point to that gives us a sense of the scale? Because I get it, in principle, there are likely to be some on the margin. But, if it's more than just the margin, what is the scale of the challenge for office real estate, and the timing of these debt maturities that would cause all of these hard decisions to be made?
Xander Snyder - Well, the Mortgage Bankers Association, or MBA, for short, published a report in mid-March that estimated that the total amount of all upcoming office loan maturities was approximately $190 billion for the remainder of 2023. So, big number, what does it mean? That represents about 25% of all outstanding office loans. Now, an important caveat to add to that is that only approximately half of that debt is bank-held and the other half roughly are held by non-bank lenders. So, if you look at just the bank-held office loans, which regulators care a little bit more about because depositors money is involved, there's about 29% of all bank-held office loans set to mature in 2023. So, a non-trivial amount.
Odeta Kushi - Yeah, those are some pretty big numbers. And it doesn't seem like this story is going away anytime soon, and I hope you'll be covering it as it develops, Xander. Listeners, if you'd like to keep tabs of the story as it develops, be sure to follow Xander on his Twitter or LinkedIn. It's @XanderSnyderX. He also regularly publishes blog posts on our Economic Center. Xander, thank you for joining us on the REconomy today.
Mark Fleming - Thanks, Xander. Before I say see you back again soon. Let's see if we can find a more positive story to tell in this regard.
Xander Snyder - You got it. Next time, we'll keep it on the cheerier side. But thanks for having me. It's been a pleasure.
Odeta Kushi - Well, thank you for joining us on this episode of the REconomy podcast. If you have an economics-related question you'd like us to feature on a future episode, you can email us at economics@firstam.com. We love to hear from our listeners. And, as always, if you can't wait for the next episode, you can follow us on Twitter. It's @OdetaKushi for me and @MFlemingEcon for Mark and @XanderSnyderX. Until next time.
This transcript has been edited for clarity.