- The commercial real estate sector is facing a trifecta of pain: remote work emptied office buildings, property values suffered and interest rates went up.
- In the fourth quarter of 2023, the national office vacancy rate rose to a record-breaking 19.6%.
- That’s a problem for banks that hold much of the commercial real estate debt, but it will also impact everyday people whose local governments rely on property tax revenue and whose retirement portfolios include real estate holdings.
(NewsNation) — The commercial real estate sector is facing a trifecta of pain: remote work emptied office buildings, property values suffered and interest rates went up.
In the fourth quarter of 2023, the national office vacancy rate rose to a record-breaking 19.6%, according to Moody’s Analytics. Offices are now emptier than at any point since at least 1979.
That’s a problem for banks that hold much of the commercial real estate debt, but it will also impact everyday people whose local governments rely on property tax revenue and whose retirement portfolios include real estate holdings.
If banks do run into challenges, as several did in 2023, it could create a “pebble in the pond effect,” said Dan Roccato, a clinical professor of finance at the University of San Diego.
“We saw this play out last year: a bank gets in trouble, and that creates uncertainty in the market,” said Roccato. “That uncertainty ripples through the stock market, that uncertainty ripples through the real estate market, and that uncertainty then shows up in your 401(k) plan at the end of the month.”
Here’s why commercial real estate is worth paying attention to — even if you don’t work in an office building.
Public services rely on property taxes
Weakness in the commercial real estate sector could spell trouble for local governments, which rely on property taxes to fund schools, roads and other public services.
Officials in San Francisco have estimated that the struggling office sector could cut city tax revenues by as much as $200 million in 2028. In Washington D.C., the drop in property values is projected to cost $464 million in combined tax revenue over the next three fiscal years.
In New York City, offices account for 20% of the city’s property tax revenue and 10% of total revenue. Under the “doomsday” scenario, the estimated shortfall works out to $1.1 billion for fiscal year 2027, roughly 3% of the total property tax levy, but within the range, tax revenues can “ordinarily vary,” according to an analysis by the city comptroller.
Other cities are more reliant on commercial property taxes.
In Boston, taxes on commercial property account for almost 36% of its total general revenues, according to the Tax Policy Center. Dallas (26%) and Atlanta (19%) also have high reliance on commercial property taxes, the analysis found.
To make up for the shortfall, city governments will have to find other ways to balance their budgets, either by cutting spending or increasing revenue from other sources like residential property or sales taxes.
Empty office buildings don’t just hurt local tax revenue. Fewer commuters means less activity in commercial office districts — restaurants and shops that depend on daily lunch rushes and foot traffic.
The cycle of spillover effects has been dubbed the “urban doom loop,” wherein struggling office districts negatively impact entire cities.
Retirement funds are invested in real estate
Over the last two decades, state and local government pension plans have increasingly tilted toward alternative investments that include asset classes like hedge funds and real estate.
Now, pension funds have more money in alternative investments than at any point in history ($1.6 trillion), including $460 billion invested in real estate, according to the Equable Institute.
Given the shift, alternative investments will play a much more significant role in public pension performance in the years ahead, and tumult in the commercial real estate market could present a risk.
Last year, the nation’s largest public pension fund, the California Public Employees Retirement System (CalPERS), saw a negative return on commercial real estate hamper its annual performance. However, the fund was still able to report a positive return thanks to a strong stock market.
For the vast majority of Americans who don’t have a pension, the stock market is exactly where the ripple effects brought on by a struggling commercial real estate sector could show up.
More uncertainty for banks, stock market
Banks are the largest lenders of commercial real estate mortgages and hold around $3 trillion of that debt on their balance sheets.
Now, creditors are facing a “maturity wall,” with almost $1.5 trillion of U.S. commercial real estate debt coming due for repayment before the end of 2025. At the same time, office and retail property valuations are down and could fall as much as 40% from peak to trough, Bloomberg reported.
That’s particularly concerning for small, regional banks, which hold significantly more exposure than their larger peers when it comes to commercial real estate.
Last year, the collapse of Silicon Valley Bank, First Republic and Signature sent shockwaves through the financial industry. More closures could be coming.
A recent working paper from researchers at USC, Columbia, Stanford and Northwestern found roughly 44% of office loans appear to be in “negative equity,” which means their current property values are less than the outstanding loans.
As a result, 10% to 20% of commercial real estate loans could default, the equivalent of between $80 billion to $160 billion in bank losses, the researchers found.
In a recent “60 Minutes” interview, Federal Reserve Chair Jerome Powell said he expects some smaller banks will “have to be closed” or “merged out of existence” due to the commercial real estate weaknesses but called the situation “manageable.”
“I don’t think there’s much risk of a repeat of 2008,” Powell said.
Bank closures don’t mean Americans are going to lose their savings — nobody has ever lost a penny of insured deposits since the FDIC was created in 1933 — but a further tightening of the belt at regional banks could make it harder to get loans and lead to more financial uncertainty for small businesses.
“We’ve already seen banks become a little bit more selective, a little bit more conservative about who they lend to and under what terms they lend at,” said Roccato.
Copyright 2024 Nexstar Media Inc. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.