US Office Properties: A Slumping Foundation
MyEListings' markets and economics editor and creates content about global macro events and their impact on US commercial real estate.
The American workplace has undergone a phase transformation, accelerated in large part by the global pandemic. As remote work became a standard for many, the ripple effects on the US office property sector became increasingly apparent.
Kastle Systems' Back to Work Barometer, a proprietary tool that gauges office occupancy rates, provides insights that are both revealing and concerning.
This indicator, by offering data from properties across ten major cities, demonstrates that even after a modest post-Labor Day increase, offices remain over half-empty on average.
But what do these numbers imply for the broader US economy, and how does the future look for office real estate?
Challenges for the Office Sector Queue Up
From Kastle-secured properties across the nation, Kastle Systems' Back to Work Barometer consistently signals a plateaued return to the office post-COVID-19.
This sluggish pace likely portends profound challenges that lie ahead for the office real estate sector.
Accelerating Slow-Moving Massive Asset Classes
A deeper look into the potential knock-on effects of vacant buildings uncovers more unsettling revelations: Since office properties tend to be slower-moving assets with longer time horizons, it can take years for incentives to work their way to owners' pockets.
Big, slow-moving assets can break things when they move too quickly. In addition to this delayed-response feature, an insidious decaying feature lurks beneath the surface, as long-term leases renew in time for less space, or worse, none.
The problem, then, can transmit itself to lenders, which, in about 45% of cases, hold non-recourse loans on subject properties. These are, in turn, backstopped by office properties which collectively constitute an estimated $3.2 trillion asset class, that is, on average, half full.
Path of Least Resistance: Revert Property to Lenders
Non-recourse loans, in turn, can result in lenders being put a glut of these uneconomical properties they must then operate, overwhelming REO departments, and which they could be unable to offload in time to stave off regulatory actions, such as being shuddered and sold off.
These, in turn, could force even further consolidation on lenders, but this would not solve the problem entirely and could create even more than the market is prepared to navigate.
Market Forces Imposing Reality on Participants
Against this backdrop, other financial indicators further intensify concerns. The 10-year treasury bond, a pivotal rate that casts a nearly-direct influence on cap rates for commercial properties, has recently surged to alarming levels.
With 10-year treasury rates hitting a 16-year high at 4.79%, this bond's trajectory only spells more trouble for an already distressed office property market. Elevated bond rates nearly directly push cap rates for these properties higher, which implies further depreciation in their market value.
The Looming Regulatory Overhaul: CRE Opacity
However, a more insidious issue lurks in the background. With no mark-to-market mechanism or real-time valuation requirements for commercial real estate holdings on corporate ledgers, potential losses remain hidden.
The only true way we can know, given the lack of transparency, is if a mass selloff ensues. And since the market requires such knowledge if massive assets are to accelerate, the likelihood of its being imposed by the market itself is likely increasing.
Hidden values only become visible when properties are up for sale or, in dire cases, are abandoned, allowing lenders to reclaim them. Such instances merely add another loop to a chain of deteriorating incentives as they nonetheless force buyers and sellers to transact.
Regulatory Reform Is Typically Reactive, Not Proactive
Historically, large-scale regulatory reforms follow crises and are not undertaken proactively. As we have called for here since last year, a comprehensive national solution is likely required, but is unlikely to be undertaken in advance of acute economic pain.
Since CRE represents a massive asset class with no centralized reporting, no mark-to-market mechanism, tremendous opacity resulting in very fuzzy ideas of loss potentials, and no anti-money-laundering protocols to which it must adhere, regulatory revolution is likely in order.
The emergence of zombie office properties is a stark reality of this scenario. These are properties that, due to low occupancy or other reasons, become economically unviable. Without proactive intervention strategies for these properties, a bleak future awaits.
The most probable path forward is an accelerated consolidation of banks. This leads to the creation of larger-but-fewer banks that may lack the local expertise necessary to navigate the intricacies of lending within the realm of commercial real estate, and the 10-year treasury represents the sea in which all participants must swim.
Key Takeaways
The Kastle Systems' Back to Work Barometer is more than just a metric—it's a lens into the future of office real estate.
The challenges reflected in the 10-year treasury bond rates and the lurking danger of zombie office properties on bank balance sheets are critical areas of concern.
As market forces conspire to force valuations to reflect reality, what that reality will look like is somewhat mysterious due to the lack of transparency in CRE reporting and recordation.
An office property selloff of unknown magnitude, bank consolidation, and regulatory reform are likely outcomes of the current confluence of inputs.
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