Turbulent times are ahead for commercial real estate loan health, which is expected to steadily decline through 2025 across various investment categories, impacting stakeholders like commercial mortgage-backed securities (CMBS) investors, U.S. banks, and life insurers. While we can expect things to worsen, Fitch Ratings predicts losses will remain manageable within existing risk assessment parameters.
The breakdown
Things are expected to worsen for loans tied to investments like office buildings, malls and hotels. Offices have been hit hardest by the work-from-home trend, leading to challenges in paying loans and lower property values. Malls are struggling thanks to more consumers opting to shop online; brick-and-mortar stores — and the all-important anchor stores — cannot attract enough foot traffic, feel the pinch and fail to renew leases. While the travel industry has regained some steam, it hasn’t yet reached pre-pandemic numbers.
The number of missed payments on these loans is expected to double by 2025, especially for older office buildings in city centers, which could spell trouble for banks and investors who backed those loans.
Since mid-2022, Fitch Ratings has significantly (by 100 basis points) increased the expected returns (cap rates) required for lower-quality office buildings, reflecting concerns about the buildings’ future value due to several factors:
- Higher tenant improvement costs: Businesses must spend more to adapt new offices to their needs.
- Lower renewal rates: Tenants are less likely to stay in the same office, creating more vacancies.
- Overpriced leases expiring: When existing, above-market rent deals end, new tenants might pay less, reducing income.
- Higher availability of empty offices: Finding new tenants becomes harder with more competition.
Life Insurers and Real Estate
U.S. life insurance companies invest heavily — but cautiously — in real estate. Their portfolios focus on high-quality properties with diversified sectors. These companies also manage their investments carefully with strong financial reserves and conservative lending practices.
Most of their real estate exposure comes from direct loans to property owners, not risky financial products like CMBS. While life insurers may face some losses due to the changing CRE market, they’re well-equipped to weather them. Their strong financial foundations, diverse investments and proven track record throughout economic ups and downs provide a safety net. At the end of 2022 (the most recent data available), the breakdown of commercial mortgages by type was:
- Apartment and multifamily: 30%
- Office: 20%
- Industrial: 16%
- Other: 16%
- Retail: 13%
- Lodging: 3%
- Mixed Use: 2%
A Crossroads for CRE
2025 promises to be pivotal for CRE as the industry continues navigating post-pandemic realities and a turbulent economic landscape. Gone are the rollercoaster years of recent times; instead, we can expect a new normal defined by creative solutions, cost-consciousness and strategic adaption. Here are other key financial trends to watch this year.
Loan crunch: Higher costs, tighter standards
Remember the era of ultra-low interest rates? It’s gone. Since March 2022, rising rates have thrown a wrench into CRE, particularly for investors reliant on regular refinancing. Adding fuel to the fire, banks are tightening lending standards, making securing loans more challenging. This strategy has led to a significant drop in commercial property sales, with million-dollar transactions down a staggering 53% in the first half of 2023.
A glimpse of hope?
A ray of light may appear in the second half of 2024, assuming certain conditions play out, like:
- Stable market liquidity hinges heavily on office property valuations and their impact on overall market confidence.
- Continued downward trend in interest rates. If the Fed lowers rates and they keep falling, borrowing could become more attractive again.
- Unwavering demand for housing. Demographics suggest housing needs will remain strong, propelling investments in the single- and multifamily sector.
Soaring construction costs: Brace for higher insurance premiums
A perfect storm of inflation, labor shortages and skyrocketing materials costs has driven construction prices to record highs. These conditions and rising catastrophic claims have translated into dramatic increases in commercial property insurance premiums, with Q3 2023 seeing an alarming 17% hike, according to the Council of Insurance Agents & Brokers Market Index.
The challenge goes beyond premiums. Construction inflation also creates gaps in coverage if policies aren’t updated to reflect current replacement costs. While material costs might stabilize in 2024, labor shortages and regional demand could hinder any potential savings.
Student housing: A beacon in a challenging market
With average office vacancy rates hovering around 15% and multifamily rent growth slowing significantly, privatized student housing has become an attractive option for investors. Historically resilient through economic downturns, student housing even maintained stable occupancy rates during the pandemic. Today, many campuses are experiencing enrollment surges, leading to a corresponding rise in housing demand, particularly at prestigious research universities and schools in lucrative athletic conferences.
Limited supply further sweetens the deal for investors. High interest rates constrain funding for new construction, and many schools lack readily available land for development. This situation has opened the door for private investors to upgrade and manage existing properties, often on behalf of the institutions themselves. The limited supply paired with upgrades allows owners to command higher rental rates. Notably, purpose-built student housing witnessed faster rental rate increases than multifamily properties in H1 2023.
Office-to-residential conversions: A potential boon, with help
With nearly 1 billion square feet of vacant office space in the U.S., landlords face fierce competition for tenants. Meanwhile, tenants are consolidating space to accommodate hybrid work models and gravitating towards higher-quality properties, putting pressure on property taxes. This scenario leaves owners and investors with a problematic choice: upgrade their office buildings or explore alternative uses with more potential than struggling office and retail spaces.
Currently, conversions face hurdles like financing constraints, zoning restrictions and complex building regulations. However, a silver lining has emerged in the form of legislative efforts. Recognizing the shortage of affordable multifamily housing, lawmakers are exploring ways to facilitate office-to-residential conversions.
For investors, multifamily properties offer continued profitability, especially when carefully considering economic and risk factors. Further, localities exploring multifamily housing as a new revenue source are actively developing incentives and tax breaks to encourage these conversions. With such support in the pipeline, expect these transformations to accelerate in the coming years.
Unlocking tax savings: The power of cost segregation studies
A cost segregation study can be a game-changer for real estate owners seeking to accelerate depreciation deductions and reduce tax liabilities. This process involves engineers and tax experts meticulously analyzing a property, identifying individual components with shorter depreciation periods — 5, 7 or 15 years — compared to the standard building depreciation timeframe. The result? Substantial early tax savings on the property.
All types of commercial properties can benefit from a cost segregation study. While newly constructed, renovated or acquired properties typically gain the most advantage, any company undertaking building upgrades exceeding $500,000 should consider this valuable strategy.
Are you a commercial real estate investor looking for a specific property to meet your company’s needs or seeking a qualified cost segregation partner? We invite you to talk to the professionals at CREA United, an organization of CRE professionals from 92 firms representing all disciplines within the CRE industry, from brokers to subcontractors, financial services to security systems, interior designers to architects, movers to IT, and more.
