Real estate experts told BI that the office sector is likely to experience a wave of distress in the coming years. Run-down, vacant offices may be sold off as owners cut their losses. This may be good news for housing supply as former offices are being converted. Even in apartments, industry veterans say.
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A corner of the commercial real estate market is experiencing a shake-up, with many office buildings facing hardship as they near debt maturity walls and struggle with the lingering work-from-home trend.
These factors have left some of the worst office buildings nearly deserted, a few fire sales are about to occur, a wave of office-to-apartment conversions, and more housing in the pipeline. Additional supply is likely, real estate experts said. Said.
Richard Barkham, chief global economist at commercial real estate investment firm CBRE, said Class B office buildings — a segment of office real estate that struggles to attract tenants primarily because they are older and need renovations — are undergoing dramatic changes. Then he said he was watching.
Vacancy rates for these second-class properties are as high as 80%, and many could be demolished or rebuilt over the next 10 years, he said.
“Banks are going to have to get rid of that property,” Barkham told Business Insider in an interview. “So we’ll have to wait and see. This will be paid off over the next two or three years, but I think we’ll see a wave of offices going back to banks. or be demolished, I say,” or converted. ”
The chain reaction appears to be already underway, with banks quietly taking troubled office properties off their balance sheets and conversions starting to trickle in.
The total amount of commercial real estate loans held by commercial banks has fallen to $2.9 trillion from a peak of $3 trillion earlier this year.
Big banks are holding back on lending to the sector, with 74% saying they will tighten standards for nonresidential commercial real estate lending in the second quarter of 2024, according to Federal Reserve data.
Meanwhile, the number of office spaces scheduled to be converted into apartments in 2024 has increased to 55,000 units, according to Yardi Matrix data. This is the highest number of office-to-apartment conversions in the last four years, and is a 357% increase from the level recorded in 2021. Quoted from RentCafe.
John Vabas, a real estate finance attorney at Polsinelli who works with commercial real estate lenders, has worked on several office-to-residential conversions this year. He said he had never worked on such a deal before the pandemic.
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Barkham estimates that office accounts for about 20% of the square footage of all CRE properties, with the worst-performing buildings accounting for about 10% of total office supply.
In a separate report, Yardi said there is about 1.2 billion square feet worth of office space that could be converted into residential space.
A CBRE analysis of office-to-residential conversions planned, underway, and completed since 2016 estimates that 1.38 billion square feet worth of office space could be converted. Barkham said this evolution could take about 10 years to fully occur in cities.
Admittedly, this kind of conversion is costly and difficult. In New York, architects are cutting holes in high-rise buildings and reconfiguring square footage, and Silverstein Properties, one of New York’s largest commercial landlords, is planning to renovate some of its office buildings by 15 It is investing billions of dollars.
Still, for homeowners facing an excess of unnecessary space, it may be worth trying to hide it.
“There is a strong base of really underperforming offices that will go under in 2025,” Barkham added. “It’s clear that we don’t need this much office space in the United States.”
A new era in the office market
While most quality buildings are occupied, office demand has generally been weak since the pandemic, when remote work became more prevalent. The U.S. office vacancy rate was 19.4% in August, up 200 basis points from a year earlier, according to data provider Commercial Edge.
The commercial real estate loan delinquency rate rose to 1.42% in the second quarter, the highest rate in nearly a decade. Meanwhile, commercial real estate prices fell an additional 9% year over year in the first quarter, according to Federal Reserve data.
But Babas says real estate investors have become more enthusiastic about the sector in the past six months, in part as buildings have been sold at deep discounts and banks have looked to take loans off their balance sheets. . He recalls a recent deal he worked on. There, property owners discounted the price of their buildings by 20% to 30%.
“I think the people who owned that building just wanted to cut their losses because it was pretty vacant,” he said.
Babas said that because of the housing shortage in the U.S., it is expected that many decommissioned offices will be converted into residential real estate. According to Yardi data, office-to-residential conversions are the most common type of conversion project, accounting for 38% of all conversions currently underway.
“The idea that people were in the office five days a week versus three days a week was the exception, not the norm. And now it’s the other way around,” Babas said. “If you do that company-wide, obviously demand will go down. And if you think about going back to the office after the pandemic and demand goes down, I think you need to start thinking about what’s next. Well, I have this space. What are the needs of the community and the location? And in New York, it happens to be a residential area.”
Washington, D.C., New York City, Dallas, Chicago and Los Angeles recorded the most office-to-apartment conversion starts this year, with a combined 19,462 conversions underway, according to Yardi data. are.
Commute times are likely to be shorter on average, and cities with more vacant offices may attract more stores, restaurants and theaters, Barkham said. However, he points out that change will not happen overnight.
“You’re going to see empty buildings and you’re going to see clear offices for quite some time,” Barkham said.
