This week we're revisiting commercial real estate expert Don Zech, and his thoughts about the future of commercial real estate...enjoy.
Cheers, JR
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Thrive and survive ‘til ’25 – what’s ahead for commercial real estate?
The lower the interest rate, the easier it is to justify marginal projects toward the end of a business cycle when only cheap money gets the deal done. Thus, that is why commercial real estate tends to boom towards the end of the cycle and then drops into the abyss when interest rates rise and/or the economy contracts. Put another way, commercial real estate is the living embodiment of the adage that easy money makes you stupid.
With interest rates high, transactions have slowed, and it is making it difficult to know what things are worth. Over the next 5 years, more than $2.5 trillion in commercial real estate debt will mature and, in most cases, will have to be refinanced at higher rates ($700 billion in this year alone!). Higher rates will mean less cash flow and less cash flow will force cap rates higher. Higher cap rates mean lower property value and so it goes.
Real estate finance is not the only place feeling the finance squeeze. The subprime auto lending market is crashing as I write. Capital One has closed ALL credit lines for auto dealers. Wells Fargo has laid off all of its junior auto loan underwriters. The average loan-to-value (LTV) on a subprime loan was 150%. That means they were lending $20,199 on a $13,500 car! Average interest rate? 18%!
With higher interest rates come less loans, with less loans, thousands of mortgage employees have lost jobs and demand for space by the mortgage industry has plummeted. The square footage signed in the first quarter fell by 85% from the first quarter last year. To put this in further perspective, in the first quarter 2020 (pre-pandemic) 183 leases were signed, while in the first quarter this year we had only 17.
If you have a loan coming up in the next three years, you should consider talking to your lender now. Lenders are not looking for non-performing loans to start hitting their books in the coming years so many are willing to look at extending existing loans or doing a “blend and extend.” In the end it will boil down to loan-to-value and debt coverage ratios.
It’s not just mortgage companies that have slowed down leasing space. There’s been a notable retrenchment in office leasing activity since mid-2022 and the first quarter of 2023 continued the decline, making it the fourth straight of declining volume in the San Diego office market. The most notable drop has been biotech which has fallen 67% in the last year. A big part of the problem is work from home and tenants are squeezing more employees into less space. The ratio of space per worker has dropped roughly 20% over the last 10 years...
