Willis Towers Watson suggested strategies for asset owners to navigate pullback in the commercial real estate market, such as diversifying their real estate holdings, and gave insight on the current state of the market in its new report, “Out of office: The status of the U.S office property sector amid bank turmoil and remote work.”
WTW also reported fewer developing projects being undertaken soon, as regional banks, which provide a significant amount of construction lending, have cut back.
According to the report, landlords will face significant refinancing risks in the next few years, as higher interest rates will result in pricier loans that will come due soon. Commercial mortgages are often structured as three- to 10-year loans for which property owners pay accrued interest in monthly installments over the length of the loan, with a one-time principal repayment at maturity.
Tightening conditions and higher rates, resulting in higher-cost loans, at a time when property values are declining make landlords’ ability to pay off, refinance or sell their properties more challenging. According to the report, $1.5 trillion in commercial mortgages will come due over the next three years, while delinquency rates have ticked up to 4.4% in July from 2.9% in January.
What to Expect in the Coming Years
Although the WTW report noted that delinquency rates are lower than in previous cycles, its analysts expect distressed activity to increase over the coming years. According to WTW, the most at-risk loans are those originated in recent years, most at peak valuations with variable interest rates.
There are other structural and cyclical headwinds for the commercial real estate industry, including the growth of remote and hybrid work and the current economic slowdown. WTW predicted office vacancies will rise and peak in 2025 as big tech companies and the federal government, some of the largest commercial tenants, reduce their office space.
According to the report, office attendance has been 40% to 60% of the historical norm. The report cites McKinsey & Co.’s July 2023 McKinsey Global Institute, Empty spaces and hybrid places: The pandemic’s lasting impact on real estate report that states office attendance has stabilized at 70% of the historical norm. “Regardless of the exact utilization figure, the paradigm shift in hybrid work arrangements will likely lead to a material decrease in the amount of office space tenants require, [and it] will take years to understand the effects on overall demand,” the WTW report stated.
While commercial utilization is decreasing, WTW noted that tenants are opting for less space, but in newer buildings—many with LEED certifications and numerous amenities (such as gyms and outdoor space)—near convenient transit locations.
According to the report, older office buildings are becoming obsolete and require significant investment by owners to maintain or renovate. The report cited data from Cushman & Wakefield plc stating that 15% of the U.S. supply of office space—mainly low-quality, older buildings—is responsible for 80% of the sector’s vacancies, as these older buildings struggle to attract tenants. WTW estimated this will result in more than 330 million square feet of excess space by the end of the decade.
WTW also estimated that 34% of commercial real estate can be suitable for use as residential or other space. This does come with its own challenges, the report noted, such as physical and zoning limitations of converting office to residential use.
How Investors Can Better Position Themselves
According to WTW, the pullback in commercial real estate debt markets presents an opportunity to fill the funding gap from non-bank capital providers. There is a big opportunity for alternative lenders, such as private credit and direct lenders, to take up commercial real estate lending as an alternative to local banks, explains Jon Pliner, WTW’s senior director and head of delegated portfolio management.
The report stated that shifting property values and tightening financial conditions have made it possible for lenders to derive equity-like returns by accessing different segments of the commercial real estate finance stack (such as senior debt, mezzanine debt and preferred equity).
Commercial real estate owners who have stakes in the newest, highest-quality buildings will better navigate any future headwinds, WTW noted, adding that commercial office space currently ranks last out of 14 different property types by interest from institutional investors. According to WTW’s report, investors should look into investing in different office subtypes, such as medical or life sciences, which are effectively immune to headwinds such as the economic downturn or remote/hybrid work.
Tags: commercial real estate, Jon Pliner, Willis Towers Watson, WTW