Capital Economics predicts US commercial real estate won't recover until 2040
Out-of-fashion office buildings are the main reason the respected economics consultancies' deputy chief property, economist Kiran Raichura, says the commercial real estate market in the US probably won’t fully recover until 2040.
High interest rates, higher operating costs and a shift to remote working have conspired against office space in particular - "It's quite possible to see that recovery take much longer than the 15 years that we've pencilled in, and it could be well into the mid-2040s even," Kiran Raichura has said.
The commercial real-estate sector in the United States therefore is likely to recover at a “painfully slow rate” from its deepening downturn as those office buildings go out of fashion, that’s according to the respected Capital Economics property economist forecast.
"It's very easy to see values take much longer to get back to those levels, and actually, the growth rate we've assumed to get back to the peak after the size of the fall we're expecting over the next few years is higher than the rate in the last 10 or 20 years," Raichura has said.
"So actually, it's quite possible to see that recovery takes much longer than the 15 years that we've pencilled in and it could be well into the mid-2040s even," he added.
Overall, US commercial property prices are down around 20% from their peak, with office buildings in business centres down even more than that, some losing almost half of their peak market value.
It could be the full impact of those falling prices has yet to be concluded. When that occurs, borrowers will be put under even more stress, also putting lenders at risk. That’s because in the US many small, regional, commercial banks are involved.
There are real worries about a threat to the wider financial system, though in theory it shouldn’t have too great an impact. However, as observers have said, that’s what people said before the 2008 global financial crisis – there’s no doubt that there are plenty of reasons to worry about the US commercial real estate market.
The German lending giant Deutsche Pfandbriefbank has struggled to reassure investors over concerns about its own exposure to the troubled US market. So, consequently, the US commercial real estate is “casting a skyscraper-sized shadow” over its lenders, on a worldwide scale, raising doubts about a potential financial crisis. Major banks from New York to Japan are dealing with the fallout with fears of a wider contagion, should the issue gather more momentum.
Columbia Business School professor Stijn Van Nieuwerburgh has been warning for some time that in the US, the turmoil in the commercial real estate market is just beginning – falling prices could easily “fire up” another banking crisis, hurting the rest of the US economy.
In the US as in the UK, commercial real estate holds a high proportion of value in the overall property market. From the large towering office buildings in city centres, to secondary office space, prime and secondary retail, leisure and industrial, to multi-occupied residential buildings; all form a substantial segment in the property market store of value.
All of these assets saw a huge boom in value over the past decade, fuelled by ultra low interest rates. This made it easy for investors and developers in the sector to “load-up on debt” without fear or favour, and the banks and finance houses were only too keen to oblige.
What happened next was two major unforeseen events: the Covid pandemic struck without warning, out of the blue came an unprecedented change in living and working routines for the present generation. Working-from-home (WFH) and flexible working changed working methods using new technology like never before.
Office use work patterns were changed out of all recognition when lockdowns hit, and these have largely persisted the same since. These changes led to record vacancy rates and a fall-off in the demand for office space, coupled with a similar fall-off for associated sectors such as hotels, retail stores, and city centre living spaces, though the latter has seen positive recovery.
Secondly, countries’ central banks, reacting to a strong hike in inflation, aggressively bumped up interest rates. Combined, the two changes – WFH and the high cost of debt - made commercial real estate investments a lot less attractive. Cash became a safer home for capital when higher returns were possible in Treasury bonds and cash accounts, placing a financial strain on lenders, owners and tenants.
Property values plunged when Covid hit and they have been falling ever since, not helped by a further knock to the economy when the Ukraine War crisis caused a hike in world energy and food prices, leading to the so-called “cost of living crisis”, particularly in Europe and the UK.
It’s still impossible to predict the long-term impact of all this on the commercial property markets as working patterns may still be normalising. It seems clear though that city centre office buildings will continue to suffer, many having lost almost half their peak market value, that’s according to research from Morgan Stanley. Industrial and warehousing seems to have come though the crises relatively unscathed, but retail has felt the blast almost as hard as the office sector, due largely to the continued growth and trend to online shopping.
Although the UK economy may have avoided a deep recession, economic pressures continue to present challenges and the commercial property market is probably top of the list. As in the US, office and retails have suffered most. However, UK lenders tend to be larger and better funded than in the US, so wider economic worries are limited here.
A further factor in the UK is the environmental lobby’s push for Net Zero. Sustainability, well-being and office amenities remain major factors when tenants assess the desirability of commercial occupancy. There’s no doubt that buildings meeting the amenities tenants desire in a post-Covid world, along with high EPC ratings ensure employee satisfaction and limit occupants’ exposure to future occupancy costs.
High interest rates, inflation and sustainability is the stark economic reality in the UK business world. The move from ultra low debt costs, to comparatively high debt costs, has led to both a drop off in demand and in investment.
But if the economy can start to recover, companies will become bolder and more optimistic. Investment in commercial real estate will return.
Lindsay Dowden, managing director at Modus has said:
“There is still high tenant demand for office space with solid ESG credentials, And we expect to see a high level of engagement with landlords and funds to reposition existing buildings to meet the government's targets in what is an evolving regulatory environment.”
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