Office Reckoning: Remote Work is Reshaping CRE

Good morning,

Office reckoning: remote work is reshaping CRE, record high rents, plus fees, and mixed signals in REIT loan data. Let’s delve into today’s topics.

📈 Market Update

🏢 Office Reckoning: Remote Work is Reshaping CRE

The pandemic-driven shift to remote and hybrid work has upended CRE, causing plummeting demand for office space and putting immense pressure on owners. Vacancy rates have soared while property values and rents have declined sharply, especially in major cities. The resulting debt crisis among real estate owners and investors could wipe out up to $1.3T in office building value worldwide, with the starkest declines in office-dependent metro areas like New York and San Francisco. While some regions like Asia and Europe are returning to offices faster, flexible remote policies seem here to stay across most of the globe, forcing a fundamental rethinking around the role and worth of traditional office space.

Markets Bucking the Trend:
Six office markets have seen sales volume growth in 2023. These markets include Tampa, Oakland, Los Angeles, Atlanta, central NJ, and Washington DC.

NYC Woes Continue:
Despite an uptick in leasing activity in August, Manhattan's office market continues to suffer from high vacancy rates, declining demand, and rents still below pre-pandemic levels.

💲 Record High Rents, Plus Fees

Landlords are increasingly charging tenants extra fees beyond just rent, including charges for parking, pets, trash pickup, pest control, mailbox use, and routine maintenance requests. Large apartment and single-family rental companies have significantly grown their fee revenue, with some doubling this income at acquired properties.

Government Pushback:
In response to rising tenant complaints, federal and some state governments are starting to crack down on rental fees. The White House got listing platforms to require fee disclosures alongside rentals, Colorado capped pet deposits, and Maine limited application fees. But landlords defend fees as necessary to cover their own increased operating costs, following similar fee trends in hotels, airlines, and entertainment.

🔺 Mixed Signals in REIT Loan Data

A new report analyzing CRE loans to REITs shows some signs of strength but also areas of concern. On the positive side, REITs seem more willing to utilize debt, as seen in rising utilization rates of credit lines. Their current ratios also improved, suggesting greater ability to cover short-term debts. However, metrics like lower interest coverage ratios indicate challenges from higher borrowing costs eating into margins. ROA and ROE also dropped, signaling reduced profitability and growth potential.

🔍️ Outlook:
The real estate market will depend on how high the Fed pushes interest rates to combat inflation. Treasury yields are at decade highs, putting pressure on REIT valuations and financing capacity. For REIT metrics like interest coverage to improve, the Fed must curb inflation without spurring further risks. If elevated rates persist, it may force cap rates and debt-to-equity ratios higher, weakening REIT valuations further. Until rates stabilize at lower levels, real estate faces valuation headwinds. But if the Fed achieves a soft landing, it could restore positive momentum.

✍️ Further Reading

• Money-for-Nothing Lawsuits Against Private-Equity Founders Get Boost (WSJ)

• CBRE Capital Forecast: Caution This Year, Some Recovery Next Year (CPE)

• Rate Hikes Curb Output for at Least a Decade, SF Fed Study Finds (BBG)

• Market Pulse: Goldilocks Payroll Data – Is Rate Lifting Labor Done after Labor Day? (Trepp)

• The Rise Of Alternative Assets In The Industrial Sector (GS)

• New York City’s Battle Against Congestion Begins at the Curb (BBG)

• State of NIMBY: The Battle to Build in NY (RD)

• US Homebuyers Weigh Climate Risk in Picking a House, Zillow Says (BBG)

• Landmark Tower in Chicago, Long Tied to Al Capone Rumors, Seeks First New Owner in Over 40 Years (CS)

• Denver’s Office Construction Pipeline Reaches Highest Level in Five Years (CS)

📊 Chart of The Day