July 25, 2024

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Opinion: Commercial real estate is in a growing crisis that seems to have no end

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Commercial retail space is advertised for lease along King Street West in Toronto on March 9, 2021.Tijana Martin/The Canadian Press

Gus Carlson is a U.S.-based columnist for The Globe and Mail.

In some respects, solving the puzzle of the looming office space crisis is a bit like being tasked with designing a plan to save the dinosaurs.

There has been a catastrophic event – the pandemic – that along with technology have changed the environment and the behaviours that shape it. Despite efforts by companies to cajole and compel people back to offices, vacancy rates in the U.S. and Canada remain around 20 per cent.

The hangover, exacerbated by stubbornly high interest rates, is just the tip of the iceberg. The longer-term problem is what to do with all that unused, undervalued office space, much of it in core downtown areas of major cities around the world. Can it be repurposed, as many retailers have been forced to do with their brick-and-mortar operations as online sales have grown? Is it a potential mixed-use solution to the current housing crisis across North America hiding in plain sight?

It may not be a case of extinction – yet – but it isn’t a pretty picture. Over the past year, there has been a sharp rise in loan extensions and delinquencies in office space, and it is expected to worsen in 2024. In simple terms, landlords have been asking lenders to extend loans in hopes that interest rates will come down at some point, but that prospect is being pushed out further in time.

You don’t need an MBA to understand that a landlord moving from a loan rate of 2 or 3 per cent to one that is 7 per cent or higher for a commodity that is losing value as the environment changes is not a rosy prospect. Extensions aren’t cheap – if you have a home mortgage, you know the fees of refinancing can be backbreaking – but they are a lesser evil than a long-term lease with a rate in the high single-digits.

Since hope is not a strategy, as the management gurus say, the wave of extensions with fingers crossed that rates will ease – what the industry calls “extend and pretend” – is part of a gathering storm that goes well beyond the financials.

How bad is it? A recent report from Trepp, the commercial real estate data and analytics firm, says office loan modifications in the U.S. reached US$1.42-billion in the first quarter of this year, 12 times the US$117-million in the first quarter of 2023. Delinquencies in April reached the highest level in two years.

The cracks have been visible for some time. About US$13.6-billion in loans were modified in 2023, double the amount of 2022, according to CRED IQ, a data and analytics platform. Moody’s Analytics predicts that roughly 80 per cent of the US$15.2-billion of commercial mortgage-backed securities (CMBS) office loans expected to mature this year are at risk of failing to refinance.

The Mortgage Bankers Association is tracking US$929-billion in maturities in 2024, a rise of US$270-billion from the beginning of 2023. Since construction of new office space has ground to a halt, this suggests the increase represents loan extensions.

The prospect of a crash or at least a hard landing is so chilling there are whispers in the United States that one possible solution will be government intervention to bail out the sector, including incentives such as massive infusions of cash, subsidized financing at giveaway rates and public-private partnerships.

That may solve the short-term financial crisis, but it doesn’t solve the long-term issue of the value of the asset. As more lenders take back the keys when loans default or aren’t renegotiated, the question is this: What is the real value of office space in a world where remote work has been proved as a viable option for the future and, especially for the next generations, is preferred? It is a somewhat pyrrhic victory if a lender cuts ties to a deadbeat landlord only to be left with an asset whose value is declining.

One potential solution is the repurposing of space. It’s not a new idea but its record of success is spotty. Just ask anyone in the retail sector, as online sales have shifted consumer preferences and devalued the real estate holdings of stores. Some have looked at everything from turning stores into childhood educational centres or warehouses and even assisted living facilities.

It may be a stretch, but to the layman, connecting the dots between millions of square feet of unused office space with the highly publicized housing crisis in the U.S. and Canada might raise the question: Is there an opportunity to kill two birds with one stone through some sort of mixed-use arrangement?

Perhaps not a silver bullet, but it may be a slice of immediate relief as governments explore developing so-called urban lazy spaces for new housing. And it may extend the lives of the dinosaurs called offices, or at least help them evolve.

Editor’s note: (June 12, 2024): A previous version of this article incorrectly stated that tenants have been asking lenders to extend leases. It is landlords who have been asking lenders to extend loans. This version has been updated.

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