Communities and businesses play a crucial role in shaping the Federal Reserve’s monetary policy. To inform our decision-making, the San Francisco Fed hosts discussions with the people we serve so we can hear their stories and perspectives on how economic data translates into real impacts in the Twelfth District. Our “Beyond the Numbers” series shares some of those insights with you.
Commercial real estate is a major driver of the Twelfth District’s economy. The development, financing, and operation of commercial real estate employs tens of thousands of people and generates billions in output. Beyond this direct economic contribution, the production, financing and management of space for business, commercial and industrial activity facilitates billions more in economic activity and employment.
Understanding the economic challenges and opportunities faced by a vital sector like commercial real estate is integral to achieving the SF Fed’s mandate to achieve price stability and maximum employment. For this reason, Sylvain Leduc, Executive Vice President and Director of Research, and Laura Choi, Senior Vice President of Public Engagement, sat down with executives representing commercial real estate investors and non-bank lenders to discuss recent trends in commercial real estate.
Performance across the sector varies by asset class, with offices struggling the most
During the pandemic and into the early post-pandemic period, commercial real estate, like many other industries, has experienced significant levels of volatility and economic uncertainty. Some asset classes, such as industrial and multifamily properties, have been performing relatively well while others, such as office properties, faced pronounced headwinds.
During the roundtable discussion, the executives noted that these differences in asset class performance continue to define commercial real estate. There is also considerable regional variation. For example, the participants noted that with respect to office and retail properties, markets that have experienced business in-migration, such as Charlotte, Nashville and Miami are doing relatively better than markets such as New York and Los Angeles, where office properties are struggling to attract tenants.
The executives all pointed to downtown urban office space as the weakest performing asset class. This is especially true for older office space (10+ years old), where there is “negative demand” for these properties, meaning more tenants moved out than moved in. In contrast, the roundtable participants did note that there is relatively more demand for newly built office space with nicer amenities, which they attributed to attempts to entice employees back into the office. They also noted that mixed-use properties are performing better than stand-alone office space.
Besides weak demand, the office space asset class is also contending with a tight lending environment for commercial real estate, a result in part of the Federal Reserve’s recent monetary policy actions. The executives noted that obtaining financing for office properties is extremely difficult and suggested that lenders may be returning to more traditional underwriting approaches. For example, although lenders may have been willing to take equity risk on a property before, many are now returning to the basic principle of first mortgages, covering amounts that can be reasonably assumed to be paid off at par at maturity. As one roundtable participant summed it up, “There needs to be a reset and borrowers will likely need to reset expectations on the amount of borrowing they’ll be offered at particular interest rates.”
Looking ahead, headwinds remain
Asked to look ahead, the executives felt that any future correction could result in losses but could also take place over a period of time as commercial real estate loans mature. Another challenge they noted was the increasing cost to build, which is slowing new construction starts in asset classes where there is healthy demand, such as industrial and multifamily.
Participants suggested that it will take some time for the financing situation to settle down, noting that banks are tightening lending and will be more selective. In addition, there is currently a difficulty assessing the value of properties because comparative sales information is lagged and not reflective of current property values. Nonetheless, the executives felt that given the overall health of the lenders, they might be able to weather the challenges.
The opportunity to hear directly from these industry leaders demonstrates the importance of these conversations. To fulfill its mandate of promoting stable prices and maximum employment, the Federal Reserve Bank of San Francisco needs to understand the economic conditions faced by the people we serve. That is why we will continue to listen and learn from our communities.
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The views expressed here do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System.