The Path Forward for Commercial Real Estate in the Twelfth District

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.

In the current economy, Commercial Real Estate (CRE) has become an area of growing attention. Observers have noted the increasing uncertainty in CRE and have expressed concern that the sector’s potential weakness could spill over into the broader economy.

Given the importance of CRE to the overall health of the Twelfth District’s economy, leaders and economic researchers at the SF Fed have been keeping a close eye on developments in the production, financing, and management of space for business, multifamily residential, commercial, and industrial activity.

Earlier this year, Sylvain Leduc, Executive Vice President and Director of Research, and Laura Choi, Executive Vice President of Public Engagement, discussed CRE trends with commercial real estate investors and non-bank lenders. The industry representatives saw a mixed outlook for the overall sector with significant challenges ahead, especially for the office space asset class.

Building on this earlier conversation, Mary Daly, President and CEO, and Laura recently sat down with a new group of CRE leaders. Besides discussing the most immediate developments in the sector, Mary, Laura, and the roundtable participants turned their attention to the future and discussed potential risks and possible solutions to the sector’s challenges.

A Tale of Four Asset Classes

Echoing the earlier roundtable, participants in the most recent discussion about CRE saw continuing uncertainty for the office space asset class. Much of this uncertainly can be traced to the transition to remote work caused by the pandemic. While more employees are returning to the office, the return is only partial. Participants noted that vacancy rates in central business districts are 20% and higher, a historic level. They also suggested this is unlikely to improve in the short-term. One participant cited a prominent industry forecast that anticipates that most employers will require employees to work in the office three days a week, a policy that could lead to a 10 to 30% decline in needed space.

Participants noted that the decline in demand for office space has had a knock-on effect on retail space. They shared that with fewer employees coming into work on a daily basis, retail businesses, especially in the downtown cores, are suffering.

The CRE leaders shared that the picture for industrial space and multifamily housing is better. Yet even here, roundtable participants saw reasons for concern due primarily to declines in occupancy and the related declines in rent growth. As one participant noted, there has been a significant amount of overbuilding of industrial space. While demand remains high, this observer believed that industrial space vacancies will start to rise.

Summing up the current situation, the CRE leaders felt that their sector faced a significant adjustment problem in the short- and medium-term.

“Stay Alive until 2028”

With this diagnosis in mind, President Daly asked the participants to discuss the prospects for an orderly versus a disorderly adjustment to the new market conditions.

While there was no clear consensus on this issue, the CRE leaders did agree that how banks react to conditions in the sector will be an important variable as the situation evolves. They reported that half of CRE funding comes from banks and credit availability is currently very tight.

One roundtable participant felt that a more orderly transition will be possible if banks would allow mortgage forbearance. However, other participants predicted a less orderly wind down, especially for variable rate borrowers.  For one, they shared that banks do not currently have enough staff to handle the volume of loan workouts that may be necessary. Secondly, they noted that there is still not enough transparency in the market related to the value of properties which makes it difficult to assess when equity has been lost. Most banks and other institutional investors have not recognized the new market valuation realities on their books.  While there is no certainty of a disorderly adjustment to the new market valuation realities, it is a very real risk, which should be considered and prepared for.

The leaders felt that there would be meaningful write downs in portfolio values in the coming year. Although potentially painful, they believed such a step would be necessary for the longer-term health of the CRE sector.

The participants felt that the market would eventually become unstuck and that capital would become more readily available. But they also noted that this would take time. As one participant remarked that during the downturn in the early 1990s, the mantra had been ‘Stay alive until 1995.’ In the current situation, an appropriate mantra my now be ‘Stay alive until 2028.’

Preparing for what’s next

President Daly concluded the discussion by asking the leaders to preview how they are preparing for their sector’s future development. Participants emphasized that despite the potential for losses, there would also be opportunities for new investment. To take advantage of these opportunities, the leaders were focused on ensuring a strong capital base, understanding property portfolios in depth, and re-thinking their staffing to make sure they have the right people in place to capitalize on future opportunities.

In developing monetary policy, the SF Fed depends on data. This data often takes the form of economic statistics and key indicators like the consumer price index and the unemployment rate. Crucially, we also draw valuable data from stakeholders who have direct insight into economic conditions on the ground. That is why roundtables like our most recent one with CRE leaders are so important.

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.

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.