Extend and Pretend

A phrase from the Great Recession has been revived to confront the moribund condition of the U.S. commercial real estate sector: “extend and pretend.”

The concept calls for property borrowers to collaborate with lenders to extend a loan’s maturity date, buying time for high interest rates to decline, rental vacancies to fill, and cash to flow again (without assurance that these things will all fall into place).

Postponing the pain worked well in 2008 for many commercial real estate owners. As the Federal Reserve methodically lowered interest rates, the U.S. economy improved, debt became less expensive, and commercial real estate assets recovered by 2012. That approach may be less successful this time around, and it’s not just the Fed’s fault.

Generational shifts in how and where people live, work, shop, and gather are affecting market prospects in the four main segments of the commercial real estate sector: office, retail, industrial, and multifamily/habitational.

For example, office buildings remain vacant in many large cities with previously thriving downtowns, as hybrid and remote work continue to be significant factors following the COVID-19 pandemic. Meanwhile, traditional malls are being demolished and redeveloped with smaller footprints and more experiential retail to meet consumers’ changing social behaviors.

These trends come amid significant depreciations in property values, tight credit conditions, and rising construction costs, as well as soaring property insurance premiums caused largely, though not solely, by the proliferation of extreme weather events across the country.

Over the past five years, premiums have on average increased by 108% for commercial building owners in the 10 states with the highest insurance losses nationwide, compared to 96% for owners in other states, according to the Deloitte Center for Financial Services. “When you look at the cost of owning and managing commercial property today, it’s hard to imagine a cost that has increased more in recent years than property and casualty insurance,” says Jamie Woodwell, head of commercial real estate at the Mortgage Bankers Association.

Although commercial property insurance premium increases have moderated in 2024, that means the record high prices in 2023 largely remain in effect. “Over the past three years, premiums have shot up in the entire commercial real estate sector at double-digit rates, due to extreme weather losses exceeding the collected premium,” says Alexandra Glickman, senior managing director at Gallagher and leader of its global real estate and hospitality practice.

Deloitte projects the average monthly cost of insuring a commercial building in the United States will increase at an 8.7% compound annual growth rate through 2030, rising from $2,726 in 2023 to $4,890. In states with the most extreme weather risks, premiums are expected to increase at a 10.2% CAGR, nearly doubling from $3,077 to $6,062 per building per month.

“Insurers are pushing back in commercial real estate, due to the high risks, high replacements costs, and regulatory challenges,” says Ramon Kochavi, first vice president and district manager at Marcus & Millichap, one of the largest commercial real estate investment sales brokerages in North America.

Among the regulatory challenges is a reform introduced in California in March 2024 that would require carriers in the state to increase the number of property insurance policies they write in high-risk areas by 5%, just one part of a broader plan to address California’s insurance crisis. “In years past, it was kind of simplistic as far as binding a new insurance policy,” says Kochavi. “Today, it’s very difficult.”

Credit Time Bomb

Hopes that the commercial real estate sector will overcome these varied challenges by asking lenders for loan extensions is complicated by the nearly $1.5 trillion in commercial mortgage debt due by year-end 2025.

Twenty percent of these loans, an astonishing $929 billion in debt of the total $4.7 trillion of the commercial mortgages in lender and investor hands, matures this year. The volume of overdue loans in the first quarter of 2024 was up 10 basis points quarter over quarter to 1.25%, a new high, according to S&P Global.

For the many commercial real estate owners unable to meet loan obligations, the obvious solution is to refinance the debt. The problem, aside from the high interest rates, is finding a lender willing to assume debt in a commercial sector that is in such precarious shape. In the office segment alone, according to Moody’s Analytics, 73% of the more than $17 billion in commercial mortgage-backed security loans coming due in March 2025 have “performance characteristics” like high debt levels and vacancy rates that make them particularly difficult to refinance.

“A lot of loans that usually would be refinanced are coming due at the same time; when that happens, they’re refinanced at quite a bump from the original interest rate,” says Kochavi. “Unless a borrower was able to grow net operating income over the last few years, which has been difficult because of the inflationary pressures, financial strain can be expected. People are worried not about what has happened but what may happen if we stay at current interest rates.”

The potential repercussions are severe and not just for borrowers. According to first-quarter 2024 regulatory data, 67 banks have exposure to commercial real estate greater than 300% of their total equity, with 60 of them at heightened risk of failure. Headlines predicting a “commercial real estate time bomb” and a “systemic credit crash” compelled Federal Reserve chair Jerome Powell to respond in March 2024. “This is a problem we’ll be working on for years,” Powell stated. “I do believe it is a manageable problem. If that changes, I’ll say so.”

Bad Day at the Office

Not every segment of the commercial real estate sector is under duress, nor are all the challenges across the industry the same. Geography, corporate work policies, crime rates, susceptibility to natural hazards, and municipal zoning regulations and building codes play outsized roles.

“People see headlines conveying that commercial real estate is a single entity, when in fact it’s a very large and diverse asset class spread out across different property types, lenders, investors, borrowers, and segments and subsegments—some of them challenged and others less so,” says Woodwell. “Where the asset is, what sort of prospects it has going forward, what interest rates, capital availability and demand will be, and the cost of insurance all factor into the equation. It’s like playing three-dimensional chess.”

Moving the chess pieces in the U.S. office segment is the most complicated. Office vacancy rates reached a record 19.6% across the country in the fourth quarter of 2023, with more empty offices than at any time since 1979, according to Moody’s Analytics. The overbuilding of the 1980s has collided with a cultural shift toward hybrid work, producing a supply/demand imbalance that threatens $38 billion worth of office buildings with defaults, foreclosures, or other forms of distress, the highest amount of risk since the Great Recession, data provider MSCI says. (See sidebar: The Future of Workspace.)

The distress is unmistakable in downtown St. Louis, San Francisco, Los Angeles, and Chicago, where scores of abandoned and boarded-up office buildings are covered in graffiti, their prior value now a pittance. A case in point is St. Louis’s AT&T Tower; bought in 2006 for $205 million, it sold in 2022 for $4 million. Another is the Hewes Building in San Francisco, which was bought for $62 million in 2016 and sold in April 2024 for $6.5 million, a nearly 90% haircut.

San Francisco’s office market has “crashed,” says Paul Meyer, president and chief financial officer of commercial real estate developer SteelWave. “We’ve got a lot of ‘zombie office space’ in both the central business districts and suburban office parks, although the suburbs are faring better. Cash flow is squeezed by business tenants reexamining their footprint, thinking they don’t need as much space in this era of hybrid work.”

Refinancing the debt is less of an option in problem markets like Chicago, St. Louis, San Francisco, and New York. “Rates that were 3 to 4% in the 2016-2022 period are now 8 to 9%,” says Meyer, noting that, in downtown Los Angeles, “some of the biggest owners have had to give back huge towers [to the banks in a foreclosure].”

Insurance brokers specializing in commercial real estate confirm the dire conditions. “Landlords in New York City, where demand for space in many office buildings is down by 30%, are giving back property, unable to get out of the hole caused by high interest rates and the loss of tenants,” says Danielle Lombardo, chair of real estate, hospitality, and leisure at WTW.

She provided the example of a billionaire real estate tycoon in New York who defaulted on the debt for one trophy tower last year and now faces foreclosure on another trophy property. “No one is unscathed, even the wealthiest and most liquid investors,” Lombardo says.

Fair market valuations for Class B and C office assets have dropped between 30% and 75%, says Glickman. “Last week, a lender bought back an office building in Dallas, Texas, for $12 a square foot. You can’t build a sandcastle for $12 a square foot.”

Unable to refinance at today’s interest rates, which are “double or triple the pricing” of when the loans were originated, Glickman says owners “either are intentionally throwing the keys back to the lenders because they don’t want to commit any more capital to the building or are being forced by their mezzanine lenders to turn over the keys.” Figures for the rate at which this is happening were unavailable. A mezzanine lender provides loans that combine debt and equity financing.

As time progresses, the quality of largely vacant office buildings on the brink of a foreclosure deteriorates. Cash-crimped owners fall behind on maintenance, repairs, and insurance. An owner struggling to cover the mortgage is probably not replacing the roof or windows past their useful life or doing preventive maintenance and on-site inspections of trip and fall hazards, says Pete Romano, national real estate practice leader at Lockton. “Consequently, the frequency and severity of losses from water damage claims, theft, vandalism, and fires increase dramatically.”

If owners are financially unable to insure the building, lenders could be held responsible for physical damage and liability claims. To offset this possibility, lenders typically buy a force-placed insurance policy. The policy does not cover the borrower in the event of a claim but rather the lender in case of default. Lenders then charge the building owner for the cost of the insurance, an expense four to 10 times more than the owner’s original premium, aggravating the owner’s financial difficulties.

Certainly, there are thousands of office buildings across the country whose owners are faring much better. “Class A assets like a newly built building in a high-end central business district with amenities that tenants like are performing pretty well,” says Paul Foye, managing director and U.S. real estate practice leader at Marsh. “For owners of older buildings that don’t fit this description, the question becomes, ‘Do we invest to make it Class A or convert it into something else, like apartments.’” (See sidebar: Office-to-Residential Conversions.)

Amid the adversity, Meyer at SteelWave perceives opportunity. The full-service commercial real estate management firm is hunting for distressed office buildings with market values down by 50% to 70%, with the goal of creating attractive spaces and amenities that offer a significant return, rent-wise. “Buying at the bottom of the market has tremendous upside. We expect to be very active this year doing just that,” he says.

Multifamily Dysfunction

In the multifamily/habitational segment, inflation, higher interest rates, and relatively low rental rates have eroded owner profits in many markets. According to Cred iQ, a platform for commercial real estate data and analysis, the segment’s distress rate, based on the payment statuses reported for each loan, increased 80 basis points in February. That was the largest increase in 18 months.

“Multifamily is by far bleeding the most,” says Lombardo at WTW. “Expenses are outpacing profits. It’s a world of hurt, depending on the geography. Higher interest rates strip the cash flow, but few investors bought interest rate caps protecting them from the rates we see now, figuring they’d flip the properties in three to five years.”

Sharing this perspective is real estate economist Joshua Harris, author of the demand forecasts published by the Commercial Real Estate Development Association, an industry trade group. “Multifamily apartment buildings were ‘priced to perfection,’ based on low interest rates and rents pegged to grow 5% annually over the next decade. Then everything changed,” says Harris. “Inflation ran up operating costs like the electric bill, and rent growth fell from the double-digit percentage increases during the pandemic.”

Asked why owners didn’t increase rents to offset the financial impact, Harris replies, “In a lot of multifamily markets like Northern Virginia, you couldn’t push rents higher because the salaries and wages in the sluggish white-collar employment segment had stalled, plus the fact there were too many overpriced apartments and a
huge shortfall of maintainable middle-market units.”

While refinancing is an option for multifamily building owners struggling to make their debt payments, the interest rates are off-putting. “Multifamily investors a few years back went to government sponsored entities like Fannie Mae and Freddie Mac to borrow at 2 to 3% but now have to refinance at 8%,” Meyer explains. “Credit in the capital markets is as tight as I’ve ever seen it, and I’ve been doing this for 40 years.”

High property insurance premiums compound these challenges. Harris, who lives in Florida, says the property insurance on multifamily dwellings in the state has skyrocketed, due to extreme weather events and higher damage repair costs. The average insurance expense per unit stood at $2,000 as of October 2023, compared to $800 two years earlier, according to CoStar Analytics.

“Profit has shrunk more for multifamily than any other asset class,” Harris says, referring to the cost of the premium in relation to the profit coming in.

In California, where Kochavi lives, multifamily building owners also must reckon with sky-high premiums, assuming they can buy commercial insurance. In the past year, Farmers Insurance and Allstate, two of the largest insurers in California, stopped accepting new applications for insurance and imposed a cap on the number of new policies written in the state, respectively. State Farm went further, discontinuing coverage for 72,000 policyholders, though Farmers announced in May it would reenter the state’s habitational market Aug. 1.

“Of those 72,000 policyholders, 42,000 were multifamily apartment building owners that now must pay double or triple for state-provided insurance in the California FAIR Plan,” says Kochavi. “An annual insurance premium that rises from, say, $50,000 to $120,000 now becomes a major line item on a balance sheet.” The FAIR Plan provides property insurance to residents and businesses unable to find coverage from traditional insurance markets.

For multifamily dwellings located in areas experiencing a high crime rate, the insurance implications are worse. “Insurers factor in a crime score representative of a neighborhood’s crime-related property and liability risks. If it’s at a certain level, you can be rejected for insurance,” says James Stuart, chief sales officer and real estate practice leader at Hub International.

There are some slivers of hope. Meyer projects that private equity capital will help fill the debt void left by the banks. Glickman concurs. “There’s a lot of money waiting on the sidelines to come in and buy distressed assets,” she says, citing large investment firms like Blackstone and Starwood as possible candidates.

In April 2024, Blackstone agreed to the roughly $10 billion acquisition of Apartment Income REIT, which owns 76 rental housing communities primarily located in coastal markets. The transaction was Blackstone’s largest in the multifamily segment. The firm told The Wall Street Journal it plans to invest another $400 million to improve the properties. That same month, Starwood completed an inaugural investment in Obsidian Capital Partners, an emerging multifamily real estate firm.

Glickman adds that “there’s also an opportunity for rescue capital, a form of new capital with debt-like features, to take a position, buy certain pieces, and get a healthy return.” Rescue capital is a form of gap financing typically offered as preferred equity to owners who can’t refinance or shore up their balance sheet.

Industrial Steady State

At the opposite end of these woes is the industrial segment. Despite high interest rates and insurance costs, the segment, which encompasses properties where goods are made, stored, and/or shipped from, has fared exceptionally well.

According to CommercialEdge, 505 million square feet of industrial space was being built as of November 2023, with completions at or near historical highs that year. In a May 2024 update on logistics real estate, Prologis projected the vacancy rate  could drop to roughly 5% next year.

Factoring in to the sector’s robust financial health are e-commerce sales, which grew by 19% during the pandemic and remain on an upswing. This is fueling construction of massive distribution centers and smaller warehouses serving the so-called last mile of transportation across the country. Meanwhile, domestic reshoring is promoting the building of new manufacturing and distribution facilities. “The industrial sector is coming off a period of two years of unprecedented growth,” says Lombardo.

Meyer agrees. “We built a large warehouse in Phoenix, and it leased right up, giving us confidence to do more of the same. I’m told that Amazon has a need to lease another five, one-million-square-foot warehouses,” he says.

Lombardo, however, is concerned that, if high interest rates persist, the future construction pipeline will shrink. “Already, fewer developers are breaking ground, demand is cooling, and vacancy is rising at a controlled pace,” she says, adding that rent growth is also slowing.

Nevertheless, insurance premiums in the segment are said to be much lower than the costs in other segments. “We’ve seen some rate increases in industrial but nothing like multifamily,” says Stuart from Hub. “There are fewer water damage claims and liability lawsuits involving tenants. It’s a desirable class that has performed well for insurers over time.”

Retail: A Tale of Two Markets

Finally, the retail segment offers two significantly different market views, depending on the product. The widespread closures of mall anchor stores like Sears, Macy’s, Best Buy, Nordstrom, and JCPenney have affected mall vacancy rates and prices per square foot. “The retail buildings in the ‘gloom and doom’ headlines are the ones needing a lot of money to fix and improve them, which in this day and age of high construction costs is overly expensive and likely to require demolition and rebuilding, which takes time,” says Harris. Approximately two million square feet of mall space was demolished nationwide in 2022. The demolished spaces are being turned into luxury apartments, modern retail complexes, and other redevelopment projects.

Part of the problem is the sheer size of some malls. Mall strategy in the 1980s and 1990s was to build 1 million to 1.25 million square feet, but demand today can’t support these dimensions in many markets, says Meyer. “We’re seeing massive malls repositioning to 400,000 square feet, with the dead retail spaces and parking spaces being repurposed into other forms of commerce, like Go-Karts and pickleball.”

The mall vacancy rate nationwide today is 110% higher than the average retail vacancy rate, according to statistics compiled by Capital One in May 2024. Like distressed office buildings in downtown business districts, sales of malls are garnering well below the original acquisition price. Meanwhile, retail faces the same insurance increases experienced by the other commercial real estate segments, eating away at profits. Premiums correspond to high exposures for stores located in areas with high crime rates, that do not properly maintain their exterior and interior, and/or that stand near buildings that are boarded up and vacant, increasing the fire risk.

But that’s only one side of the story. Much of the rest of the retail segment is in the midst of an extraordinary upswing. Retail sales increased 0.7% in March 2024, month over month, according to the U.S Department of Commerce. That was well above the Dow Jones forecast for a 0.3% increase over the one-month period. “Retail has bounced back from the pandemic,” says the Mortgage Bank Association’s Woodwell, “proving their resilience, generating cash flow, and attracting a great deal of interest from the capital markets.”

Several interviewees attributed the segment’s resurgence to the general public’s profound yearning for social interactions after the isolated stay-at-home years of the pandemic. Diverse retailers are responding to these wishes by providing customers engaging experiences and amenities like live music, immersive multimedia, free coffee and wine, and AI-powered shopping assistants.

“Assuming quality properties, retail is leasing up, with no vacancy rates, setting all-time rental rates in a lot of markets,” Harris says.

Chris Maguire, CEO and chairman at SRS Real Estate Partners, notes that retail faced a situation similar to that which the office market is in now, but its evolution offers a path forward for that segment. “Office buildings are where retail was four or five years ago, but even their owners realize the value of amenities that delight people, with newer buildings offering spaces for fitness centers, coffee shops and ‘gourmet celebrity’ restaurants, [creating] an environment where employees want to work.”

The Queen’s Gambit

What’s in store for the commercial real estate sector? The answer depends on rising vacancy rates, expiring loans, and declining values as much as interest rates, capital market availability, and insurance pricing.

No one interviewed for this article expects a quick recovery in the segments under the most duress. “There’s a lot more pain to come before we see a shakeout,” says Meyer. “I’ve been told by a couple major banks that, if the borrower is a good actor, they’ll stick with them. If this is not the case, they’ll take back the asset and sell the debt at whatever price it clears. That’s the tough talk we’re hearing out there.”

Lombardo agrees the pain will linger. “It sometimes feels like there is no end in sight,” she says.

Several sources raised the Lazurus-like possibility of the Federal Reserve lowering interest rates. “At the end of the day, what’s driving things is the refinancing costs, which are directly related to interest rates,” says Romano. “We don’t know if or what the Fed will do to mitigate the situation. The government hasn’t stepped in yet.”

The Federal Reserve’s high interest rates remain a headwind affecting the cost of construction, adversely influencing the cost of insurance, says Woodwell. Meyer concurs: “If the Fed drops rates one tick, capital will flood into the commercial real estate market. We’ve been through this before. It’s all about momentum, but this one will take a while.”