Office buildings are struggling in the wake of a new reality. After the COVID-19 pandemic, the telecommuting culture has taken root, and as a result, downtowns are suffering.
A late 2022 study, heralding a real estate apocalypse in the making, calculated that building values had fallen by an average of 44.8% by the end of that year. At the end of the third quarter of 2023, the U.S. office vacancy rate exceeded 20% for the first time since 2008, according to media reports. In San Francisco, Dallas and Houston, the vacancy rate exceeds 25%.
The Commercial Mortgage Situation in Canada is Bad, but Not as Bad as the U.S.
In Canada, the vacancy rate is lower, but still rising. From an average of 16.9% at the end of 2022, it has risen to 17.7% according to CBRE's latest report. In urban centers, the average rate is 18.4%.
This figure conceals a two-pronged situation: on the one hand, in category A buildings, the average rate is 15.9%, while in category B buildings, it is 22.7%. On the other hand, some cities have rates as high as those in the U.S., including 32% in Calgary, 25.7% in London, and 23.3% in the Waterloo region.
Certain factors distinguish Canada from the U.S. scene. Canadian real estate “is less competitive,” explains Christopher Tsichlas, Senior Vice President, Credit Ratings, Real Estate and Public Finance at DBRS Morningstar. “Many owners are solid institutions investing for the long term. So we're less likely to see fire sales. In addition, Canada is probably a little more urbanized than the U.S., which is more conducive to maintaining downtowns.”
More than Half of U.S. Commercial Real Estate Mortgages Might Need to be Refinanced
This real estate distress traces a trajectory destined to collide with that of the banks, especially in the U.S. “More than half of the approximately US$2.9 trillion in commercial real estate mortgages will need to be refinanced over the next 24 months, and regional banks account for 70-80% of these loans,” writes a recent Morgan Stanley analysis.
“Even if current rates remain stable, adds Morgan Stanley, new lending rates will likely be 350 to 450 basis points higher. For building owners themselves, secular headwinds from the adoption of remote/hybrid working options pose additional complications that could accelerate the depreciation of corporate real estate." Morgan Stanley predicts a drop in commercial real estate value of over 40%, "worse than during the Great Financial Crisis".
Banks are very weakened by rising interest rates, a fragility that will be compounded by the real estate crisis, according to a recent study by New York University's Stern School of Business. On the one hand, the study calculates, banks' assets (loan-backed commercial securities and U.S. Treasuries) have suffered unrealized losses of $780 billion to date as a result of rising rates. On the other hand, the total loan portfolio (commercial and individual loans, and mortgages) of US$17.5 trillion has lost 10% of its value, or US$1.7 trillion.
Relying on these figures produced by his alma mater, economist Nouriel Roubini recently wrote in an article published by Project Syndicate: “In fact, judging by the quality of their capital, most U.S. banks are technically close to insolvency, and hundreds of them are totally insolvent.”
Morningstar Believes U.S. Bank Losses Will Be Manageable
However, the banks' distress is not universal, points out Eric Compton, stock analyst at Morningstar.
“Among the banks I analyze, I don't see a major problem, he says. There are going to be losses, but they will be manageable, as the banks I cover have sufficient profits and capital to absorb those losses. I think there are going to be some smaller banks that will take a lot of losses because of the commercial real estate losses, but none of the banks I analyze fall into that lot since the ones I follow all have assets in excess of US$50 billion.”
And it's far from certain that the full shock will reach banks. Compton lists a number of alternatives available to both banks and owners: sale of buildings by the owner or by the bank in the event of a takeover, restructuring of mortgages, and finally "the owner may find access to other sources of financing", stresses the analyst.
This is a development also envisaged by Josh Varghese, co-founder of Axia Real Assets. “Alternative lenders could enter the scene and lend at higher interest rates. This could help stem any hemorrhaging.”
Canadian Banks Are Not as Much at Risk
One might suspect that the situation of many U.S. banks is precarious, which is not the case for Canadian banks, according to a National Bank study. According to analyst Gabriel Dechaine, office real estate loans account for an average of 12% of the total commercial real estate loan portfolio of the six major banks, rising to 20% in the case of the Royal Bank.
According to the analyst, Canadian bank profits could suffer declines of up to 20%, although the shock will be more in the order of 8% to 10%. According to Alexandre Brassard, senior economist at CPA Canada, Canadian banks are in a better position than their American neighbors because their commercial real estate loan portfolios represent only 2% of their total assets, compared with 13% in the case of American banks.
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