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The commercial real estate crunch

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2023-08-11

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The crunch in commercial real estate is rippling across American property, banking, and investment sectors.

Earlier this week, the ratings group Moody's raised questions about the level of exposure several banks have to commercial real estate (CRE), either downgrading their ratings or warning of possible future actions. This sent shares in dozens of banks in all directions as nervy investors wondered what was going on.

On Thursday, Bloomberg provided part of the answer, reporting that major banks, including JPMorgan, Goldman Sachs, and Capital One, are among the lenders attempting to shed their exposure to commercial real estate debt. However, not all banks are able to secure buyers, and Moody's downgrades and warnings are likely to result in actual cuts and increased expenses for these banks.

Then, on Tuesday, WeWork, the once $US40 billion office building and lifestyle group, admitted that it was teetering on the edge of collapse. "Our losses and negative cash flows from operating activities raise substantial doubt about our ability to continue as a going concern," WeWork stated in a filing with the SEC on Tuesday.

The combination of the Covid pandemic, which led many businesses to exit their leases in favour of remote work, and the subsequent economic slump, has left WeWork laden with debt and struggling to generate cash.

Given this scenario, it should come as no surprise that Australian property owners are taking drastic actions to reduce their vacant buildings. They are demolishing them at an unprecedented rate. In fact, more office space was demolished in Australia during the first half of the year than new buildings were completed.

According to data from Jones Lang and LaSalle (JLL), one of the biggest commercial real estate brokers in the country, it was the first time the amount of office space being demolished exceeded new construction.

Jacob Rowden, U.S. office research manager for the commercial property brokerage, told Bloomberg, "We would have a lot of confidence in saying that the national office inventory has never actually declined in the past. We have done some high-level estimates in the past and think that the closest we came to negative inventory historically would have been during the 1930s at the height of the Great Depression."

The difference was striking: according to JLL, 14.7 million square feet of Australian office space was demolished in the first half of the year, while only 4.8 million square feet of new capacity was added.

Normally, many analysts would view this as a negative since the costs of those demolitions and the write-down in the value of the razed buildings still need to work their way through company and bank/investor accounts. However, it's a swift and brutal response to an oversupply situation that won't disappear, no matter how many companies (large and small) attempt to coerce or convince employees to return to full-time or even part-time office work.

JLL sees positives from the demolitions and other developments: "A slowing volume of deliveries, increased leasing activity, and accelerated demolitions and conversions of older-vintage products are pointing to the increasing likelihood that Australian office vacancy rates will peak over the near term and begin to decline in 2024."

"While office markets remain subdued due to the lingering impact of remote work and a reversal of over a decade of historically low interest rates, signs have emerged that the Australian office market is beginning to turn a corner and is tentatively on the cusp of a recovery.

"Tenants remain defensive and continue to downsize office portfolios through large volumes of sublease space being added to the market, but improved leasing momentum across most markets led to the first quarterly increase in gross leasing activity in four quarters."

JLL states that return-to-office directives from a growing range of employers, both private and government, have impacted 1.5 million Australian office-based employees so far in 2023, and "another 1 million will face mandates that take effect through the end of the year."

Interestingly, JLL forecasts the emergence of peak attendance days for offices each week, and employers will have to take this trend into account when allocating space.

"The dominance of hybrid schedules and crowding of hybrid employees on Tuesdays and Wednesdays will continue to drive higher occupancy on peak attendance days than weekly averages imply. As attendance continues to normalise, tenants may increasingly feel expansionary pressures."

However, despite this emerging optimism, JLL states that the June quarter was another challenging quarter for property owners, although not as tough as the three months leading up to March.

"The combination of increasing sublease vacancies and downsizing tenants continued to drive net occupancy loss across Australia, with an additional 12.5 million square feet of negative net absorption in the second quarter. Although absorption remains negative, this was a notable deceleration of occupancy loss, declining nearly 40% from Q1 net absorption.

Negative net absorption indicates that more office space is being added to the market than is being filled. Despite all the optimism, the Australian commercial real estate market remains an unattractive place, and Moody's was justified in questioning many banks on their exposure and ability to handle future problems.

In May, Jones Lang LaSalle pointed to an 18% annual drop in first-quarter global leasing volumes, and in July, they added to that by showing that prime office rental growth in New York, Beijing, San Francisco, Tokyo, and Washington D.C. had turned negative over the same period.

According to Moody's Investors Service, global banks hold about half of the $US6 trillion outstanding commercial real estate debt, with the largest share maturing in 2023-2026.

Reuters reported last month that Australian banks revealed spiralling losses from property in their June half figures and warned of more to come.

"Global lenders to Australian industrial and office real estate investment trusts (REITs), who supplied credit risk assessments to data provider Credit Benchmark in July, said firms in the sector were now 17.9% more likely to default on debt than they estimated six months ago. Borrowers in the UK real estate holding & development category were 4% more likely to default," Reuters reported.

To make matters worse, many property investors will be looking at lower earnings in future years. According to Capital Economics, global property returns of around 4% a year are forecast for this decade, compared to a pre-pandemic average of 8%, with only a slight improvement expected in the 2030s.

"Investors must be willing to accept a lower property risk premium," Capital Economics said. "Property will look overvalued by the standards of the past."

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