The amount of distress in the U.S. Commercial Real Estate increased to USD 71.8 billion during the middle of the year, marking the fourth consecutive quarter of growth. Distress refers to financially troubled assets and properties taken back by lenders. In the last quarter, distress exceeded property owner and lender workouts by approximately USD 8 billion. This represents the largest increase in distress since the second quarter of 2020 when the pandemic began.
Trouble in the Commercial Real Estate Sector
During the second quarter of 2023, offices accounted for over 80% of the added distress, amounting to USD 6.7 billion in net inflows. By the end of June, the office sector held the highest share of marketwide distress, making it the first time since 2018 that neither the retail nor hotel sector was the primary contributor.
The total value of potentially distressed assets reached USD 162.3 billion by the end of the second quarter. It’s important to note that not all potentially distressed assets result in full financial trouble. Of the assets classified as distressed in the midyear report, 35% had previously been considered as potentially distressed. In late June, federal regulatory agencies issued a policy statement on commercial-property loans and workouts, urging lenders to collaborate with creditworthy borrowers who may be facing financial strain.
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Crisis is brewing in the Non Commercial Real Estate Sector
As of the beginning of 2023, Homebuyer Debt-to-Income Ratios (DTIs) have reached around 40%. This indicates that homebuyers are allocating approximately 40% of their gross income to cover mortgage and interest expenses. The current DTIs are at the same level as observed in 2006, which was a significant year in the housing market, right before the onset of the global financial crisis.
A DTI ratio of 40% implies that a considerable portion of homebuyers’ earnings is being dedicated to housing-related expenses, leaving a smaller proportion of their income available for other financial commitments and discretionary spending. This could have implications for housing affordability and overall financial stability, as high DTIs can lead to increased vulnerability for homebuyers in times of economic challenges or rising interest rates.
Offices Surpass Malls to Become the Most Distressed Asset Class
According to MSCI Real Assets’ report on Wednesday, the distress in the US office building sector surged by approximately 36% from the first quarter, totaling about $24.8 billion by the end of the second quarter. This surpasses the previously leading commercial real estate laggards, hotels, and retail properties.
By June, retail properties, including malls, accounted for $22.7 billion in distress, while hotels faced $13.5 billion in distress. The overall value of troubled commercial properties, including all sectors, reached nearly $72 billion, indicating a 13% increase from the first quarter.
The report highlights that the office sector took the largest share of marketwide distress, a significant shift from previous years, surpassing both retail and hotel sectors.
Looking forward, the situation is expected to worsen for office buildings, as investors do not foresee a quick return to pre-pandemic office usage and a decline in remote work. An additional $162 billion of properties are identified to be in potential distress, facing challenges such as delinquent loan payments, high vacancy rates, or maturing debt.
The US office sector faces higher stress compared to other real estate segments due to weakened demand caused by widespread acceptance of remote work. The average office usage in ten major US cities remains at about half of its pre-pandemic levels, indicating a prolonged recovery. More than 20% of US office space was reported vacant as of June 30.
Office building prices have experienced a 27% decline in the year leading to June, surpassing the 12% decline seen across all commercial property types. This situation has led corporate landlords like Blackstone Inc., Brookfield Asset Management Ltd., and Starwood Capital Group to halt payments on office buildings they consider to be unprofitable.
Furthermore, office properties with maturing debt face higher vulnerability to stress due to the increased cost of borrowing since the Federal Reserve began raising interest rates to curb inflation. Approximately $189 billion of office building debt is estimated to mature in 2023, with an additional $117 billion due in 2024, as reported by the Mortgage Bankers Association.
1 Billion Square Feet of Unoccupied Office Space in the U.S.
In April, Brookfield, one of the largest office owners in America, faced a $161 million loan default covering 12 office buildings, predominantly in the Washington, D.C. market. This default occurred amidst a backdrop of low occupancy rates, with other office giants like Blackstone and WeWork also defaulting on office debt this year.
Based on data from JLL, the graphic above reveals nearly 1 billion square feet of empty office space in the U.S., highlighting the significant impact of vacant office towers.
As of the end of the first quarter of 2023, America recorded a record-breaking 963 million square feet of unoccupied office space. Manus Clancy, senior managing director at Trepp, estimates that approximately five to ten office towers are at risk of defaulting each month.
The following cities are ranked based on their total square feet of office vacancy as of Q1 2023, encompassing central business districts and suburban areas.