Commercial Real Estate’s False Flag

As we have shown before, it’s statistically one of the worst times to buy houses in history given mortgage rates and price appreciation compared to disposable income. Yet, there are no signs of stress in the housing market with historically low levels of delinquencies. When trouble arrives at one’s doorstep it will be after mortgage rates fall and an enormous supply of homes flood the market. The more ominous real estate worry from the Cassandra crowd relates to offices. Is this a cannon shot across the real estate doorstep heralding an economic recession or an isolated sector that is ring-fenced from the rest of the industry? We’ll choose the rosier outlook.

Office space landlords are hurting and there is more pain to come. Office holders are not reeling from the economy and interest rates as much as they are from a unique Covid trigger that greatly accelerated the work from home trend. The new Generation Z entrants to the workforce actually want to work in the office, but Covid and its strong labor demand recovery made Millennials and Boomers realize that they prefer working from home. The economy is fine, but office space in big cities is undergoing a mass repurposing trend to absorb excess supply. Other non-office sectors of commercial real estate (see chart below) are navigating the high borrowing rate environment adequately, although the new construction pipeline is drying up like springtime in the Mojave desert. 

Builders will increasingly struggle for business and be forced to cull their herd of workers as long as the cost of project financing remains near multi-year highs. Unlike residential loans of 15 to 30 years, commercial loans are typically 5 to 15 year, and most did not refinance their loans duirng the free money era of Covid. For now, there are no signs of widespread stress for commercial real estate borrowers who are crossing their fingers and toes for Fed Chair Powell to cut rates over the next year a few times as promised. This is an area worth watching for signs of troubled waters, but for now there is only an isolated pebble causing a ripple in the commercial real estate pond.

 

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