Commercial property crisis offers upside

The surge in interest rates over the past year has been a major worry for many homeowners. In some parts of the world, including the US and parts of Europe, mortgage holders face a jump in payments as fixed-rate loans come up for renewal.

But owners of offices and retail properties are also feeling the strain. Morgan Stanley Wealth Management has estimated that around half of the US$2.9 trillion in commercial mortgages in the US will need to be renegotiated over the next two years, and that the new loan rates will climb by as much as 4.5 percentage points.

Landlord headaches

This is just the latest threat to landlords, many of whom have been hit by the trend to remote working since the Covid-19 pandemic. The office vacancy rate in the US climbed to 19% at the end of 2022, according to real estate adviser JLL. This national average conceals pockets of even greater pain for landlords in cities like San Francisco, where around 30% of offices are empty, close to eight times the level prior to the pandemic.

Similar dynamics are at play in Europe, with a combination of rising vacancy rates and soaring borrowing rates. Landlords on both sides of the Atlantic are also facing pressure to spruce up older buildings to conform to more demanding energy-efficiency standards – at a time when inflation has been pushing up the price of construction and maintenance. The result looks likely to be a slump in prices – with Citi analysts predicting a 40% slide in European real estate values by 2024. Morgan Stanley Wealth Management is forecasting a similar decline in the US, which would be a larger fall than the one that followed the 2008 financial crisis.

CFO opportunity

So how bad is the downturn likely to be? And what will this mean for CFOs when it comes to haggling over leases on offices, retail space and warehouses? Will embattled landlords be able to pass on higher borrowing costs to businesses? Or will rising vacancy rates and distressed sales give CFOs the upper hand?

First, it might seem surprising that commercial landlords didn’t always take advantage of ultra-low interest rates following the pandemic to lock in low borrowing costs well into the future. The structure of commercial loans is highly varied, explains Thomas LaSalvia, head of commercial real estate economics at Moody’s Analytics. ‘Where there are new construction or properties that need to be renovated, loans are frequently made at variable rates and on an interest-only basis to cover upfront costs until properties are fully leased out,’ he says. ‘It is often only when a property stabilises that the loan is shifted to a five or 10-year fixed rate that amortises.’

The result is that borrowers who started a project between mid-2020 and early 2022, when interest rates were at rock bottom, now face a big jump if they have to refinance. Even borrowers who fixed five-year loans around 2018, when Fed funds were still below 2% versus over 5% at present, are now confronting far higher costs. A lot of new construction loans were only three years, according to LaSalvia.

Happily for CFOs, most experts agree that few landlords are likely to be able to saddle tenants with the extra cost. ‘The supply and demand dynamics just don’t favour landlords in much of the commercial property market,’ says LaSalvia. ‘So it’s a great time for chief financial officers to get bargains.’

For companies whose leases are coming up for renewal, it can be possible to extract major concessions in many cases, such as two free years on a 10-year lease, a significant discount by historical standards, says LaSalvia. ‘There has never been a better time for CFOs, especially if their leases come due soon.’

Meanwhile, with many companies scaling back their office footprint, as more staff work at least part time from home, there are more opportunities to sublet unused space. ‘There is an incredible amount of property available for sublease in this market,’ says Steven Wasserman, a consulting CFO for a range of companies in the Boston area and a finance lecturer at Bentley University. ‘As a CFO you can get some great deals. In the short run, not many landlords will have the leverage to pass on rising costs.’

Impressive discounts

For companies willing to settle for less prestigious, second-tier buildings in less desirable locations, the discounts can be even more impressive. With more companies opting for a smaller space in more upscale properties, rental prices on less pristine European office space could fall by more than 50%, according to a US investor cited by the Financial Times.

‘This is a market for the haves and have-nots,’ Wasserman says. ‘CFOs shouldn’t expect big discounts on new buildings in prime locations, with all of the latest efficiency upgrades.’ And certain categories of commercial real estate have remained resilient. While the shift to e-commerce has sent prices and rents on retail space into the doldrums, there is a thriving market for warehouse space, with more consumer companies now needing distribution spaces as they combine an online presence with bricks and mortar.

One strong card that landlords have is that the cost and hassle of moving can make companies eager to stay put – even when cheap sublet space may be on offer. ‘For a CFO, especially of a larger company, moving is a major logistical operation – often involving redesigning the office space, rewiring the electrical system, and other moving expenses,’ Wasserman says.

But with major discounts on offer, many CFOs will have a rare opportunity to squeeze out economies on one of their major expenses. The woes of commercial property owners – whether specialist funds, insurance companies or pension funds – are turning into a boon for companies looking to save money on their office and retail space.