Office space key risk to Colorado’s outlook
A $1 trillion wall of debt needs refinancing nationally
Commercial real estate represents an anchor that is likely to only grow heavier in the months ahead as apartments join office space in stressing banks and weighing on the larger economy.
“Office is a four-letter word right now,” said Marcel Arsenault, CEO and founder of Louisville-based Real Capital Solutions, while moderating a panel on commercial real estate at the Colorado Business Economic Outlook Forum, hosted by University of Colorado Boulder in early December.
Falling interest rates might provide some relief, but they won’t reverse the reluctance lenders have when it comes to refinancing the massive amount of commercial real estate loans coming due, loans that were made when property values were much higher and interest rates much lower.
The share of available office space in downtown Denver crossed 30% in the third quarter, marking the highest vacancy levels since 1990 when the state was coping with a severe energy bust.
So-called “zombie” buildings have seen tenants flee or downsize, causing their cash flows and valuations to plummet. They are assets that are not viable, but not yet dead, plodding slowly toward their demise as they drag massive amounts of debt behind them.
“Even if you get the building for free, there is not enough margin to meet tenant concessions,” said Carl Koelbel, COO of Koelbel and Co., who also was on the panel.
Coming up behind the office market, which is in a recession, are multi-family and industrial spaces, which have crossed their peak and are oversupplied, according to the Real Estate Market Cycle Monitor published by University of Denver professor Glenn Mueller.
Metro Denver has about 120,000 new apartment units on the drawing board. Roughly 48,000 of those units are under construction, 24,000 have a set construction start date but aren’t underway and 48,000 are in earlier planning stages, according to Apartment Insights.
Multifamily may join the list of swear words on the lips of bankers as developers try to roll over construction loans into mortgages and secure enough tenants to fill their units, Arsenault said.
“We do have a large pipeline,” said Christopher Gillies, vice president of development at LMC, a subsidiary of Lennar focused on multifamily development and management.
But so far the apartment market in Colorado is proving resilient despite all the added supply, he added. Statewide the apartment vacancy rate in Colorado, not counting metro Denver, stood at 6.0% in the third quarter, which was up from a 5.1% rate a year earlier, according to a recent report from 1876 Analytics LLC and CHFA.
In metro Denver, where the bulk of new apartments will land, the vacancy rate was 5.4% in the third quarter, down from 5.5% in the second. The average rent was $1,888 a month, up $18 or 1% from where it was a year earlier, which suggests a balanced rather than glutted market, according to the Apartment Association of Metro Denver.
Historically, multifamily building permits represent about 30% of all residential permits, but for the past two years, they have exceeded single-family permits. The Colorado Business Economic Outlook forecasts multifamily permits, at 18,500, will drop below single-family permits of 19,400, in 2024, marking the slowest pace since 2016.
Residential building permits of all types in the state, which peaked at 56,524 in 2021, are expected to come in at 38,700 in 2023 and 37,900 in 2024.
After peaking at $15 billion in 2021, the value of residential construction is expected to come in at $10.4 billion in 2023 and $10.7 billion next year, according to the Outlook. Nonresidential construction is expected to remain flat at $5.5 billion next year, and so is nonbuilding construction at $5 billion.
Arsenault suggests that the solution to overbuilding in multifamily is actually overbuilding. He predicts rents will fall and vacancy rates will soar, to as high as 15%, a painful signal to developers that they need to back off.
Unlike office space, the region faces a deficit of 100,000 housing units, according to a study from Up for Growth. Everything under construction will eventually be needed. But if apartment vacancies get high enough, it could force a pullback severe enough to leave the apartment market undersupplied long-term, which was the case with single-family last decade.
Debt problem
The multifamily glut is a problem that is still developing. The more pressing challenge next year will be how to rework all the bad loans tied to office buildings.
Easy and cheap capital contributed to a commercial real estate boom that now has to be unwound, and the process could get ugly, predicts Arsenault. His firm has sold off $1 billion of its real estate holdings and is sitting on cash, waiting for the smoke to clear, which he estimates could take eight to 10 years.
The country has about $6 trillion in CRE loans, and about half of that total is held at banks. For just under half of banks in the country, CRE debt represents the largest single loan category in their portfolios, according to the Financial Stability Oversight Council (FSOC) in its 2023 annual report.
“As losses from a CRE loan portfolio accumulate, they can spill over into the broader financial system. Sales of financially distressed properties can reduce market values of nearby properties, lead to a broader downward CRE valuation spiral, and even reduce municipalities’ property tax revenues,” the FSOC warned.
A white paper from the National Bureau of Economic Research estimates that about 14% of all CRE loans and 40% of all loans tied to office buildings have negative equity, meaning the underlying assets are worth less than the debt on them.
Research firm Capital Economics predicts office building prices could fall another 20% on average, bringing the peak-to-trough decline to around 43%. That is an average, for the market as a whole. Some buildings are effectively worthless.
For struggling building owners counting on a speedy rebound, Capital Economics estimates peak office market values reached before the pandemic won’t be seen for another two decades. Waiting it out isn’t an option.
And another thing is working against a grit-itout approach. About a third of all CRE loans and more than half of all office-building loans are expected to face major cash flow problems because rents can’t cover loan payments and other expenses, the NBER estimates.
If about 20% of CRE debt defaults, NBER researchers predict banks could be hit with $160 billion in additional losses. Those losses, when combined with earlier write-offs because of higher interest rates, could make 482 banks with $1.4 trillion assets effectively insolvent.
This added stress will come on top of the five largest bank failures on record in the first half of 2023. Led by the collapse of Silicon Valley Bank, those failures were because of rising interest rates, falling values for debt instruments, and a heavy reliance on uninsured deposits.
All banks are under much tighter regulatory scrutiny as a result, said James Payne, a senior vice president at U.S. Bank, during the panel. That will make them less inclined to take on the added risk tied to CRE loans.
The Mortgage Bankers Association calculates a $1 trillion “wall” of maturing commercial mortgages will come due over the next two years. Even if willing lenders can be found to refinance those properties, borrowers will likely have to contribute additional capital and any new loans will come at a much higher interest rate, further straining cash flow.
In Denver, debt research firm Trepp said the five buildings with the largest loan amounts in default include World Trade Center I & II, 1670 Broadway, Meridian One Colorado, Gateway Plaza at Meridian and Columbine Place.
Combined, they represent $223 million in bad debts, and all five buildings are under a special servicer — someone appointed to see if the properties can make enough to cover payments or if they will need to be put through foreclosure.
“Lending has become more challenging,” said Koebel. Office financing is untouchable, construction financing is difficult and funding for affordable housing is challenged. Lenders are hesitant to finance new projects, and they don’t want to finance purchases of existing properties, he said.
And while a recession might give employers more leverage in forcing workers back into the office, Koelbel said he doesn’t see an easy solution to address “zombie” buildings. They will either have to transition to another use, which requires putting in even more money, or they will eventually have to be torn down.
“There really is no offramp for these buildings,” he said.