The commercial real estate market has a lot of heat around it and is currently facing concerns from experts about the commercial property industry. The winds of change are blowing through the commercial real estate market. Interest rates, long held at historically low levels, are on the rise. Meanwhile, a complex interplay of factors is leading to pockets of receding rents in certain sectors. This confluence of events begs the question: are we headed for a full-blown commercial property crash?
How Markets Move
Broad market shifts frequently occur in three distinct phases: denial, migration, and panic. Denial is self-explanatory. Migration occurs when an increasing number of people move to the opposite polarity, whereas panic occurs when everyone rushes for the exit at once.
We have seen denial and are now seeing migration, as evidenced by a drop in transaction volume and a growing disparity between what buyers will pay and what sellers are willing to accept. Panic can be avoided temporarily, but such capitalization has significant economic consequences.
The Squeeze: Rising Rates and Their Impact
Like a vice tightening around investment potential, rising interest rates present a significant challenge. Higher borrowing costs eat into profit margins, making developers and investors more cautious. The allure of new construction projects diminishes, potentially leading to a slowdown in development activity. Additionally, existing property owners with adjustable-rate mortgages may face increased debt service, impacting their cash flow and ability to reinvest.
The Double Whammy: Receding Rents in Key Sectors
While not a universal phenomenon, certain segments of the commercial real estate landscape are experiencing declining rents and broker scams. The rise of remote work has cast a shadow over the office market, with vacancy rates rising in many urban centres. Because, let’s be serious, why would companies want to spend money when they’ve had a taste for savings? Although some have suggested hybrids to increase productivity with employees, the percentage pre-covid is still low.
Retail, already battered by e-commerce competition, faces additional pressure from changing consumer habits and store closures. These factors contribute to a scenario where property owners struggle to command the same rental rates as before, further squeezing their bottom lines. Everything seems to be increasing and there doesn’t seem to be any give from any side, which is creating this snowball effect of stores closing down and buildings becoming obsolete.
Vacancy Crisis: Will We Ever See Bustling Offices Again?
The commercial office market since COVID has seen a dramatic change and it’s not in a positive way. While the blame can’t all be put on the impacts of COVID, there are actually several other contributing factors, including the shift to remote working being well sought after, which I can sympathise with. Rush hour traffic can be draining and make an 8-hour shift feel like a 12-hour day.
Additionally, technology has enabled the take-off of e-commerce and home deliveries, meaning businesses aren’t favouring tangible spaces and investing in fulfilment centres and dropshipping, cutting out logistical costs and employee costs and saving a lot of time. With modern-day spending habits changing, online shopping seems to be thrashing in stores every year and some companies are adapting to this and cutting these physical store costs.
With these new and established remote work policies, several businesses have successfully achieved a more decentralised work pattern, making the need for physical office space almost obsolete. While some companies remote working simply wouldn’t work, some careers utilise this, and individuals favour that kind of opportunity.
Changes in government policy have also contributed to the shift in commercial real estate. They are currently aiming for a net zero by 2025. The Minimum Energy Efficiency Standards (MEES) are regulations that require buildings in England and Wales to meet a minimum level of energy efficiency before they can be rented or sold. In many cases, the implication is that commercial buildings will require significant investment to meet existing standards.
Commercial Landlords Listen Up
Landlords should have noticed by now how many businesses didn’t return back to offices after the pandemic and how remote working is becoming both normalised and sought after from both a business and employee perspective.
To battle these challenges, the need for more modern, tech-enabled office spaces that can cater to preferences and ambitious businesses is a “flight to quality,” implying that more money has to be spent first to reap the rewards and get businesses back into offices and the need for smaller spaces.
The overall result of these factors has led to the inevitable decline in office property values in many locations, as occupancy rates have significantly dropped over the past few years. This change has resulted in a reduction in demand for traditional office spaces and these businesses that are looking for space are spoilt for choice. Commercial property owners are forced to reduce prices to remain competitive, it’s better to reduce your rates and get a bite rather than have it sit there empty.
Warning: Inflation and Interest Rates
Since the market crash in 2008, interest rates have reached an all-time low. This has the effect of increasing asset values, particularly the value of residential property. However, due to a high level of government funding during the pandemic period (money and printing) and supply issues during the long post-pandemic period, commercial property owners in developed countries have seen a rapid rise in inflation.
Solutions
Renegotiating lease terms and lowering operating costs in the short term while looking for ways to improve the building’s attractiveness, sustainability, and utility in the long run are obvious examples. Borrowers should have open and transparent discussions with lenders about loan amendments, refinancing options, subletting, and even potential asset sales.
Alternative options include partnerships, joint ventures, alternative funding sources, and seeking equity investors.
