De-Bunking the Doomsday Delusion

A rising chorus has proclaimed the death of U.S. commercial real estate (CRE) — and the banks that lend on it. But to paraphrase Mark Twain, rumors of real estate’s death may be greatly exaggerated. Much of the recent anxiety stems from profound misconceptions.

A rising chorus has proclaimed the death of U.S. commercial real estate (CRE) — and the banks that lend on it. Naysayers fear a “doom-loop” of falling prices and contracting credit, leading to further losses. The concern is understandable: Like most asset classes, real estate has suffered from higher interest rates. Bank failures— though not caused by real estate — have underscored the risks posed by longer-duration assets to liquidity and balance sheets. And high-profile defaults in Los Angeles, San Francisco, and New York have raised the specter of mounting distress.

But to paraphrase Mark Twain, rumors of real estate’s death may be greatly exaggerated. Much of the recent anxiety stems from profound misconceptions. Consider the following:


CLAIM: Work-from-home is killing commercial real estate.

COUNTER-POINT: CRE fundamentals are about the strongest on record.

There is no denying that the U.S. office market is challenged. Office-utilization rates are mired at around 50% of pre-pandemic levels nationally (albeit higher mid-week and outside major coastal cities).[1] Layoffs in the technology and financial industries — big users of office space — have worsened the blow. But the world of real estate is much larger than office buildings. The share of offices in the core real estate fund index is 19% and falling.[2] Industrial (32%) and residential (29%) are much larger, and along with retail (10%), are in very good shape.[2] Collectively, the vacancy rate for U.S. property is near its lowest level on record (since 1988) and net operating incomes (NOIs) are growing briskly.[2]


CLAIM: Bad real estate loans will cause a financial crisis.

COUNTER-POINT: Banks have considerable protection against real estate losses.

Higher interest rates and lower asset values may strain some borrowers’ ability to service and refinance existing debt. Yet many loans have plenty of cushion to absorb these pressures. Over the past five years, core real estate cash flows have increased 21% and prices 15% (after recent declines).[3] The Federal Reserve has observed that loan-to-value (LTV) ratios average about 50%-60% across lenders, and its 2023 stress tests concluded that even under draconian assumptions – prices falling 40% and unemployment soaring to 10% — loan losses at large banks were easily manageable.[4] To be sure, smaller banks have more exposure, but like their larger peers, they sport near-record levels of capital.


CLAIM: Real estate faces a credit crunch.

COUNTER-POINT: Credit is tightening, but the effects are uneven.

It seems reasonable that banks could retrench amid heightened investor and regulatory scrutiny. A net 68% of senior bank loan officers reported a tightening of lending standards in the third quarter of 2023, on a par with Global Financial Crisis (GFC) and COVID peaks.[5] Yet there is little evidence of a credit crunch so far: Spreads on core real estate loans have barely moved, remaining in line with historical norms and well below COVID peaks.[6] Why? Perhaps because insurance companies, government sponsored entities (e.g., Fannie Mae and Freddie Mac), CMBS, and private credit, which together account for half of the mortgage market, are filling the void.[7] Still, we will likely see greater impacts on construction financing, where banks have traditionally played a significant role.

In some ways, prospects for real estate are improving. Cooling inflation may herald an end to Federal Reserve rate hikes, providing relief to valuations. That is not to say that CRE is out of the woods. A recession could hamper leasing and COVID-delayed construction will temporarily lift apartment and industrial supply. But lower prices and tighter financing are curtailing new projects, and any recession may be mild. If so, then real estate’s positive momentum will only slow, not stop, and then re-accelerate next year. Taking a longer view, chronic housing shortages, burgeoning Sun Belt migration, a nascent retail renaissance, relentless e-commerce expansion and efforts to bolster supply chains are just a few of the forces that will drive demand for different types of real estate for years to come.

The next 12 months might be somewhat choppy as improving capital markets collide with a soft patch in fundamentals. But conflicting signals are the hallmark of inflection points, where opportunities are often at their greatest. Fortune may favor the brave investor who can seize the moment, capitalize on attractive valuations, and ride the next cycle.

Additional Resources

After Recent Volatility, the Industrial Market is Normalizing to Pre-COVID Levels

Not all commercial real estate is created equal. While some office properties are struggling, Industrial real estate continues its strong performance.

Retail Right-sizing Fuel Strong Sector Performance

While capital continues to favor industrial and residential investments, the retail sector’s robust performance has been barely noticed.

Real Estate Fundamentals Defy Higher Interest Rates

U.S. real estate investment performance has struggled in response to rising interest rates. Yet underlying fundamentals remain robust.

1. Kastle Systems. As of September 2023.

2. NCREIF (NFI-ODCE). As of June 2023.

3. NCREIF (cash flow); GSA (prices). As of March 2023.

4. Federal Reserve, “2023 Federal Reserve Stress Test Results.” As of June 2023.

5. Federal Reserve. As of September 2023.

6. CBRE. As of June 2023.

7. Federal Reserve. As of June 2023.

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