Navigating Rates

Office real estate – medium-term headwind?

For many white-collar workers in the West, one of the enduring changes brought about by the Covid-19 pandemic was a change in workplace location. According to data from the Survey of Workplace Arrangements and Attitudes, before the pandemic fewer than 5% of US workdays were taken from home. After peaking at 60% in the early weeks of the pandemic, this remains at nearly 30%. This drastic change in working patterns is causing a profound shift in demand for office space.

Key takeaways
  • The change in working patterns caused by the pandemic has led to a significant revaluation of office real estate.
  • Given the sharp increase in financing costs, a fair question to ask is if whether commercial real estate (CRE) can create significant risk in the US financial system and specifically for banks.
  • Unlike in past real estate crises, this time the exposure of large US banks is low. Risk appears to be concentrated in smaller banks, although granular disclosure here is limited.

Cushman and Wakefield report that, by the second quarter of 2023, nearly one fifth of US office space was vacant1, a dramatic increase from the roughly 13% vacancy rate before the pandemic. The increase in vacancy rates shows no signs of slowing, and is likely to increase further. As leases come to an end, firms will make adjustments to their real estate footprint to accommodate this shift in working patterns.

The rising vacancy rate, combined with the significantly higher interest rate environment, has led to a large reduction in commercial real estate (CRE) values, particularly for office. The total value of US office CRE is estimated to be around $5tn, although some analysts believe that this value could decline by more than one third in the coming years. Unlike some previous crises, the losses this time will likely be spread widely. Disclosure around who the ultimate owners of US office real estate is patchy. While REITs and Private Equity firms are large owners of commercial real estate, most of their exposure is outside the office area. While a quarter of REIT assets were office at the turn of the millennium, by 2021 that had shrunk to around 5%. Likewise, the largest private equity firm globally, Blackstone Inc, recently reported that US office represents less than 2%1 of their real estate portfolio, down from more than 60% in 20072

Many of the assets have been picked up by pension funds, endowments and foundations, who likely own a majority of real estate. These investors typically have around 10% allocation to real estate, and some of the largest have begun to write down the value of their real estate in response to the weakening market. However, after years of strong returns from equities and alternative assets, and with limited near-term cash requirements, these value reductions are likely to be manageable for these investors. In the past, banks have had significant exposure as lenders. Banks have often been significant enablers of real estate booms – extending larger and larger loans supported by ephemeral valuations of the underlying real estate – before suffering significantly in the aftermath. The Global Financial Crisis in 2007-9 is the most prominent recent example of this. However, such an outcome is less likely this time: the largest US banks have kept exposures down, with almost all reporting that office exposure represents less than 4% of their loan books, and that these loans were more conservatively underwritten than CRE loans written before the Global Financial Crisis, with loan-to-value ratios below 60% and good debt service cover. To date, the impact on banks has been small: reported losses on office CRE loans have been minimal, although delinquency rates on loans have nearly tripled from the low levels seen in late 2022. 

So, if not with the large banks, where does the risk lie? Within the financials industry, there are two areas at most risk from large loans to real estate. The first is at smaller banks (those with less than $100bn of assets). These smaller banks, of which there are more than 4,000 in the US3, represent around a quarter of total US banking system assets, but are estimated4 to hold more than 70% of the bank loans to office and downtown retail CRE. Many of these loans were made relatively recently and at elevated property values, as these banks sought to deploy the huge inflows of deposits seen during the extraordinary monetary and fiscal stimulus deployed in response to the pandemic. According to Moody’s, the number of US banks with CRE concentrations in excess of regulators’ 2006 CRE guidance levels has increased from 300 to 700 in the last two years (implying more than one out of every 10 US banks has CRE concentrations in excess of supervisory guidance). These smaller banks will suffer two additional challenges. First, in many cases their office loans are concentrated in a small number of markets. While nationwide office vacancy rates are close to 20%, the vacancy rate is much higher in major cities like San Francisco, New York, Chicago, and Los Angeles, as well as some regional markets. The exact location of the underlying buildings matters, and some banks will have large exposures to particularly challenged markets. Second, in many cases the loans these banks have made are too small to be of interest to non-bank lenders, preventing these banks from exiting problem loans. The challenge for investors is to assess which of the 4,000 banks have large exposure, as disclosures on this matter vary significantly by firm.

 Office CRE Lender Share

MSCI Europe consensus EPS

Source: Morgan Stanley (March 16, 2023), Real Capital Analytics

The second sector most at risk is life insurers. Real estate as an asset class is attractive to this investor type: with large amounts of long duration customer capital, real estate and loans to real estate represents a long duration, asset-backed asset class. Based on estimates from Jefferies, the largest life insurers have around one sixth of their investment assets invested in CRE. However, because of the high leverage embedded in life insurers business models, the real estate exposure approaches 200% of statutory capital. Like the large banks, the large life insurance companies have reported that they see the risk as being low, with loans  to value on office loans around the 50-60% level and with the loans well covered by rental income. These metrics will likely continue to deteriorate, but the risk to the life insurers looks low.

While losses might be large, they will be widely dispersed and are likely to be realised over many years, as the vast majority of real estate loans mature beyond 2025. Borrowers and lenders have time to resolve problem loans, which will be a key focus for many institutions in the coming few years. 

1 Q2 2023 results
2  SDC conference 2023 transcript
3 FDIC data
4 Estimate from barclays

 

 

  • Disclaimer
    Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security

    The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the data is not guaranteed and no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted. This material has not been reviewed by any regulatory authorities. In mainland China, it is for Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations and is for information purpose only. This document does not constitute a public offer by virtue of Act Number 26.831 of the Argentine Republic and General Resolution No. 622/2013 of the NSC. This communication’s sole purpose is to inform and does not under any circumstance constitute promotion or publicity of Allianz Global Investors products and/or services in Colombia or to Colombian residents pursuant to part 4 of Decree 2555 of 2010. This communication does not in any way aim to directly or indirectly initiate the purchase of a product or the provision of a service offered by Allianz Global Investors. Via reception of his document, each resident in Colombia acknowledges and accepts to have contacted Allianz Global Investors via their own initiative and that the communication under no circumstances does not arise from any promotional or marketing activities carried out by Allianz Global Investors. Colombian residents accept that accessing any type of social network page of Allianz Global Investors is done under their own responsibility and initiative and are aware that they may access specific information on the products and services of Allianz Global Investors. This communication is strictly private and confidential and may not be reproduced, except for the case of explicit permission by Allianz Global Investors. This communication does not constitute a public offer of securities in Colombia pursuant to the public offer regulation set forth in Decree 2555 of 2010. This communication and the information provided herein should not be considered a solicitation or an offer by Allianz Global Investors or its affiliates to provide any financial products in Brazil, Panama, Peru, and Uruguay. In Australia, this material is presented by Allianz Global Investors Asia Pacific Limited (“AllianzGI AP”) and is intended for the use of investment consultants and other institutional /professional investors only, and is not directed to the public or individual retail investors. AllianzGI AP is not licensed to provide financial services to retail clients in Australia. AllianzGI AP is exempt from the requirement to hold an Australian Foreign Financial Service License under the Corporations Act 2001 (Cth) pursuant to ASIC Class Order (CO 03/1103) with respect to the provision of financial services to wholesale clients only. AllianzGI AP is licensed and regulated by Hong Kong Securities and Futures Commission under Hong Kong laws, which differ from Australian laws.

    This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors (Schweiz) AG; Allianz Global Investors UK Limited, authorized and regulated by the Financial Conduct Authority; in HK, by Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; in Singapore, by Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z]; in Japan, by Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424], Member of Japan Investment Advisers Association, the Investment Trust Association, Japan and Type II Financial Instruments Firms Association; in Taiwan, by Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan; and in Indonesia, by PT. Allianz Global Investors Asset Management Indonesia licensed by Indonesia Financial Services Authority (OJK).

    3067164

Recent insights

Embracing Disruption

For many years, investing in China’s State-Owned Enterprises (SOEs) has typically been viewed by international investors as, at best, a low-quality proxy for China’s economic growth. They have been synonymous with low profitability, questionable governance, and poor shareholder returns.

Discover more

After an eventful few months in the markets – and looking forwards to a potentially volatile final quarter – Greg Hirt, our Global CIO Multi Asset, joins us once again to share his views and convictions on the global economic and market landscape.

Discover more

Achieving Sustainability

Technology brings new opportunities, but also sustainability challenges. The sector must balance both for an improved sustainability footprint.

Discover more

Allianz Global Investors

You are leaving this website and being re-directed to the below website. This does not imply any approval or endorsement of the information by Allianz Global Investors Asia Pacific Limited contained in the redirected website nor does Allianz Global Investors Asia Pacific Limited accept any responsibility or liability in connection with this hyperlink and the information contained herein. Please keep in mind that the redirected website may contain funds and strategies not authorized for offering to the public in your jurisdiction. Besides, please also take note on the redirected website’s terms and conditions, privacy and security policies, or other legal information. By clicking “Continue”, you confirm you acknowledge the details mentioned above and would like to continue accessing the redirected website. Please click “Stay here” if you have any concerns.