Current Office Cycle Could Last Longer Than GFC Downturn

Trying to understand the office market has become difficult. Some knowledgeable people in CRE are sure that now is the time to invest in office. Fitch Ratings isn’t in that camp.

The firm “expects a more protracted U.S. office commercial real estate sector recovery during this cycle than following the Global Financial Crisis,” which, if prescient, is not a pleasant thought.

Compared to other cycles — not just the GFC but the late 1990s and early 2000s — all had begun upturns with 18 to 24 months. The current downturn is at about 48 months and is still continuing.

It took the late 90s downturn about 19 months for office properties to return to full value. From the 2000s downturn, it took about 33 months to regain the dissipated value. The GFC? About 87 months, or 7.25 years. On the positive side, the current fall in value by Green Street Advisor’s count, which Fitch used, is down to 65% of value. For the GFC, it fell to about 53%. But, again, this time around office hasn’t yet hit bottom. “The secular shift to hybrid and remote working and challenging refinancing conditions will drive the slower, more elongated recovery timeline for office and lead to permanent property valuation impairments and higher CMBS loan losses relative to expectations at issuance,” the firm wrote.

One big difference is that in previous examples, the Federal Reserve lowered interest rates in an attempt to stimulate the economy and assist a recovery. With higher interest rates to push down inflation, the central bank can’t cut rates to help refinancing, and it looks like plans for cutting rates will be pushed off more than people have thought.

Fitch has projected that 10-year Treasury yields will end 2024 at 4.3% and 2025 at 4.0%, while “the market has tempered its earlier expectations for significant rate cuts by the Federal Reserve.” They also think that the U.S. CMBS delinquency rate will double from the 3.6% of February 2024 to 8.1% at the end of this year and 9.9% in 2025, higher than the post-GFC peak.

“In conjunction with elevated rates and lower cash flows, this would suggest that the workout of some CMBS office loans may settle at values close to this cycle’s lows,” Fitch wrote. And according to the data they provided, the loss severity on defaulted CMBS office loans has climbed from just over 20% in 2009 to close to 60% in 2022. The resolution timeframe has gone from about 2.5 years between 2009 and 2019 to more than four years, “indicating property liquidations and the realization of losses for office loans currently in default could play out through 2028 and beyond.”

Distressed property values on CMBS office loans are down by about 50% on average from original valuations at issuance. “Fitch’s loss expectation for office loans within its rated U.S. conduit portfolio averages 7.7%, which marks an increase from 3.8% at the time of issuance and is also significantly above the overall average loss of 5.2% for all property types,” they wrote.

The ultimately point is that these are trends and extremes that probably won’t quickly resolve themselves.

Net Lease Spring:

Held April 16-17 in NYC, Net Lease Spring will bring together hundreds of dealmakers from the nation’s top firms. This year’s program will feature 5.5 hours of face-to-face networking and over 5 hours of content focused on micro and macro trends for 2024, being resilient through market volatility, how to serve your corporate tenant clients and much more! Learn more or register here.