Five years ago, if you’d asked me the most likely cause of the next US recession, I’d have said commercial real estate. From industry professionals’ insights at places like SIEPR to anecdotally seeing thinned storefronts and mall closures across the country, the sky-high valuations of commercial real estate seemed like a bubble ready to pop.
Five years (and one worldwide pandemic) later, commercial real estate has deflated, but still faces a big cliff and collapse. Higher interest rates, weak demand for office space, and a big shift in how Americans want to spend their time (and money) all adversely affect the current commercial real estate paradigm.
Higher interest rates and weaker demand for office space go hand-in-hand. Five years ago, low interest rates meant that commercial developers were more willing to leverage massive debt to build. Those loans are now coming due, and higher delinquency rates could roil the global banking and lending system, let alone the impact of half-finished buildings and vacant real estate across cities and suburbs. In addition to higher interest rates, companies are looking to downsize their office footprints as waves of white-collar layoffs and hybrid work policies reduce the need for the grandiose campuses of the past decade. Even companies with all in-person work have hybrid working styles (few US employees can truly “shut the laptop off” when they leave the office — calls, video meetings, and cleaning up Excel sheets on VPN await), and these modern work approaches further change Americans’ time demand in city centers.
The power lunch and dinner meetups after work have faded. In their place, Americans may pick up a grab-and-go lunch from a nearby takeout place, eat at their desk, and order a burrito off of Doordash for dinner to arrive right as they get home. This is an oversimplification, but it’s an illustrative example of how the most prized commercial real estate of yesteryear (restaurant space near big offices, the big offices themselves with billion-dollar views, and an assortment of post-work bars and entertainment) is no longer as in-demand as it once was. Unless the big commercial real estate investors start a big push for longer lunch hours and allocating money to host more team events in the city, I don’t see this trend shifting anytime soon.
Online media and resource availability is also upending traditional anchor tenants. People are more willing to shop for clothes online and turn to Amazon, Etsy, or a favored indie retailer over a massive Nordstrom storefront. The proliferation of YouTube, Twitch, Steam, Netflix, and other watching/gaming entertainment eats into mall and arcade culture of past decades. Industries that depend on close proximity translating into higher spend are shrinking storefront space and rethinking digital strategy instead.
The final complicating factor is that loans and leases are coming due in the next few years. In San Francisco, a third of existing office leases are set to expire by the end of 2025. In New York City, 55 million square feet of office space (much of it in older buildings) is set to expire by 2027. 2nd tier cities are also facing an exodus after initial pandemic gains, with people leaving Miami, Austin, Denver, and Portland. Depending on how trends continue, these cities could face a glut of new commercial construction as companies spurn slower downtown growth, with builders unable to recoup the debt they took on to build in the first place. All of this threatens to tank commercial property prices, upkeep, and drag nearby storefronts and local economies down with it.
One bright spot for commercial real estate is new consumer patterns favoring hyperlocal engagement. In San Francisco, for example, many outlying areas have revitalized and vibrant commercial centers with a small-town feel. The Inner Sunset, Richmond, Hayes Valley, and Mission neighborhoods all have bustling streets where people meet up for activities, check out a new pop-up gallery, or grab dinner at a favorite local restaurant. Across the country, I’m seeing people turn to similar joints, choosing storefronts and restaurants in outlying neighborhoods and exurbs where they have moved in response to getting priced out of closer-to-work locations by large conglomerate landlords.
I don’t think that bright spot is enough to stop a commercial real estate crunch. All the real estate glut is concentrated in areas that people don’t want to live in, and/or where there isn’t sufficient supply of residential real estate to revitalize areas into hyperlocal economies. Unless there’s massive subsidization to quickly create apartments in downtown areas that people actually want to live in, the most valuable commercial real estate properties on paper will rapidly face a reckoning from tenant move-outs and aging infrastructure. As they empty, these properties may drag the US into a recession, further exacerbating the cycle.
Andrew Jabara 