Market Trends

San Francisco's Soaring Office Vacancy Rates Highlight Widespread Struggles in US Commercial Real Estate

The landscape of San Francisco's commercial real estate is marked by a record high vacancy rate, painting a stark picture of the challenges faced by the office sector nationwide. In a striking visual reminder of this trend, an empty office space stands quiet in a building in San Francisco, California, captured on Tuesday, Dec. 5, 2023. According to leading real estate brokerage CBRE Group, San Francisco's office vacancy rate soared to an unprecedented 34% in the third quarter.

In a report released by Bloomberg, it was revealed that a troubling $52 billion, or 31%, of all office loans incorporated in commercial mortgage-backed securities (CMBS) were facing distress as of March. This percentage has nearly doubled from 16% in the preceding year. The unease is not uniformly distributed, with some metropolitan areas feeling the heat more intensely than others. For instance, Chicago and Denver stand out with a staggering 75% and 65% of office loans deemed at risk, respectively.

Mounting Challenges for the Office Sector

The woes of the commercial office sector are manifold, compounded by the dual hurdles of languishing occupancy rates and climbing interest rates. The effect is a pronounced plunge in property valuations, creating a storm that lenders and borrowers are struggling to weather. Losses are mounting, and financial institutions continue to add troubled loans to their watch lists. In response, borrowers are opting to prolong their existing loans, clinging to the hope that property values will make a turnaround.

The complexity of the situation extends beyond immediate financial impacts, with the pressures hinting at broader economic trends. On Friday, a release showed underwhelming job gains, signaling a potential cooling in the economy. This data has prompted market traders to anticipate the Federal Reserve's rate reduction to potentially arrive as early as September instead of the later forecast of November.

Despite the glimmers of hope for future lower interest rates, industry experts like Michael Cohen, a managing partner at the commercial real estate consultancy Brighton Capital Advisors, warn that the road to recovery may still be fraught with challenges. Cohen articulated his concerns via email, stating, "I don’t think there can be rate cuts fast enough to save commercial office buildings and other assets that are poor performing or overleveraged, like multifamily, without a loan modification from the lender.”

KBRA Analytics, the firm behind the daunting 31% figure, asserts that their assessment encompasses both single-asset single-borrower and conduit CMBS loans. This breadth suggests that the identified risk is systemic, spanning various forms of investment structures in the commercial mortgage arena.

The Broader Impact on Commercial Mortgage-Backed Securities

The tremors felt in the office loan segment have reverberated across the CMBS market. A broader look at this impact reveals critical insights for investors and stakeholders in the commercial real estate debt market.

In a note dated May 3, Barclays strategists Lea Overby and Anuj Jain contemplate the current environment's subtleties. Following the less aggressive Federal Reserve statements earlier in the week, coupled with the weaker-than-expected payroll data, there is a reduced fear of continued rate hikes. This backdrop potentially makes an investment in conduit CMBS at the upper end of the capital structure an attractive proposition.

Furthermore, the Barclays strategists shine a light on the comparative performance of CMBS versus corporate debt, with the former having lately underperformed. This dissonance has rendered the AAA conduit CMBS appealing in comparison to corporate bonds. Nevertheless, caution is the order of the day, particularly toward mezzanine debt, as well as Single Asset Single Borrower (SASB) and Commercial Real Estate Collateralized Loan Obligations (CRE CLOs). The caution is grounded in the observation that, "While special servicing and delinquency rates remain well below their Covid peaks, they are considerably higher year-over-year and appear to be rising."

Navigating the CMBS Landscape

Indeed, the CMBS sector has experienced significant activity that sheds light on investor sentiment and market dynamics. Recent developments—detailed in a series of high-profile stories—reflect active efforts by key players to adapt and thrive amidst market fluctuations:

• CMBS Investors Get Some Payments After Dustup That Shook Market
• KKR Taps Asset-Backed Debt to Kick In More Money for Its Funds
• CMBS Delinquency Rate Surges to Highest Since September 2021
• Trafigura Eyes $300 Million Esoteric Bond on Trade Receivables
• Western Asset Sees Value in Commercial Real Estate (Podcast)
• GoldenTree Taps Blackstone’s Shannon as Synthetic Deals Increase
• Sunnova Energy Huddles With Adviser on Balance Sheet Options (1)
• Credit Risk Transfer Index Extends Gains for More Than Year
• Buyouts of Delinquent Commercial Real Estate CLO Loans Jump 210%
• Banks Sell Loans to Private Credit in New Balance Sheet Twist
• Mortgage-Backed Scorecard Stuck in Neutral as Fed Delays Easing
• MBA Mortgage Applications Fell 2.3% Last Week
• Chicken Finger Restaurant Chain Zaxby’s to Borrow in ABS Market
• Water Parks Company Taps CMBS Market Again as Sales Rebound
• Barclays Calls Junk Rated Rental Car ABS Unappealing Amid Risks
• Mortgage YTD Returns Rank Second Worst in History: Chart Pack
• CLOs ‘Torment About Technicals’ Partly Unfounded, JPMorgan Says
• Fed Policy Changes May Dictate MBS Demand as Bank Buying Pauses

This extensive list of headlines underscores the multifaceted nature of the CMBS market and the creative strategies firms are using to navigate the landscape even as they face unprecedented challenges.

Looking Ahead: A Busy Week in Commercial Debt Markets

The forward motion does not stop, as indicated by the recent premarketing endeavors of several financial entities. With Ford, GM Financial, Pagaya, Sallie Mae Bank, and Vertical Bridge setting deals in motion on Thursday, the ensuing week is projected to be bustling. Market participants expect these deals to reach pricing stages, contributing further to the track of the broader bond and securitization market trending.

This comprehensive examination of the commercial real estate landscape shows a sector in flux, grappling with significant headwinds but still moving forward. Amid record-high office vacancy rates and the ebb and flow of interest rates, stakeholders across the board—from borrowers to lenders to investors—are reevaluating their strategies and repositioning for what the future holds.

In assessing the future of the CMBS and broader CRE debt markets, a fundamental understanding of macroeconomic signals, investor sentiment, and strategic financial maneuvering will be crucial. As the market navigates through this period of uncertainty, resilience, innovation, and adaptability will likely define the winners in the long run.

©2024 Bloomberg L.P.

For those interested in delving deeper, further information on these developments can be found on the website of Bloomberg L.P., providing up-to-date insights and analysis: Bloomberg - Are you a robot?

It is clear that while current signs offer a mixed bag, the capacity of the market to innovate and evolve could yet meet the challenges head-on, offering pragmatic solutions and new opportunities for growth.

Reading between the lines of the market activity and economic indicators, it becomes evident that the office sector's landscape, particularly within the United States, is deeply interconnected with larger economic trends. The coming months will be critical in discerning whether the predicted rate cuts and market adjustments can create a conducive environment for recovery or if further turbulence lies ahead for the struggling office real estate market.

In conclusion, while the office sector faces a daunting challenge, the resilience of the CMBS market exhibits the industry's relentless quest for equilibrium. With various factors at play, including evolving economic policies, institutional strategies, and investor initiatives, the commercial real estate landscape remains a pivotal arena for financial and economic analysis in the years to come.