Large offices in major US cities are the most at risk in commercial real estate

Big office buildings in large U.S. cities are the most at risk from turmoil in commercial real estate, according to Goldman Sachs Research. There are signs that smaller offices in suburbs, as well as newer buildings in central businesses districts, could be more insulated from the stress.

Office buildings in central metropolitan areas have been the hardest hit by losses in occupancy since the pandemic as more employees work from home. By contrast, suburban offices, and medical offices in particular, have been less impacted, especially in smaller American cities, Goldman Sachs Research analyst Caitlin Burrows writes in the team's report. Newer office properties in central business districts have been the most insulated from occupancy losses, she writes.

While banks hold more than half of the $5.6 trillion of outstanding commercial real-estate debt, according to Goldman Sachs Research, the composition of lenders tends to be different for large and small offices. International banks, commercial-mortgage backed securities (CMBS) and investor groups to tend have a higher concentration of loans in central businesses districts, averaging a 71% share of the market. Local and smaller banks are much more skewed toward suburban offices (31% share of the market) and medical offices (43%), versus just a 10% share of loans for central metropolitan offices. Large national and regional banks are more evenly distributed among the office subtypes, but with an emphasis on suburban (22% share of lending) and medical offices (30% share).

Geography also matters. International banks, CMBS, investor groups, and insurance companies made up around 65% of loans in major markets since 2019, while office loans from smaller banks are more heavily skewed towards smaller markets, according to Goldman Sachs Research. Commercial lending by national and regional banks tends to be relatively evenly distributed among the markets.

Commercial real estate has been under stress amid a rapid increase in interest rates as the Federal Reserve seeks to contain inflation, Chief Credit Strategist Lotfi Karoui says in an episode of Exchanges at Goldman Sachs. A substantial portion of commercial real estate loans are floating rate, which makes them particularly vulnerable to Fed policy, and a large chunk of the debt will mature in the next two years. Smaller banks, which provide much of the financing for commercial real estate, are under pressure following the collapse of Silicon Valley Bank. Securitization and CMBS issuance have fallen compared to last year. "At a higher level, it's really the inability of the asset class to adjust to the prospect of a higher, for longer, cost of funding" that's putting so much stress on the market, Karoui says.

In many cases, valuations in commercial real estate will probably drop further, Jeffrey Fine, global head of Real Estate Client solutions and product strategy in the firm's Asset and Wealth Management business, says in theExchangespodcast. As sustainability becomes a bigger concern, there's a large swath of buildings that were developed more than 50 years ago that require investment. As these loans mature, he says banks aren't necessarily in a position to take these assets back on their balance sheets and simultaneously invest in them to stabilize their value or reposition them for a different market. "There's going to have to be a very organized public and private partnership to figure out a careful unwind of this current dynamic," he says. "Otherwise, we have a very messy situation on our hands."

There are a number of differences between the pressures in real estate markets now and during the financial crisis in 2008. While larger office loans in central business districts are in the crosshairs now, there wasn't as much differentiation between the performance of small and large office loans or by geography during the subprime mortgage crisis, Burrows writes in the report.

In addition, lending standards and credit quality are higher than they were 15 years ago, Karoui says in Exchanges. "Whatever issues we're going through right now, they're not symptomatic, in my opinion, of years of loose underwriting standards," he says.

But at the same time, there's never been such an over-supply of office space in some markets, which risks creating a negative feedback loop where landlords must lower their rents, which in turn puts pressure on their income and drives valuations lower, Karoui says. "That negative feedback loop risk is quite high," he adds. "But I would say history will tell you that losses play out over many, many years. They don't materialize instantaneously."

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