No End In Sight For The Financial Tsunami Hitting Office Space Investors, Owners And Tenants

As hybrid and remote work continue to leave office spaces empty, investors who bet on office properties are concluding that the sector has lost its economic utility 

Half-empty office buildings in the financial districts of major U.S. cities are expected to be hit hard by hybrid and remote work, tighter credit and higher interest rates for the foreseeable future.

Investors are pointing an accusatory finger at COVID-19, which has potentially changed the workplace forever. Office buildings full of workers before the pandemic have come to look like backlot sets for "The Walking Dead," with empty and dusty floors and the businesses surrounding them shutting down due to a lack of customers. 

Few optimistic scenarios are being painted for the future. McKinsey Global Institute recently put a big warning stamp on that scenario when it reported that in a "moderate scenario," office space demand will be 13% lower in 2030 than it was in 2019. In a more "severe" scenario, McKinsey predicts that demand will fall by 38%. The same report also predicts office prices will drop 26% on average in the moderate scenario through 2023, but in a severe scenario, they'll fall 42%. 

Wells Fargo Investment Institute lead analyst Brian Lane told Marketwatch that a $1 trillion "wall of worry" is coming through the end of 2024 as commercial real estate loans come due. 

"Property owners are facing higher vacancy, reduced net operating income, falling prices and rising capitalization rates," Lane wrote. "While valuations have started to decline in most property types, there is likely more downside."

Bank regulators are taking a page from the 2008-09 financial crisis playbook to help lenders weather the approaching tidal wave of troubled commercial real estate loans.

To try to combat the incoming tsunami, the Federal Reserve and Federal Deposit Insurance Corp., among others, have done what one would expect to prepare for a potential disaster. According to The Wall Street Journal, they've issued a 90-page guidance document giving banks direction on how they might extend and/or restructure loans without necessarily having to take losses. Though the emergency directive was already in place, they added a section on short-term workouts.

With a caveat, the directive shares its theory that banks should be working out loans. Borrowers must have the willingness and ability to repay their debts. The regulators are also, through their policy, pushing financial institutions to "work prudently with borrowers who are, or may be, unable to meet their contractual payment obligations during periods of financial stress." 

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Much of the policy urges flexibility. For example, it states that in certain situations, banks can modify loans without taking a loss even if the properties backing them are worth less than the debt.

In the meantime, office owners must strategically cut deals with their tenants. The Philadelphia Business Journal reported that companies are trying to negotiate their leases based on their current space needs. The law firm Fox Rothschild is reducing nearly 40% of its office space in Philadelphia with a new lease deal while advertising agency Digitas is downsizing its leased space by almost 50%.

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