Commercial real estate is stuck in a slow motion train wreck

• Commercial real estate - hotels, malls, offices - are facing down massive post-pandemic problems.
• We can all see the work from home and ecommerce trends coming and the CRE disaster seems like a slow motion trainwreck.
• And that trainwreck could drag the rest of the US economy down with it.
• This is an opinion column. The thoughts expressed are those of the author.

Back in 2016, a colleague of mine, Michelle Wuc ker, published a terrific book entitled "The Gray Rhino." The title alludes to humans stalking the grey rhinoceros, a species widely known to be jittery and prone to charge and maim. Yet the awareness of their likely behavior does not deter the curious from getting closer for a look.

Similarly to foolish humans trying to approach a grey rhino, Wucker writes about events that are themselves not random surprises, but occur after a series of warnings and visible evidence. The grey rhino is a situation that is staring you in the face, about which you have depth of knowledge yet proceed as though there is little risk.

And right now there is a two-ton grey rhino staring down the US economy: More precisely, $6.5 trillion of assets in the US commercial real estate (CRE) industry. This coming CRE threat, in the three major non-residential sectors of the industry, is snorting loudly and padding its foreleg, while we all stand and stare.

So let's open our eyes and have a cautious look. And just as with charging animals, being prepared is critical to protecting against loss - not of life and limb in this case, but of systemic safety and soundness.

The "Big Check-out" is not over in the hotel industry

First is hotels, which have been hammered by the COVID-19 recession. Since hotels have no leases to protect their revenue stream, as much as 10% of the sector closed entirely during the 2020 lockdowns and 3% of locations remain closed, according to STR, Inc. Even hotels that remain open throughout good portions of the pandemic are struggling with bills and debt backlogs even as revenue bounces back. Nationwide revenue per available room - a key metric for the industry - was down 29% through April compared to 2019 levels.

Given the likelihood of the American consumer engaging in a fair amount of "revenge spending" as the economy fully reopens, the hotel sector is likely to see substantial improvement over the summer. But the improvement could be short lived because there are obvious issues that are likely to wreck renewed havoc come autumn.

Hotel room rates and occupancy are built on business travel and conference room demand, which makes up roughly 30% of demand during normal times. That business, often booked far in advance, provides hotels with a baseline to build on when pricing other rooms. In some of the biggest conference destinations the size of the corporate business can be closer to 50% of total business.

What will happen when many hotels try to rebuild their business volumes all at once? Big, fat discounts. On top of this timing issue, this critical piece of the hotel business also faces an existential threat. Many business meetings that were thought to require travel pre-COVID have been shown to be efficiently conducted on Zoom or other video calls. What that means to future levels of travel is, frankly, unknowable. But it is not likely to be positive.

Finally, the value of many hotel properties has been decimated by the pandemic. 23% of all hotel loans became delinquent and billions of dollars of loan interest went unpaid - whether as the result of outright defaults or forbearance by lenders - and will need to be dealt with. And the ability of other hotel owners to continue to make debt payments was enabled by Payment Protection Program (PPP) loans to over 19,000 of the 54,000 hotels in the US totaling nearly $11 billion (and that excludes loans under $150,000). Most alarmingly, $1.65 billion of those PPP loans were made in March and April of this year, demonstrating that the PPP is still acting as a lifeline for the industry. And that program ends this month.

Accordingly, the "Big Check-out" in the hotel industry will echo into late 2021 and 2022.

Not buying retail

The second part of the commercial real estate market facing a crunch is retail malls. This beleaguered industry was already facing pressures before the pandemic - mounting losses of big anchor tenants and the rise in online shopping. But the COVID crisis has taken retail property woes into the stratosphere, going well beyond the mall space. Strip shopping centers and, most particularly, urban street front retail are struggling too.

Take the super-expensive Manhattan storefronts, where unoccupied retail space available averaged over 25% of total square footage at the end of the first quarter of this year.

As in the case of hotels, retail property is also facing a business cultural change that was accelerated by lockdowns. In Q1 2021 online shopping (excluding groceries and gasoline) now comprises 15% of retail sales, and appears to be rising. As comfort with clicking and buying becomes ever more prevalent, the need for bricks and mortar shopping space will naturally continue to diminish.

We also have a PPP loan overhang in the retail sector - non-chain stores, franchisees and restaurants - which introduces an additional unknown regarding the number of merchants able to survive the withdrawal of those advances.

Retail property was already "on sale," and now faces the prospect of "liquidation" in many markets.

Return to the bedroom?

Finally, both the least clear and the most substantially problematic sector in commercial real estate is office space. The cultural shifts that will follow 15 months of working from home will be slow to manifest themselves in terms of declining demand for space. But it should be readily apparent to all that the #WFH genie is not one that can be put back into the bottle.

Other than industrial property owners, office landlords typically enjoy the longest lease terms, averaging between eight years in the nation's largest cities to 5+ years elsewhere. So the pain of decisions by tenants to reduce their office space will be spread over a longer period. And if the foregoing shifts are not dramatic, landlords may be fortunate enough to straddle a good deal of the recession in their sector. I would not, however, hold my breath.

In this case we must look to availability as a guide, not the amount of office space currently vacant. Nationally, office vacancies spiked over 18% in the first quarter of this year. But availability rates (inclusive of space that has been vacated but still subject to leases) are running much higher than vacancies. In Chicago, vacancy is just over 16%, while availability is 22.3% of total space. In New York City, even with its high percentage of large, creditworthy tenants, availability already exceeds 17%.

Kastle Systems' 10-city Return to Work Index suggests only 28% of workers have returned to the office as of this writing. And with about 15% of office leases expiring each year, 2021 and 2022 are likely to see a bloodbath in downsizing and outright abandonment of space.

A larger problem?

There is one winner in the CRE industry - industrial property. Specifically in the warehouse and logistics sector, that is now overwhelmed with all the increased volume of online shopping and medical materials distribution. Multifamily rental real estate in large cities that experienced wholesale emigration during the pandemic will have real difficulty, but the rest of that sector should be fine as everyone needs someplace to rest their head at night.

But the challenges facing the three major commercial real estate sectors discussed above are very real and could turn more in a negative direction with the passage of time. And a major repricing in these sectors could instigate a more systemic problem among holders of loans secured by impacted properties, to say nothing of loss of wealth among equity owners.

The last time the nation saw a specifically commercial real estate recession (more like a depression in some markets) was way back in late 1980s through early 1990s. Mostly due to overuse of mortgage debt (rather than a sudden drop in rents and incomes), it spilled over into what became the Savings and Loan crisis and required the government to undertake wholesale asset liquidations. Moreover, it caused a recession that took real GDP a year and a quarter to recover from.

It also yielded buying opportunities of a lifetime for some.

Today, properties are generally less leveraged, but face unprecedented challenges on the income side that threaten substantial loss of value. And the one thing that most materially bailed-out commercial property from the devastation of the early 90s and the Great Recession - a substantial decline in interest rates (which always serves to boost property values) - can't really happen now with market costs of funding approaching their practical limits on the low side.

So, beware this particular grey rhino. Because when this one hits, it's gonna be a bumpy ride.