Is feeble CRE demand a replay of weakness that ultimately devastated shopping malls? New paper leans toward ‘yes’

Is current weak demand in commercial real estate (CRE) a repeat in the type of decline seen over the past several years in commercial shopping malls? A new paper released Thursday by Treasury’s financial research arm explores that question – and the answer may be yes.

The paper also asserts that certain risks are presented to financial stability from the weak CRE demand.

The paper, a “brief” from Treasury’s Office of Financial Research (OFR), compares the decline in malls to the recent weak demand in CRE. It asserts that there are signs that actual office occupancy by workers remains at or below 50%, signaling that employers lease significantly more office space than they currently need.

“Should firms reduce their office space requirements to reflect the reality of employees’ work-from-home preference, the CRE office sector could suffer a contraction, posing a risk to (1) financial institutions with exposure to the sector and (2) municipalities reliant on CRE tax revenue,” the paper states. “In fact, a diminished CRE office sector, recently valued at $3.2 trillion, could suffer a significant devaluation over time. That would generate significant financial instability through loan defaults, foreclosures, and equity value depletion.”

The paper makes two key assertions: that “work-from-home” programs for employees (brought about by the coronavirus crisis) has weakened the CRE sector; and that future demand for office space appears weak.

The paper compares the events in CRE to the demise of shopping malls, which the paper asserts came about from online shopping, or e-commerce.

“Once a ubiquitous fixture of American life, regional malls in the U.S. have declined in number by one-quarter, and no new regional malls have been built in nine years,” the paper by OFR states.

The paper claims that e-commerce affected regional shopping malls in two ways: by creating a situation in which too many malls with too much “gross leasable area” (GLA) were chasing too few retail sales; and by causing retailers to vacate those regional malls with “less-desirable locations or infrastructure in a flight to quality.”

The paper asserts that there is “mounting evidence” that CRE could go the same way as the shopping malls. “Office space available for sublease is growing, and structural office occupancy rates remain at or below 50%,” the paper states. “We have not witnessed a significant number of marginal office buildings going vacant (that is, having too much office space chasing too few tenants), but given the experience of regional malls and the extraordinary amount of office space that is leased but not used by employees, it seems possible that such buildings could go vacant in future.”

In terms of financial stability, the paper points out three issues that do pose threats from the weakness in CRE:

  • High potential for significant losses for financial institutions with equity or debt exposure to the CRE office sector.
  • High likelihood of losses of commercial real estate tax revenue to municipalities as appraised values for tax purposes decline.
  • High cost and difficulty of repurposing marginal office buildings.

The paper concludes there are six warning signs of future CRE office sector consolidation:

  • Codification of work-from-home in future employment agreements.
  • Continued increases in office space available for sublet.
  • Continued low actual worker occupancy of office space.
  • Downsizing of firms’ office space requirements in new leases.
  • Continued deterioration in the value of office REIT stocks.
  • Increases in delinquencies and defaults in the office sector.

Work-from-Home and the Future Consolidation of the U.S. Commercial Real Estate Office Sector: The Decline of Regional Malls May Provide Insight