How Office Vacancies Affect Homeowners and Renters’ Bottom Line

Over the last three months, we are beginning to see warning signs about potential “cracks” in the commercial office building space due to office vacancies.  Many analysts are concerned that this could be the next domino to fall after the regional banking crisis as property owners of large office buildings may be at risk of defaulting on their maturing debt. While these commercial real estate trends have recently been discussed, few have evaluated the financial implications to the average homeowner and renter.   In this blog article, we will review potential scenarios that homeowners and renters should consider to protect their finances in the future.

How are office vacancies impacting commercial property owners?

The key trends impacting commercial office property owners in select urban cities include: lower or stagnant rents, higher interest payments and costs to refinance debt and limited access to capital for upgrades.  These challenges make it extremely difficult for property owners to maintain these buildings and have been magnified based on growing unemployment, higher interest rates by the Federal Reserve and the regional banking crisis.

Lower or Stagnant Rents

First, property owners are experiencing lower rents for their buildings due to companies either adopting a hybrid remote or full-time work from home policy.  Companies realize they no longer need the same amount of space and with the recent economic slowdown in growth, they are also laying off workers, renegotiating leases and downsizing office space. Large employers (e.g., Apple, Meta, Amazon, Google, M&T Bank, KPMG, Omnicom) are all downsizing and rethinking their office space needs.  Other large retailers like Bed Bath & Beyond, Nordstrom and others are closing locations outright.

According to Cushman & Wakefield’s Marketbeat Report for US Office Buildings in Q1 2023, office vacancy rates have increased to ~18.6% nationally.  This statistic is much higher in the following top 20 markets:

Furthermore, property owners have not been able to raise rents despite increasing costs to prevent further vacancies with annual rent increases limited to only ~1%, suggesting stagnant office rents.  

Higher Interest Payments & Costs to Refinance Maturing Debt

Second, property owners are experiencing higher interest payments given the Fed’s continued approach to hiking rates. Many of their loans are floating or adjustable rate mortgages, and thus, the interest payments are increasing. Additionally, with the Fed’s higher effective Fed Funds rate, property owners will also experience higher costs to refinance their upcoming maturing debt.  About one-third of all CMBS are maturing over the next two years. Given higher interest rates and increasing vacancy rates, the valuation of commercial office buildings could be reduced by 28% across the US according to a recent study by Columbia and NYU.  These dynamics would make refinancing much more expensive because of declining building valuations and lenders would question whether property owners would be able to make future debt payments at higher rates.  Lenders may require office property owners to put more cash upfront and implement more restrictive borrowing terms.

If building owners are unable to refinance their existing debt, they may be at risk of defaulting on their loan.  Banks could then be subject to significant losses, which may require them to auction buildings off to the highest bidder.  It’s too early to tell how many office buildings will go into default over the next two years as every market’s tenant rental dynamics, vacancy rates and debt situations are highly unique.  At a macro level, we believe this will be more of a market-to-market, isolated event rather than a systemic one.  Recent analysis by Trepp suggests that commercial office building loans owned by regional banks represent only 2% of the total commercial real estate debt maturing ($1.5T) before 2025.

Limited Access to Capital

Finally, with the recent failure of multiple regional banks, banks are not lending capital to property owners due to credit tightening.  Therefore, this leaves property owners with limited options in offsetting rising vacancy rates and growing costs due to inflation because 1) they lack funds to upgrade buildings for more modern amenities and flexible hybrid working spaces and 2) they cannot convert corporate office buildings into residential housing.  Both options require capital investment and with a recent credit squeeze, there have been very limited lending transactions.  Additionally, increased projected vacancy rates due to higher unemployment beyond big tech to other industries (e.g., retail, finance, consumer) will force property owners into a dilemma of how to increase occupancy rates and manage rising expenses in an increasingly challenging lending and employment environment.

What scenarios should be prioritized for homeowners and renters?

Even though we do not yet know the full extent of commercial office property owners at risk of defaulting on their existing debt, we believe there are three potential scenarios that homeowners and renters will need to consider to support future planning.  Depending on the specific market, homeowners and renters may be impacted differently based on the extent office vacancies, city reliance on commercial property tax revenue and how well each city manages their budget.

Scenario 1: Higher residential property taxes and rent increases

In this scenario, local cities may suffer a budget shortfall because they would experience a drop in property tax collected from commercial office property owners, especially in markets that have high vacancy rates and where property taxes represent a significant portion of the city’s budget. In the analysis below, we’ve highlighted in RED the top cities where residential homeowners and renters may be impacted. 

Note: Property tax includes both commercial and residential property taxes.  This analysis is directional to inform cities that may eventually raise property taxes on residential property owners given budget shortfalls.

Key markets to watch include:

• Fairfield County, CT
• Houston, TX
• San Francisco, CA (office vacancy rates have now climbed to 30%!)
• Hartford, CT

Ancillary markets to monitor given relatively high vacancy rates and property tax contributions include: Los Angeles, Westchester County, and NYC.

City governments in these markets would likely have to identify opportunities to offset the financial shortfall either by raising taxes and reducing expenditures.  Our thesis is that city governments would raise property taxes on residential property owners because raising taxes in other areas may not be feasible.  With increasing unemployment, it would be difficult to make up the difference in payroll taxes.  Most cities are also not tourism hubs and thus, increasing the sales tax may be insufficient.  Therefore, raising the property tax on residential homeowners may be their only option.

According to the Martin Cantor, the Director of the Long Island Center for Socio-Economic Policy, shifting the collection of the shortfall towards residential is a possibility.  In a recent interview with TBR News Media, he suggested “If these commercial landlords can’t make money, they’re going to file for property tax relief.  And if they get it granted, that property tax is going to be shifted to residential.”  If this occurs, homeowners will experience higher property taxes and pass on the incremental property taxes to their renters.

Depending on where you live, the type of property and legislation, this scenario may not occur. For example, in San Francisco, Proposition 13 limits property tax increases to 2% annually. Check to see if there is local legislation that protects you from exorbitant property tax increases.

Scenario 2: Declines in office space reduce home valuations and rents

Alternatively, if commercial office valuations drop and vacancies continue to increase, small businesses surrounding these buildings will likely suffer and may go out of business.  This possibility could lead to lower valuations for homeowners in nearby neighborhoods.  A great example of this trend is in San Francisco. Home prices are dropping in parallel with higher office vacancy rates, closing businesses, and rising crime rates. All of these dynamics have made certain neighborhoods no longer attractive.

Similarly, renters will unlikely want to rent in these neighborhoods as they are less desirable and residential landlords may likely have to lower rents to maintain occupancy and attract new renters.  

Scenario 3: Delays to refinance mortgages

Finally, new homeowners that purchased their home over the last 6-12 months at higher interest rates may have to wait longer to refinance their mortgage.  Banks with significant exposure to bad commercial office loans may be tighter with extending credit.  According to Trepp, 30% of commercial real estate loans are maturing in 2023 and significantly more in 2024.  This suggests that the timeline for evaluating the full extent of the default risk on these commercial office loans will not be known until late 2023 to mid-2024, pushing out bank considerations even further for mortgage refinancing.  Even if the Fed decides to start to lower rates in 2024, an increase in defaults could keep credit tight and ultimately, impact time to mortgage refinances.

How can you protect yourself?

While the impact of the commercial office market remains uncertain, there are specific actions that both homeowners and renters may want to consider to mitigate any negative impact on their finances:

For homeowners and residential landlords:

1. Build up savings to anticipate a potentially higher property tax bill in the future
2. Grow rents or lower expenses to offset increases in upcoming property taxes
3. Delay major internal or external renovation projects that may further increase your tax bill
4. Hire an attorney to appeal your tax bill and review any potential exemptions
5. For investors: look for properties that have lower real estate taxes, have “caps” on annual increases to property taxes or have tax incentives in place (e.g., 421-a tax abatements)

For renters:

1. Try to negotiate longer-term leases at fixed rents to prevent future increases (e.g., 2-year vs. 1-year leases)
2. Consider downsizing apartments, if possible, for lower rents in the event of rent increases
3. Rent in locations with less reliance on tax revenue from commercial office buildings
4. Sublet your existing space to earn more income either with additional roommates or for storage
5. Manage your budget to reduce spending in other areas to offset the increase in rents

Over the next few months, it will be important to monitor the impact and extent of defaults of commercial office buildings, particularly in key urban cities and how it might affect your financial situation.  While the apocalyptic situation may not arrive, it is always a good idea to be prepared to protect your finances so that there are no surprises. We hope our perspective has been helpful!

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