For the years after they opened up to the West, China has been seen as one of the main (if not the main) drivers of global growth. Anyone driving through their new concrete highways that are in better shape than those in America can see this, with formerly empty fields lined up with skyscrapers and other structures that are too many to count in passing.
However, their real estate sector, once the engine of growth, is now in shambles with major debt defaults from their largest developers like Evergreen and Country Garden. Entire empty city blocks with brand-new skyscrapers are being demolished because of a lack of demand. Hard to believe, right?
Likewise in major US cities and other urban parts of the world, commercial real estate is slowing down due to several factors. Many of these are directly attributable to the pandemic as well as technology trends. There are a few bright spots such as data centers and warehouses because of AI and online shopping servers. Still, office spaces are not one of those.
Because of the pandemic, most people were forced to work from home using applications like Zoom and Google Meet. Unfortunately for the office sector space in particular, WFH has caught on as many companies are comfortable with it. Although there has been a pullback from the total WFH situation that occurred during the pandemic, with a few exceptions. Except for manufacturing and other sectors that require a constant physical presence, many white-collar employees these days are just required to be in the office a few days a week, with part of that time allowed to be from home or not in the office.
Although Fortune 500 companies and blue chip professional firms still want to show off their ESG-compliant shiny new office spaces, the majority of smaller companies that are suffering from a poor economic climate have cut down on their leased spaces.
These smaller companies that might have normally leased entire floors of office space now lease smaller footprints since fewer of their workers are coming to the office at a given time. The older B- and C-class buildings, many of which were built decades ago, are dark and show their age, and are not ESG compliant. In addition, artificial intelligence (AI) threatens to remove many types of white-collar work that normally needs an office.
Adding to the woes of this sector is the fact that debt is now more expensive because interest rates have risen continuously since March 2022. The Ameribor overnight interbank lending rate between banks rose from 0.1% in March 2022 to 5.438% in March 2024. This is the banks' cost of borrowing money (outside of deposits which cost them the monthly savings rate), and they need to add their own interest rate profit after they lend it out for home mortgages, car loans, and other types of loans. The result is a higher cost of borrowing for everyone, and this shows up in different types of debt.
This complicates the situation with real estate, which is normally funded mostly by debt since these projects typically cost several million dollars to finance. Although developers often pony up a certain small amount of equity, in reality, most of the financing in real estate is debt from banks and other sources. The cost of that debt has gone up.
Put yourself in the shoes of the lender. The ten-year treasury bond yields are now in the 4%-5% range each year, at zero risk because the issuer is the U.S. government. Would you lend to a project that promises you 7%-8% each year, but given the risk of default by the borrower due to various factors, including lower lease payments on the property for the next few years? Most likely, even if you are not a finance expert, you would put your money in the ten-year U.S. bonds and forget about the pain and worry of losing your shirt.
Not many investors these days are keen on investing in office space the way they would have done years ago.
What is the way out of this? One is for the Fed to stop raising rates (which they seem to be doing at the time of writing) and start lowering rates so that office developers can renegotiate their debts at lower than current rates instead of defaulting (which is now happening often). However, since current CPI inflation statistics do not seem to be reaching the Fed goal of 2%, that doesn't seem likely.
Assuming that debt does become slightly cheaper, can something be done about WFH and AI? Probably not much because these are long-term trends. If the economy does pick up, maybe more companies will earn more and lease more office space. But in the near term, that does not appear likely. Working from home is popular, and jobs will be lost to AI as the technology improves.
At the moment, unless something drastic happens, it looks like we are seeing the slowdown of the office commercial real estate sector as an investable asset class. It will remain there, but perhaps no longer be held as an investment asset in the same volume as it is today.
Uncommon Knowledge
Newsweek is committed to challenging conventional wisdom and finding connections in the search for common ground.
Newsweek is committed to challenging conventional wisdom and finding connections in the search for common ground.
