Morgan Stanley says commercial real estate will crash harder than during the Great Financial Crisis. Here’s how 5 other top institutions see it playing out

There seems to be a consensus that the office sector is most at risk, given the widespread shift to working from home that emerged from the pandemic, which has largely impacted demand. However, how that will affect the overall market, depends on whom you ask. 

To better understand what might come next for commercial real estate, let’s take a look at recent papers published by Capital Economics, PwC, Morgan Stanley, Bank of America, UBS, and Goldman Sachs.

In a report by Kiran Raichura, Capital Economics’ deputy chief property economist, he likens the beleaguered office sector to malls, which he says have seen no real recovery. Both sectors lack demand, and in the case of offices, it’s because of the shift to working from home.

The research firm suggests that the “35% plunge in office values we’re forecasting by end-2025 is unlikely to be recovered even by 2040,” which means that office values probably won’t regain their pre-pandemic peaks in the next 17 years.

The firm’s reasoning? Office key-card swipes are down to 50% of pre-pandemic levels (which were already at 70% to 75%). That low utilization is pushing companies to reduce their physical space, equating to a higher vacancy rate of 19% in the first quarter of this year versus 16.8% in the last quarter of 2019. Still, Raichura says, the true increase is roughly double when taking sublease vacancy into account. Therefore, office vacancy has already seen a bigger increase than that of malls between 2016 and 2023. 

Additionally, major landlords are already returning their stranded office assets to lenders, which will likely increase following an uptick in commercial mortgage backed securities delinquencies seen in May, according to the firm. All the while, real estate investment trust investors are “shying away from office.” After more than three years into the downturn, the office REIT total returns index is down more than 50% relative to the all-equity REIT index, similar to the drop in the regional mall REIT total returns index in the beginning years of the retail sector’s correction, Capital Economics points out. 

This is all to say that the road ahead for office owners is “set to be an arduous one,” as Raichura put it, without addressing the overall state of commercial real estate.

In PwC’s midyear outlook, the professional services company simply said commercial real estate is not crashing. Despite the Federal Reserve’s interest rate hikes that have pushed the cost of borrowing up and a pandemic that changed the way people work, PwC argues there are still opportunities for deals moving forward. 

“We believe the sector is not in a crisis, as successful dealmakers will find opportunities, with green shoots evident across all subsectors, including the much-maligned office subsector,” PwC noted. 

That being said, transaction volumes were down across all subsectors within commercial real estate for the first quarter of this year compared with the same time last year. Office was down 68%, hospitality was down 55%, and industrial was down 54%, according to the report.  Nonetheless, PwC expects leasing activity and deal flow to return as interest rates and economic policy improve. But for now, the sector will continue to face headwinds and dealmakers might have to get creative. 

“Commercial real estate assets are facing multiple challenges against the backdrop of higher interest rates and reduced appetite for bank lending into the space,” PwC said. “The increased cost of debt is forcing dealmakers to take more time upfront to assess the right debt/equity mix to finance transactions and has elongated negotiations as buyers and sellers slowly align on valuation expectations.”

Lisa Shalett, chief investment officer for Morgan Stanley Wealth Management, sees a “huge hurdle” ahead for commercial real estate, and particularly office properties that have seen rising vacancy rates and falling property values since the pandemic. All the while, the entire sector faces a wave of loan maturities ahead, likely amid stricter lending standards. That’s apt to result in an increase of delinquencies and defaults and a decline in property values, which Shalett echoes in her assessment. 

“More than 50% of the $2.9 trillion in commercial mortgages will need to be renegotiated in the next 24 months when new lending rates are likely to be up by 350 to 450 basis points,” Shalett wrote. For those reasons, Shalett and the bank’s analysts “forecast a peak-to-trough CRE price decline of as much as 40%, worse than in the Great Financial Crisis.” 

Shalett also suggests that no sector will be “immune” to the fallout that will occur from these expected defaults and delinquencies that would go beyond landlords and banks.  

Bank of America analysts repeatedly stressed that the challenges ahead for commercial real estate are manageable, citing a few reasons why. But first, let’s take a look at what Bank of America suggests are the two key challenges ahead. The first: high inflation that’s pushed the Federal Reserve to raise interest rates, making it much more costly to service new and maturing commercial real estate mortgage debt. The second: remote work, which has proved to extend beyond the pandemic and has largely diminished demand. 

“We conclude that the challenges are real and significant, but for several reasons, they are manageable and do not represent a systemic risk to the U.S. economy,” Bank of America analysts wrote.

So what are some of those reasons? First, there are financing tactics that commercial real estate borrowers can employ to avoid defaulting on their debt, like loan modifications and extensions. Therefore, the 17% of loans analysts claim are maturing this year can be refinanced using tactics that will potentially protect distressed borrowers from higher costs in today’s economic environment. Second, Bank of America analysts argue that office properties account for 23% of commercial real estate loans maturing this year, but that’s just 3.8% of all commercial real estate. Lastly, improvements to underwriting following the Great Financial Crisis mean loans are less risky. In two trends that Bank of America analysts observed, they found that debt to service coverage ratios are materially higher and loan to value ratios are materially lower—signaling a shift from lenient underwriting pre-GFC.  

Analysts at UBS, the Zurich-based multinational investment bank, argue that “headlines are worse than reality,” and a repeat of 2008’s liquidity crisis is unlikely. In their less dire tone, analysts claim that roughly $1.2 trillion of the outstanding $5.4 trillion in commercial real estate debt (aside from multifamily) is set to mature, likely at higher rates. Still, that is expected to add to existing challenges within the office sector (that they claim accounts for 15% of total CRE value), instead of posing a systemic risk. But that means office property owners could be more likely to default on their debt.

“About $1.3 billion of office mortgage loans are currently slated to mature over the next three years,” analysts wrote. “It’s possible that some of these loans will need to be restructured, but the scope of the issue pales in comparison to the more than $2 trillion of bank equity capital. Office exposure for banks represents less than 5% of total loans and just 1.9% on average for large banks.”

Despite their optimism, things can still get worse, particularly in the case of a severe recession. 

“While we view potential losses as manageable, we would expect a meaningful deterioration in CRE to pressure banks’ shares due to both earnings/profitability risk,” analysts wrote. 

Goldman Sachs analysts went straight for the office sector, which, they said, “has been the subject of high investor focus in recent months, and rightly so, in our view.” 

While analysts suggest that multifamily and industrial properties have remained resilient, they pointed to three risks for the sector. First, analysts said that CRE borrowers are exposed to higher rates, which equates to higher costs and increased exposure to floating rate liabilities. That takes us to the second risk: Refinancing could be painful. Their estimate is that $1.07 trillion worth of commercial mortgage loans will mature before year-end 2024.

That means that “many borrowers will likely have to refinance their fixed rate loans at higher rates,” analysts wrote. For beleaguered office property owners, the ability and willingness to refinance at a higher rate will be limited. Lastly, Goldman Sachs analysts suggest that financing conditions will tighten further moving forward. However, unlike others, analysts didn’t explicitly blame the bank failures. Instead, they stressed the roles banks play in commercial real estate transactions. 

“The potential for disruptions to U.S. commercial real estate activity from a pullback in small bank credit availability is substantial, unaided by the fact that the segments most dependent on bank financing—offices and retail properties—are also facing the strongest risk of functional obsolescence,” analysts wrote.