The commercial real estate (CRE) industry faces significant challenges, leading economists to grow concerned about its future. The COVID-19 pandemic has profoundly impacted the industry, resulting in lower occupancy rates and changes in work and shopping patterns. Office and retail property valuations have been declining, and the efforts of the Federal Reserve to fight inflation by raising interest rates have further hurt the credit-dependent industry.

As of July 2023, Tucson is facing significant challenges in its office real estate market due to the lingering effects of the pandemic. According to Costar, the office market absorbed just 65,000 square feet over the past year, and the vacancy rate for office space stands at 9.8%, indicating that many buildings still need to be occupied. In addition to the vacant office spaces, more than 330,000 square feet are available for sublease, further exacerbating oversupply. The industrial market is very tight, with a vacancy rate of less than 3.4%, and the market absorbed 799,000 square feet over the past year.

The pandemic-induced shift to remote work has led many corporate tenants to reconsider their office space needs. While some companies are downsizing and opting for more expensive, higher-quality spaces, others are trying to economize by reducing their office footprint and offering more flexible work arrangements. This uncertainty and fluctuating demand are putting office landlords in a tough spot, as they need to find new tenants to fill the empty spaces and maintain cash flow.

Adding to the challenges is the impact of rising interest rates, which make refinancing commercial mortgages a risky proposition for landlords. The high debt burden attached to office buildings, combined with a potentially declining rental income, could lead to financial difficulties for property owners, and it also poses a threat to the banks holding these loans. This domino effect could have broader implications for the overall economy.

The situation in Tucson reflects broader trends in office markets worldwide, where the future of traditional office spaces is uncertain. The pandemic has accelerated remote work and flexible work arrangements, and businesses are reevaluating their real estate needs considering these changes. This presents a significant challenge for property owners and the financial institutions that have invested in the commercial real estate market.

The commercial real estate market faces a “perfect storm” of higher interest rates, tight credit, and fast-maturing debt. Commercial property owners find it challenging to refinance their loans at higher rates, while a credit crunch has made it harder to obtain loans. Securing commercial real estate loans is becoming increasingly complex, leading to a potential crisis in the industry.

One primary concern is the stress on small and mid-sized banks, the direct lending source to commercial real estate developers and managers. These regional banks are experiencing liquidity pressure, leading them to pull back on commercial real estate commitments. As a result, it has become more difficult for businesses to refinance or obtain loans, and credit has become scarcer and more expensive.

In the worst-case scenario, borrowers cannot refinance, banks report losses, and, in a recurrence of what transpired at Silicon Valley Bank and First Republic in the spring, worried depositors pull their funds, placing banks on the verge of insolvency.

Reduced Tax Revenues: Property tax revenues for local governments also decrease as property values decline. This reduction in tax income can create budget shortfalls for essential services, such as funding for public schools, police departments, fire departments, and other municipal services.

Overall, the situation in Tucson’s office real estate market highlights the need for adaptability and innovation in the face of evolving work patterns and economic uncertainties. To address these challenges, landlords may need to explore creative solutions to attract tenants, such as offering flexible lease terms or repurposing office spaces for other uses.

Different commercial real estate market segments are experiencing varying levels of impact. Multifamily and industrial assets have relatively stable fundamentals. However, office and retail properties are facing significant challenges. The shift in how office space is used has reduced demand, making it difficult for office owners to refinance loans and generate positive cash flow. Retail is also facing challenges as excess pandemic savings are being spent down, and the Federal Reserve’s efforts to increase unemployment may impact retail spending and the asset class.

Economists are also concerned about the potential return of stagflation, a combination of high inflation and a weakening economy. Many economists predict a recession this year and expect inflation to remain above 4%.

The Benefits of a Tenant’s Market More Flexibility for Tenants

Tenants fear that more office owners will default on their mortgage obligations. To ensure their operations’ continuity, they seek safeguards from landlord default.

Before renewal of a lease or renting new space, businesses frequently want to find out the recent track record of the building owner. This can be a significant concern for tenants. A few months ago, a series of notable property defaults brought owner risks to the spotlight.

Office properties have been affected as the Federal Reserve has raised interest rates to fight inflation, which topped 9%   last year. This signified the end of inexpensive and plentiful debt for property owners as billions of dollars became due.

It is a golden opportunity for renters to gain the upper hand in conversations with landlords. However, it may also prove a minefield; even if rentals rates are falling, available space is readily available, and rent-free months are becoming more prevalent. However, occupancy and construction costs and timelines are increasing.

Even if a landlord promises incentives to a tenant, their lenders could reject a transaction if it fails to provide sufficient revenue to satisfy debt service requirements.

Aside from an exceptional group of high-end properties, buildings with functional obsolescence suggest the likelihood of rising landlord defaults in the coming months. Considering this, some tenants might want to renegotiate their leases, fighting to include a few clauses that protect tenants against future business disruptions, which is becoming increasingly common and gives occupants the option of either extending their leases if things go well or sublease their spaces to other tenants if things go poorly. Flexibility is crucial, and it is written in contracts. The nature of commercial real estate negotiations has changed, transferring some of the long-held leverage of landlords to tenants.

Engaging an experienced broker can be beneficial when repositioning your company to address the challenges of today’s market. A skilled broker with expertise in commercial real estate can provide valuable insights, advice, and services that can help you navigate the complexities of the current business landscape.  Commercial Real Estate Group of Tucson 520-299-3400.