Real estate expert calls vacant office space ‘staggering,’ warns of unprecedented tumultuous situation.

Real estate expert calls vacant office space 'staggering,' warns of unprecedented tumultuous situation.

The Impact of Rising Interest Rates on the Construction Sector

Construction Workers

John Fish, the head of construction firm Suffolk and chair of the Real Estate Roundtable think tank, recently discussed the challenges facing the construction sector in an episode of the What Goes Up podcast. In this conversation, he sheds light on the dangers posed by the recent rise in interest rates and offers insights into the potential consequences for the industry.

The Challenge of Rising Interest Rates

According to Fish, the increasing interest rates have created a precarious situation for large structures, especially in cities like New York. With nearly a hundred million square feet of vacant office spaces, the situation is staggering. Currently, these buildings are only partially occupied, ranging from 45% to 65%. However, the cost of capital to support these buildings has nearly doubled, resulting in a double whammy for developers. Occupancy rates are down, decreasing the value and income from these properties, while the cost of capital has skyrocketed.

This unfortunate combination has had a significant impact on the real estate industry, as the capital markets have effectively frozen. The lack of understanding about asset value has made it challenging to evaluate price discovery. Without a clear sense of where the bottom is, it becomes difficult to navigate through these uncertain times and find a way forward.

Government Intervention

However, there is a glimmer of hope. In June, the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and other federal government entities provided policy guidance to the industry. This guidance is seen as a positive step for a couple of reasons. Firstly, it demonstrates government leadership on a pressing issue that many are hesitant to address due to its potentially negative impact. Secondly, it offers a clear direction and support for both lenders and borrowers.

The critical aspect of this guidance is that it allows for troubled-debt restructuring, similar to prior programs. Qualified borrowers with quality assets can work together to restore the value of the assets. This policy allows for an 18- to 36-month extension, essentially a “pretend and extend” strategy. Unlike the long-term forward-guidance proposal from 2009, this current approach is primarily aimed at regional banking systems. While large financial institutions have a relatively small portion of their portfolios in real estate debt, regional banks have a larger exposure, ranging from 30% to 40% of their books. The policy direction therefore provides an opportunity for workout solutions for good assets and borrowers.

The “Extend and Pretend” Approach

The idea of “extend and pretend” can come across as derogatory when referencing this approach, but it may be the most viable solution to overcome the current challenges. Fish highlights the potential consequences of a systemic problem in the regional banking system, which could have far-reaching and cataclysmic effects. Many banks in suburban areas are heavily reliant on real estate, and if these institutions start to falter, it would have an immediate impact on the economy.

Furthermore, the repercussions of lower real estate values are not limited to the banking sector. With 70% of revenue in American cities coming from real estate, a significant decline in property values would directly affect tax revenues. This, in turn, would impact essential services such as police, fire departments, and schools. It is crucial to approach the current situation cautiously to prevent the destabilization of what is perceived as a robust industry.

In conclusion, the rise in interest rates has placed the construction sector in a precarious position. The combination of decreased occupancy rates and increased capital costs has strained developers and frozen capital markets. However, the government’s recent policy guidance provides a ray of hope for the industry. By allowing troubled-debt restructuring and offering an extension on loans, it gives an opportunity for good assets and borrowers to navigate these challenging times. Although the approach may be seen as questionable, it offers a potential lifeline for the regional banking system, suburban economies, and the overall stability of the construction sector.