In the decade before the COVID-10 pandemic, the commercial real estate (CRE) sector enjoyed robust global growth. Favorable market conditions for the real estate sector included low-interest rates, plentiful capital, and a low probability of recession. As a result, CRE prices rose 6% annually on average from 2009 to 2019, with North America turning in the top performance, according to an International Monetary Fund report. CRE prices fell dramatically as the pandemic began, especially in North America and Europe.

Real Estate Performance Pre COVID-19

Before the pandemic, commercial real estate was robust as office and industrial sectors benefited from low vacancy rates, higher rents, and surging tenant demand. For example, in 2015’s first half, real estate deals were on a strong upswing. Through June 2015, U.S. commercial real-estate transactions rose 36% in value to $225.1 billion year-over-year, according to Real Capital. In Europe, transaction values climbed 37% to €135 billion ($148 billion), the best first half of the year since 2007.

The catalyst for the booming market was low-interest rates and a considerable amount of capital placed into economies by global central banks. As a result, a number of investors preferred to invest in commercial real estate because the possible returns were more attractive than on bonds and other assets. Asian and Middle Eastern investors were also purchasing significant U.S. real estate properties.

Cap Rate Versus Interest Rate

Before the pandemic, low interest rates and easy access to capital also meant that the spread between interest rates and capitalization rates was wide. A cap rate, or “capitalization rate,” is used to compare different commercial real estate properties based on the value and income produced from the investment.

The cap rate equals the net operating income of a property divided by the property’s value. The debt costs used on a property are not included in the equation. Therefore, an investor must know the interest rate, such as the current U.S. Ten-Year Treasury rate, to help calculate if a real estate investment will be worthwhile.

For example, if an investor could purchase a property at a 7% cap rate when the 10-year Treasury yield is 5%, the spread would be 2% or 200 basis points. However, if a property was acquired at a 5% cap rate and the interest rate at 2%, the spread would be higher, a 300-bps spread. As a result, a higher spread has the potential for a higher levered yield. Typically, the cap rate will decline as interest rates increase. The value of a commercial office building’s asset value may fall 5% for every .25% interest rate increase by the Federal Reserve, according to CXRE.

In mid-2015, low-interest rates buoyed the appeal of commercial real estate, especially in major cities where economies were growing strongly. A 10-year Treasury note had a yield of 2.2% at the time. But in that period, New York commercial real estate enjoyed an average capitalization rate of 5.7%, according to Real Capital. So, the potential return on commercial real estate was quite compelling.

Post COVID-19

However, the COVID-19 pandemic significantly changed the real estate market. As the world continues to emerge from the pandemic, the industrial sector is performing well, but the office market is lagging with rising vacancy levels.

Sales volume declined significantly across all commercial real estate types in the second and third quarters of 2020, according to the National Association of Realtors. For sales transactions of $2.5 million or more, sales volumes of all types of real estate fell 61% in the second and third quarters of 2020 compared to a year earlier. However, office properties fell 76%, apartment 59%, retail 55%, and industrial 42%. The report also states that office occupancy fell by 64 million square feet in the same period, compared to a rise in occupancy throughout 2019.

The U.S. office occupancy rate fluctuated before, during, and after the pandemic. U.S. office real estate vacancy crept up during the coronavirus pandemic, according to Statista. Before 2020, the national quarterly vacancy rate hovered around 12% percent, but after the pandemic began, the vacancy rate rose above 15%.

In some markets, such as Manhattan, the glut of office space for lease has continued to expand. For example, through April 2023, companies could choose from 94 million square feet of office space if they needed additional workspace, according to real estate firm Colliers. The company also reported that Manhattan’s vacancy rate was 17.4% this past May, which matched the rate in February 2022 and the high market level since the company started compiling the New York City office market statistics in 2000.

Across the U.S., the vacancy rate is about 20%, according to JLL. Other major cities with a high vacancy rate include San Francisco, 26.4%; Houston, 25.6%; and Dallas, 25.0%. Cities with lower vacancy rates include San Diego, 12.3%; Richmond, VA, 13.3%; and Orlando, 13.3%.

Commercial Real Estate Loans

Through mid-2023, most commercial real estate landlords have managed to stay current with mortgage payments since office leases usually run for a decade, and lenders have agreed to extend expiring mortgages in some cases.

Nevertheless, approximately $1.5 trillion of commercial real estate debt must be paid by the end of 2025 as it comes due, according to a report by Morgan Stanley. The analysts estimate that banks are on the hook for as much as 70% of commercial real estate loans that mature over the next five years. About $270 billion in commercial real estate loans held by banks are set to expire this year, according to Trepp Inc.

At the same time, the value of some of that real estate is declining for a few reasons. U.S. Commercial real estate values declined by 15% in March, according to data provider Green Street. The lower valuation was caused by continued hybrid work (meaning companies’ demand for office space has declined) and rising interest rates.

Office buildings were the collateral for $1.2 trillion of debt at the end of 2022’s second quarter, according to Trepp. In early 2023 there were a few defaults on commercial real estate loans. Since that time, the number of defaults and list of real estate assets that are on the watch list for non-payment of mortgage loans continues to spike higher.