Commercial real estate market could crash soon. Here’s why

The commercial real estate market may be headed for a crash that rivals the 2008 financial crisis this year.

Office and retail property valuations could plummet as much as 40% from peak to trough this year as higher interest rates make it harder for investors to refinance trillions in looming debt, according to Lisa Shalett, chief investment officer for Morgan Stanley Wealth Management.

"MS & Co. analysts forecast a peak-to-trough CRE price decline of as much as 40%, worse than in the Great Financial Crisis," Shalett wrote in a weekly investment note. "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."

Complicating the matter is the fact that small and regional banks are the biggest source of credit to the $20 trillion commercial real estate market, holding about 80% of the sector's outstanding debt. Regional banks are at the epicenter of the upheaval within the financial sector, and there are concerns that the turmoil could make lending standards drastically more restrictive.

During a credit crunch, banks significantly raise their lending standards, making it difficult for businesses or households to get loans. Borrowers may have to agree to more stringent terms like high interest rates as banks try to reduce the financial risk on their end.

Banks were already tightening lending standards before the crisis within the industry began. A quarterly survey of loan officers published by the Fed showed that a growing number of banks tightened lending standards and saw reduced demand in the final three months of 2022.

"Refinancing risks are front and center" for commercial property owners, a separate Morgan Stanley note said. "The maturity wall here is front-loaded. So are the associated risks."

Even before the collapse of Silicon Valley Bank and Signature Bank in early March, the commercial real estate market was struggling with a number of challenges, including higher interest rates and waning demand for office space as more companies allow employees to work from home.

"Commercial real estate, already facing headwinds from a shift to hybrid/remote work, has to refinance more than half of its mortgage debt in the next two years," Shalett wrote in a weekly report published this week.

The Federal Reserve has raised interest rates nine times from near zero to upwards of 4.75%, and it is expected to approve a 10th rate hike during its next meeting that is scheduled for May 2-3. It is the steepest jump in borrowing costs since the 1980s.

Still, others are less pessimistic about the future of the commercial real estate market. Solita Marcelli, UBS Global Wealth Management chief investment officer of Americas, said the headlines regarding office space "are worse than reality."

"An expected credit crunch on the back of rising cost of funding for banks may further compound its troubles," Marcelli said in a note. But she added, "We don’t believe a repeat of the 2008 liquidity crisis is likely — where capital markets essentially closed for financing."

"In our view, the health of the overall banking system and market liquidity conditions are substantially better than they were during the [Great Financial Crisis]."