What is it, who are the players, and why has it been deemed “by far the most serious looming issue?”
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Commercial properties are expensive. Very expensive. One of the apartment buildings my employer completed a few years ago cost over $200 Million. While we could have theoretically saved money out of the company’s profits for years to build up that much cash to build the property, like pretty much all medium and large businesses we borrowed the money instead. This allowed us to move forward with the projects years (possibly decades) sooner than we could have otherwise and also gets us some tax breaks because a large portion of the money we take in for rent is going to pay off the mortgage and is thus not a taxable “profit”.
Most companies with commercial real estate NEVER pay off those debts in full. Instead they go back every decade or two, when interest rates are relatively low, and refinance their properties. They cash out any equity, including any increase in value of the properties. This allows them to continue to get the advantage of deducting the loan payments from their income at tax time while giving them a large cash infusion (the additional borrowed money from the new loan) to use for things ranging from property maintenance (a new HVAC system or renovations to modernize a property) to helping to fund new projects (build a new building or buy an existing one from another company.) Also a good bit tends to be used to pay dividends or buy back shares to pay back the shareholders whose money (used to buy shares in the company) funded the company to begin with.
As for the players, most of this debt is either in the form of bonds that are sold to the public or loans from banks of various sizes. The looming issue is that one of the many longer term effects of Covid is that many people are working from home, at least part time. As a result, companies that rent space in office buildings have realized they can cut back on the size of the office(s) they are renting and save quite a bit on rent and utilities. That’s great for those companies, but companies like the one I work for (which has a division that owns office buildings and rents that space to tenants) are suddenly having a harder time keeping their buildings fully rented out to pay those mortgages. While some companies are diversified enough and have the resources to weather this change, others are suddenly finding themselves too stretched out. And with interest rates increasing, they cannot easily refinance their properties to raise some quick cash.
No one know just how this process is going to play out over the coming years. The odds are that some real estate management companies will collapse as they lose tenants faster than they can replace them (or at least replace them at the same cost to lease). It is likely that a number of older buildings will be repurposed, possibly converted to apartments. This is not an “easy fix” because the buildings were not designed for this use and will, in most cases, require extensive renovations to meet local codes before they can receive permits for occupancy. Companies that are already facing a cash flow problem likely won’t have the money to spend tens of millions on these projects. Others will be torn down and replaced with something entirely new. And some buildings will probably end up abandoned for years. In many respects this is similar to what has happened to the large shopping malls that used to thrive back in the 70s, 80s and 90s, but today are being torn down and replaced because they simply cannot make enough to survive.
The concern some economists have is that the commercial real estate market is so big that, depending upon how these changes play out, it could seriously impact the rest of the economy. If hundreds of billions of dollars in bonds become worthless, the odds are the average citizen’s retirement savings will take a hit since many of the funds they invest in bought those bonds. Also, if the companies start to default on debts to banks and file bankruptcy, the banks may lose a huge amount of money which may push some of them into insolvency as well. Even banks that don’t become insolvent may be forced to cut back on lending due to these losses, which will affect common people (lower credit card limits) and other businesses which won’t have as much access to loans while the banks digest the real estate loan losses.
Edit: Earlier I mentioned the shareholders in public companies having funded the company initially by buying those shares. Simply selling more shares is not a fix in most cases because the investors will look at the company’s finances before buying (publicly traded companies are required to publish this data by the SEC in the US and you can download that information for free from the SEC’s website for any company traded on a US Stock Market). If the investors see the company has falling revenue and it is trying to sell more shares, they are either going to not buy those shares or only buy them at a huge discount, which will bring the value of their other shares down to match and ultimately hurt the company as well. Many companies hold the shares they have bought back from investors as a “last ditch” method to raise cash if things get really tough. It will allow them to raise some cash, but selling those reserved shares or issuing new ones, particularly when investors see the company is struggling due to the SEC reporting requirements doesn’t end up saving many companies that find themselves in such a dire position.
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