What’s next for commercial real estate after the $500 billion wipeout of 2023? It’s a lot more complex than ‘mass

Sooner or later, commercial real estate’s day of reckoning had to come. Following an era of “cheap money” that stretched all the way back to the 2008 housing crash and Great Financial Crisis, fueling an “everything bubble” that coincided with an age of “superstar cities” and their mega-valuable office buildings, the higher interest rates of 2023 were a shock. It’s largely this higher interest rate environment that’s caused the substantial distress experienced thus far, amounting to what research firm Capital Economics estimates at a $590 billion loss in commercial real estate property values this year. But just how bad will things get in the new year?

Capital Economics, for its part, predicts another $480 billion wipeout in commercial real estate values next year, and another $120 billion loss in 2025, for a 24% peak-to-trough value decline.

The failure of a mass return-to-office is the poster child for the woes of commercial properties post-pandemic. But the sector encompasses much more than just office buildings, which are undergoing their own existential shift. As Moody’s Analytics’ head of commercial real estate analysis told Fortune, “the story of office isn’t a story of mass obsolescence, it’s more of a ‘it’s going to take time for it to normalize and discover what it is in the future.’”

More distress in office

The prospects for such a normalization, though, is getting more challenging. This summer, Kiran Raichura, Capital Economics’ deputy chief property economist, predicted office values would plunge 35% by the end of 2025. As of early December, his prediction changed for the worse. Capital Economics now expects office values to fall more than 40% peak-to-trough by the end of 2025, with no recovery even by 2040.

Raichura cites higher interest rates in the longer term than initially expected. If you think back to the 2010s, he says, real rates (i.e., interest rates adjusted for inflation) were around zero to 1%. His team projects those will be more like 1.5% to 2% in the 2030s. While he expects the Federal Reserve to cut interest rates next year, as most do, he thinks rates will eventually come back up to present levels. Currently, Raichura said we’re still about halfway through the office sector’s crash: “There definitely has to be some distress, or more distress, to come in the pipeline next year.”

An obvious sign, Raichura explained, are increased office delinquencies as borrowers fail to make their loan payments, which appear in commercial mortgage-backed securities data. “I think it’s still got a long way to go into next year, so that’s something that we expect to continue rising,” Raichura said, referring to the office delinquency rate. Over time, he suspects banks or other lenders will take over some of these delinquent properties and more office space will come to the market, some at substantial discounts.

“A lot of what’s going to drive next year is just continued maturities,” or debt coming due at a time when refinancing isn’t so cheap, said Kevin Fagan, head of commercial real estate analysis at Moody’s Analytics. This year, Fagan said, banks and other lenders have offered a lot of  extensions and workout agreements to property owners, but that generosity won’t last forever.

In his view, vacancies will start to fall in the years after 2025. Still, we’re not in the clear by any means. “It’s going to be a rough year for office next year…the maturities that are coming through, we’re seeing about 75% of them are going to be in trouble,” Fagan said. He said they will likely have low revenue (in the form of rents) relative to their loan amount, among other factors that lenders find undesirable, and will be hard to refinance for borrowers without putting a lot more equity in. “It’s going to be a pretty bloody headline year,” Fagan said.

This era is definitely a sea change for offices, said Al Brooks, JP Morgan Chase’s head of commercial real estate. “I don’t think we’re going to go all the way back ever,” he said. Older, less desirable offices are already taking the biggest hit, Brooks said, and those will likely need to be repurposed. Like many, Brooks doesn’t see offices being converted to housing on a large scale because of how costly that is, despite the country urgently needing new housing.

Still, office is only 3% of the real estate investment trust market and around 20% of the commercial real estate market, estimates Rich Hill, head of real estate strategy and research at Cohen & Steers. Nevertheless, rents are coming down, capital expenditures are going up, and balance sheets aren’t great, in some cases.

Not in the clear

It was a rough year for buying and selling commercial real estate, and that’ll continue next year to some degree, Fagan predicted. Capitalization rates, which tend to indicate risk (the higher they are, the riskier the property), have been volatile and “very bloody,” he said. (While they can be hard to measure, capitalization rates are calculated by dividing a building’s net operating income by its current market value.) A great deal of the pain we saw this year within commercial real estate came from rising and unstable capitalization rates. “This is a cycle where [distress is] deeply tied to rates, not fundamentals…that’s very unusual,” Fagan said, and because interest rates affect how properties are priced, values have taken a hit. That’ll continue next year, potentially in the form of delinquencies as creative financing options lose steam.

“While the commercial real estate market and the commercial real estate lending markets are certainly facing headwinds, it’s been far from a collapse,” Hill said. It’s looking more like a slow grind, Hill explained—a grind that the market has already priced in and which may not be as bad as people expected six or so months ago. The real estate investment trust market, which he believes is a leading indicator in both downturns and recoveries, has likewise recovered substantially after setting new lows. Private market valuations across the entire sector are down to 10 to 15 percentage points, and he thinks we’re slightly more than halfway through the correction that Cohen & Steers is anticipating.

“I want to be very clear that we are not in the clear,” Hill said. While he thinks we may be past the worst of it, he predicts property valuations will fall further.

“This is a once-in-a-generation type event,” Hill said. “This is only the third time in the modern real estate era where valuations have fallen as much as they have.” The two prior eras that saw similar declines in commercial real estate valuations were in the early 1990s, post-savings and loan crisis, and 2008, post-Great Financial Crisis—both seismic events whose effects on the broader economy were felt for years after. Hill said. Still, as he explained it, this is a normalization—the deflation of a balloon, not the popping of a bubble.

Some risk in multifamily 

Now to multifamily. While there are challenges to apartments as the rental market softens, it’s a strong asset in the medium and long term, Hill said. In the low-interest-rate environment of the pandemic, apartment valuations were high, and, for many properties, potentially overvalued. With today’s higher interest rates and  increased risk, those values have plunged. That’s apart from the fact that in many regions, especially the Sunbelt, there is an oversupply of these buildings.

Then there’s floating rate debt, which poses a substantial risk to select multifamily properties. Some apartments purchased at peak valuations and financed with short-term floating rate debt have loans that are maturing just as rents are slowing and interest rates are much higher. That’s partly why we’re seeing multifamily property valuations down, Hill explained. Additionally, aside from floating rate debt, Fagan said that almost all new supply coming to the market are high-quality, luxury apartments. Given that many renters are already strapped, with the rent-to-income ratio in the country over 30%, Fagan said rents can’t be pushed up much further.

Over the last year, borrowing costs rose and rents flatlined. That’ll likely continue next year, meaning building owners’ income streams won’t rise, Raichura said. Consider Florida, he said, where there has been a lot of investment in multifamily; investors bought apartment buildings at low interest rates during the last couple of years, with the belief that rents would rise substantially, as they previously had, but rental growth has stopped while costs (such as insurance and maintenance costs) have increased.

Multifamily is “certainly the one in the short-term, apart from offices, where I would be most concerned,” Raichura said, adding that “we’d expect to see more issues arising next year.”  He predicts apartment values will decline 20% from the middle of last year to the end of next year.

The biggest investors will likely be insulated due to their sheer size. Brooks, when asked about JPMorgan’s multifamily holding, said, “we’re the largest, we don’t have any problems.” Others may not be so lucky, he noted—especially assets that were overleveraged or projected unrealistically high rents.

“If you want to avoid a lot of losses, it’s what I did five years ago that mattered,” he continued. “These portfolios are built over decades, with customers you’ve been vetting for decades. This is a long game, these are long-dated assets.”

Still, he noted, “we’re not going to be immune.”

“If you thought 3.5% money was going to last forever, you didn’t leave any cushion in your cash flow analysis, that’s not prudent,” Brooks said. “Those were the lowest rates we’ve had in history, that’s not going to go on forever.”

This story was originally featured on Fortune.com

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