Out of office: The status of the U.S. office property sector amid bank turmoil and remote work

Executive Summary

• Bank failures in addition to high-profile property defaults in early 2023 has spurred unending negative media coverage surrounding U.S. commercial real estate (CRE) and the office property sector. In the following paper we aim to help investors interpret the dire headlines and better navigate the CRE landscape moving forward.
• Recent troubles encountered by the largest CRE lender type (i.e., banks) has further impeded the property price discovery phase that was initially set in motion at the start of the rate hiking cycle in 2022. Distress is showing signs of picking up, especially for the most challenged property types (e.g., lower-quality office) and markets (e.g., urban central business districts), a trend we anticipate continuing amid a non-zero interest rate policy environment.
• Reality is finally starting to sink in among market participants that the hybrid work model (i.e., in-office and remote) is not transitory. The monumental shift in work habits has intensified the existing “flight to quality” trend for both owners and occupiers which will continue to pressure office supply-demand fundamentals for the foreseeable future.
• Near- to medium-term tighter financial conditions present the possibility for attractive risk-adjusted returns across the CRE capital stack (i.e., senior debt, mezzanine debt, preferred equity) as well as an opportune time to be a buyer of discounted CRE loan pools as banks prune their balance sheets. Newer, higher quality office properties will win out over time, but investors’ portfolios with diversifying exposure across the real assets spectrum more broadly (including office subsectors medical office and life sciences) will be better positioned to achieve their risk and return objectives with greater downside protection.