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Three years after the pandemic started, parts of the commercial property market are finally starting to buckle under the strain as it becomes clear that office work will never return to the post-Covid norm.

The spike in interest rates and job cuts across most sectors including tech are adding to an already tough picture, contributing to rising loan delinquency rates and some big defaults that certainly won’t be the last. Offices are only half as full as they were before the pandemic.

It’s not all doom and gloom, though. While things are looking bleak in the short term —especially for the biggest cities like New York and San Francisco — I believe there are good reasons to be optimistic about commercial real estate in the long run as American entrepreneurialism and creativity find new uses for the excess space. 

The market for office space is far from dead. People are returning to the office, at least for a few days a week, as they realize there’s a certain energy from being around others that can’t be replicated at home. Most companies are actively encouraging that, with one recent survey finding that 90% of companies will require workers to return to the office at least part of the time this year.

Smaller cities like Dallas, Phoenix and Indianapolis haven’t been hit nearly as hard and are likely to rebound more quickly than larger gateway cities since they have less surplus office space and don’t have the long commuter slogs that make remote work so attractive elsewhere.

The best hope for tenants, landlords and lenders to survive this downturn and even thrive in it is to be flexible and creative, both in their use of space and in their dealings with each another.

One tried-and-true strategy I’m seeing from landlords is to diversify into different asset types by applying their commercial expertise to the retail and multifamily sectors. 

Another approach is to divide buildings up into smaller, more flexible spaces to accommodate employers who are transforming to hybrid models. Co-working firm WeWork has seen its valuation plunge but its fundamental idea of using office space in a flexible, fluid way is likely to endure. Many landlords are adopting this dis-intermediary approach successfully on a smaller scale. A nimble repositioning of office buildings — the majority of which are far from obsolete — should help rejuvenate the sector in the coming years.

Landlords who want to implement this shift are facing some obstacles      though. One is that many are locked into loans with lenders who don’t allow loans to be longer than the average tenant duration. The other is that it’s hard in this environment to pass hefty refitting costs on to tenants through higher rents, especially if they aren’t signing long duration leases. So smart, innovative landlords are doing things like putting in moving walls and creating extendable spaces to achieve the same flexibility at a much lower cost than refitting fixed walls for each tenant. 

The current situation is ripe for conflicts between tenants and landlords, but they should seek to collaborate. Conflicts are more likely to benefit the lawyers in the middle more than anyone else. Many tenants feel trapped in expensive, long-term leases that are no longer justified by their now-limited use of a space. But they need to understand that breaking the lease could put landlords at risk of a loan default, or force landlords to sell the building at an inopportune time because of their loan covenant terms. Tenants should come to the table with creative ideas about their rent and the use of space that could help both sides and that don’t sound like an ultimatum. 

One tenant I know was able to work out a new deal with their landlord early in the Covid crisis by offering to keep renting half of their 6,000 sq foot space, even though they only needed a quarter of that original space. The tenant agreed to pay the full rent for the first month and then taper it down by 10% per month thereafter. We need more of this kind of creative collaboration, with give and take from both sides, to address the glut of office space.

In the medium term, much depends on location. There are worrying signs that some of the biggest cities, particularly New York, Chicago, and San Francisco, are in for a prolonged period of commercial real estate pain and restructuring. 

San Francisco’s downtown has been significantly hollowed out, with office buildings at about 40 percent of their pre-pandemic occupancy and vacancy rates soaring to 24% from 5% in 2019. 

Rather than a dramatic property pricing collapse, we’re likely to see markets like these enter a state of long-term paralysis due to a lack of economic incentives. Demolishing downtown office buildings is enormously expensive; so is converting them to residential use. If tenants default, banks often have very little incentive to move forward with the foreclosure process because they’ll be saddled with the property’s taxes, insurance and utilities with little prospect of selling the property at an acceptable price. 

A property buyer considering the massive costs of refitting an existing space might only want to pay, say, $10 million for a building on which a bank lent $35 million (when the bank thought it was worth $50 million). That’s a recipe for a long stalemate that could have very negative social impacts on downtown zones. That’s why there’s a strong argument to be made for some kind of government intervention to help these markets, which generally don’t qualify for the tax incentives like those properties located in Opportunity Zones

Overall, though, I’m confident the free market will do its thing and enable commercial real estate to return to health in coming years, albeit looking very different from the way it is now.   

Jim Small is the CEO of SANTÉ Real Estate Investments.

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