After getting used to working from home during the COVID lockdown, many of us in Singapore have been back in the office this year. MRT is busy during rush hours. Everything is good here. But some REITs listed in Singapore that own office real estate in the United States have been battered. What is going on? Is a commercial real estate crash coming?
What Happened?
First, the commercial real estate issue is not just isolated to the United States. Other countries may also face similar problems, but the US has one of the world’s largest commercial real estate markets, so it’s worth looking deeper into. The seed of the potential commercial real estate crash was planted years back but has been exacerbated in recent years.
Low Interest Rates from the 2008 Great Financial Crisis
The aftermath of the Great Financial Crisis of 2008 saw the Federal Reserve cut the interest rate to nearly 0% to stimulate economic growth again. The easy money policy was running for more than a decade. Borrowing at a near 0% interest rate is just as good as free money. This policy unleashed one of the biggest bull runs in recent decades.
Many real estate investors took this opportunity to acquire commercial real estate using leverage. With the economy recovering, office-type real estate saw rising occupancy rates and rental income. The property valuation kept climbing as the easy money policy continued. And the party kept going until that fateful day in early 2020.
COVID Lockdown
In early 2020, the COVID pandemic hit the world. The global economy shut down. Almost all countries implemented a lockdown, not allowing people to leave their homes. This lockdown implies that businesses must adapt to the work-from-home situation. Some even started to adopt remote work policies allowing them to hire outside their area.
Fast forward a year later, the pandemic abated, and life started returning to normal. The reopening was in full force. People started frequenting their favorite restaurants, malls, and clubs again. But one thing that some people still love is their work-from-home lifestyle. Some workers were resistant to coming back to their office.

Work-From-Home Is Becoming Acceptable
Before the pandemic, the idea of working from home was just a wild imagination. After the pandemic, work-from-home started to become more acceptable. Many companies allow a hybrid arrangement by allowing several days working from home and several days from the office. Some companies even went fully onboard with remote work arrangements. This work arrangement is okay for the business if productivity is maintained or even increased. However, this is bad news for real estate investors. What will happen with all these available office spaces if there is lower demand from companies to lease office space?

Interest Rates Rising Fast
Inflation had been raging in 2022. To combat this inflation, the Federal Reserve had no choice but to raise the interest rate to create a restrictive environment and slow down the economy. This rate hike will hopefully bring inflation down to a more acceptable level. The Fed has been raising the interest rate at a swift pace.

Refinancing and Low Occupancy Rate
Remember that many of these commercial real estate were acquired using debt? Bad news, they will need to refinance them eventually, but they are no longer in the 0% interest rate environment. The interest rate is now at 5%. They have to refinance at this much higher borrowing cost.
This refinancing cost and the lower occupancy rate due to the work-from-home arrangement may catalyze the incoming commercial real estate crash. As a perspective, a whopping $1.5 trillion of debts needs to be refinanced within the next two years. If the interest rate stays elevated in the next two years, imagine how much costlier all those debts will be after refinancing with the current 5% interest rate. The Fed has hinted that they will not cut rates this year. The high interest rate may stay with us for a bit longer.
Price is a Function of Demand
Fundamentally, the real estate price is a function of demand. If there is not much demand, the price cannot sustain its high valuation, and a correction may be coming. Because of the subdued rental market, these commercial real estate managers will earn lower rental incomes. Unfortunately, their expenses will increase due to the much higher borrowing cost. Some less well-managed managers may become unprofitable and may need to liquidate their holdings.
Because many of these commercial real estate managers are REITs, there are additional requirements that these REIT operators must fulfill, such as maintaining a healthy maximum aggregate leverage ratio. If they exceed this ratio, they must divest their real estate holdings to shore up their finances. Unfortunately, fewer buyers will be interested in acquiring commercial real estate with such a high borrowing cost if the rental demand continues to be at a depressed level. With more sellers and fewer buyers, the price may continue declining. This scenario is potentially how the commercial real estate crash may play out.
Early Warning Signs
In the past few months, many landlords have started to default on their loan repayments. Blackstone, one of the largest landlords in the US, also began to struggle with their loan servicing on some of their real estate. Surging interest rates make refinancing those loans unprofitable. This can be just an early warning sign. As higher interest rates persist, more waves of default may come.
Silver Lining
But not all are doom and gloom. The good news is that we may be reaching the tail-end of this interest rate hike cycle. The Fed and the market expect only one or two more hikes this year before starting to reverse next year. However, the bad news is that they still expect the rates to be above 4% throughout 2024 and above 3% throughout 2025.
Implication to REITs
As a REIT investor, you may want to position yourself accordingly. The performance of commercial real estate differs by country. So far, Singapore’s commercial real estate market has not been impacted too much in terms of demand. But the US market may not be as lucky as Singapore.
Financial Health
REIT managers will eventually need to refinance their debts, and the higher interest rate will make their borrowing costs shoot up. This, in turn, will lower their distribution per unit to the shareholders.
If you believe a commercial real market crash is possible, you may want to be more cautious when assessing a REIT portfolio and financials. Look at their portfolio holdings and geographical location, and evaluate whether the market they have exposure to is resilient enough.
Aggregate Leverage Ratio
In the worst case, if the property valuation declines while the total debt increases from the high borrowing cost, the REIT may exceed its maximum aggregate leverage ratio. When this happens, the REIT may be forced to divest its holdings to strengthen its financial situation. Forced selling during a market downturn is usually not preferable for shareholders. As prudent investors, it is wise to pay attention to this aggregate leverage ratio level and avoid those with high ratios.
If you have been monitoring the Singapore-listed REITs with large exposure to US commercial real estate, you would have noticed that their prices have recently been beaten down and trading at a significant ‘discount.’ The market is forward-looking and has been pricing this potential commercial real estate crash. What do you think? Do you agree with the market?