Office Sector’s Path to a New Normal is Slowed by Capital Misallocation

The profound shifts in the labor market caused by the COVID-19 pandemic forced the real estate industry to rethink how Americans use office space. According to WFH Research, US workers are increasingly farther from their employers. The mean distance rose from 10 miles in 2019 to 27 miles in 2023, and the share of workers living more than 50 miles from their employer has risen 7-fold.

However, despite nearly a five-year reckoning for the office sector, property valuations are still fishing for the bottom. According to MSCI Real Capital Analytics data, Central Business District (CBD) office prices continue to post the most severe declines of any sector, falling 18.7% in the past 12 months and down 0.2% month-over-month in October.

Contrary to the occasional headline reporting on a major firm asking its employees to return to the office full-time, remote work trends have stabilized, and savvy operators are upgrading their stock to compete for critical tenants. So why is it taking so long for Office to turn around?

Maturity extensions appear to be part of the answer. A recent analysis by the Federal Reserve of New York found that the “extend and pretend” practice, where a bank extends the maturity date on a distressed loan to avoid writing off their capital, leads to increased credit risk and misallocation. Using loan-level supervisory data on maturity extensions, bank assessment of credit risk, and realized defaults for loans to property owners and REITs, the analysis finds that the practice has crowded new originations over the past year and a half.

Put more simply, as banks extended loans to avoid acute losses, the prices of distressed assets—which many office properties find themselves—have taken longer to reset. On top of that, with bank capital locked into existing loans, it can't be deployed to new investments with higher upside.

According to the Mortgage Bankers Association’s commercial and multifamily originations activity index, origination volume dropped by 20% between Q1 2022 and Q3 2024. While origination activity was undoubtedly dampened by higher interest rates, tighter credit standards, and heightened uncertainty, the New York Fed projects that distress-related maturity extensions contributed to between a 4.8% and 5.3% drop commercial originations since Q1 2022, explaining roughly a quarter of the decline.

While these extensions led to fewer defaults, banks took these actions due to weak underlying capitalization, which resulted in a strong positive relationship between maturity extensions for distressed mortgages and bank undercapitalization. The downstream effect of the extensions is a jump in the share of CRE loans maturing in the near term. As of Q4 2023 projections, 27% of total bank marked-to-market will come due over the next three years.

The findings of the New York Fed study suggest that in the short term, the impact of this misallocation will mainly show up through slower development of key post-pandemic market transitions in the real estate sector, such as office-to-residential conversions and modernizing recreational spaces in large cities. The good news is that as these loans gradually mature in the coming quarters, CBD office prices should stabilize, and capital will free up. For office operators that have managed to renovate, amenitize, and generate new value for tenants during this market freeze, the thaw could present new growth opportunities.