**The Vulnerability of Commercial Real Estate to High Interest Rates**
Commercial real estate is susceptible to the impact of high interest rates, especially after a period of cheap money. The office sector is particularly at risk due to a decline in demand caused by the prevalence of remote work. Capital Economics predicts a significant drop in office values and believes that recovery is unlikely even by 2040.
**Insights from Kiran Raichura on the Outlook for the Office Sector**
Fortune had a conversation with Kiran Raichura, the deputy chief property economist at Capital Economics, to gain deeper insights into the firm’s perspective on the office sector outlook. Raichura emphasized that the current downturn in the office space is different from previous ones due to the presence of structural shifts.
**Methodology and Factors Influencing the Plunge in Office Values**
Raichura explained that the increase in interest rates is affecting all real estate sectors. The rise in the risk free rate has led to an increase in commercial real estate capitalization rates. Additionally, there has been a well-documented reduction in the use of physical office space, leading to a decrease in occupancy. This reduction in space has resulted in increased vacancy rates, weaker rental growth, and declining net operating incomes. The 35% drop in office values is a combination of the rise in rates, increased risk premium, rising vacancy, and falling rents due to remote and hybrid work.
**Changes in the Office Forecast Over Time**
The office forecast has been downgraded substantially in the last few months. The banking crisis in March had a significant impact on the availability and cost of debt finance for real estate investment. It also affected investors’ confidence in the outlook for real estate. The clarity in the office sector, with investors giving back assets and not investing further, has led to a realization that the market needs to reprice substantially.
**Why Office Values Are Unlikely to Recover**
There are two reasons for the unlikely recovery of office values. First, the reduction in demand for office space is a structural change. Even if firms maintain their size, they are choosing to reduce the amount of space they require. Second, there has been a shift in interest rates, with forecasted rates expected to remain higher than in previous years. This increased rate means that real estate cap rates need to be higher, resulting in lower prices. The recovery is not expected to be supported by a reduction in the interest rate environment.
**The Current State of the Office Sector and Potential Downturn**
The office sector is currently experiencing a crash. Evidence from data and client feedback suggests that it is a challenging time to be an office landlord. Banks are also withdrawing debt from the sector. The increase in interest rates and the adoption of remote and hybrid working have had a significant impact on the demand for office space. Capital Economics forecasts a 35% peak-to-trough fall in office values. While there has already been a 15% fall in values, the full impact is yet to be reflected in valuations. Some larger discounts have already taken place in cities like San Francisco, where assets have been traded at significant discounts.
**The Possibility of Office Values Fully Recovering**
Raichura believes that office values will eventually recover, although it may require a change in the use of the asset. In some cases, the office space may be transformed for alternative purposes, which may not reflect office numbers directly.