Where we are today.

While the Covid-19 pandemic penetrated all corners of life, perhaps no area was more disrupted than how we work. Seemingly overnight, work-from-home went from a novelty to a necessity, and nowhere was the shift felt more acutely than in office commercial real estate (CRE). As of today, Kastle Systems Back to Work Barometer (measuring app, keycard, and fob usage in ten major U.S. cities) shows building occupancy is still just half of pre-pandemic levels. And while slowly improving, the return-to-work effort – and the office buildings at its core – continue to face challenges. Louisville has not been spared from this trend, with CBRE Managing Director David Hardy noting recently that “in 2019, the vacancy rate for all the class A buildings, which is typically the towers in the market, was about 14%. And today, it’s about 25.5%. So that’s an 82% increase in the vacancy rate in downtown Louisville.”

Further complicating the matter is the rapid jump in interest rates over the last year plus. To combat soaring inflation, the Federal Reserve took their benchmark interest rate from 0% to over 5% in just 16 months. And while a bulk of loans are locked-in at the low rates available pre-2022, many will need to be refinanced or extended in today’s higher rate environment – and potentially soon. At the same time, credit standards have tightened significantly since the March 2023 regional banking crisis, with the Fed’s July Senior Loan Officer Survey noting, “banks reported tighter standards and weaker demand for all commercial real estate loan categories.” The credit crunch, seemingly, is on.

Of course, as of writing, the macroeconomic story is not one of weakness, but rather of unexpected strength. Inflation has fallen rapidly, and the U.S. economy is decidedly not in recession. Elevated consumer spending has been sustained by a drum-tight job market, lingering Covid-era fiscal stimulus, and a post-pandemic surge in travel, leisure, and experiences activity. This has staved off recession – and the related job loss – that would normally put even further pressure on office real estate.

Where we’re headed

Despite said resilience, there seems little doubt that some pain is ahead for office CRE. Eventually, higher interest rates paired with higher vacancy rates should result in markdowns and losses. As University of Louisville Professor of Real Estate Finance and Founder & CEO of Ness & Associates Patrick Nessenthaler posits, “I believe the catalyst for the next wave of distress will come from the banking regulators. Both small and large banks have a portfolio of real estate loans with valuations that are stale. Once a revaluation is triggered by the regulators, we are going to see the next wave of distress hit the sector as banks will require significant equity infusions from their borrowers.” The question is just how significant the markdowns will need to be, and over what time frame will the process occur. Ultimately, the $1 trillion plus in CRE debt coming due over the next several years will force the issue, and the Fed’s determination to keep rates “higher-for-longer” will continue to weigh.

But while the cyclical forces of higher rates are a somewhat familiar challenge for Louisville real estate, the bigger question is what to be done about the nearly 4 million unoccupied square feet of office real estate in a post-2020, flexible-work-friendly world. One common proposal is the conversion of offices into residential housing, mixed-use space, and/or hospitality/retail. Nessenthaler again: “Most major urban city administrations are unveiling recommendations to facilitate these conversions. The challenge is for the public sector to create enough economic subsidy to make the conversions financially feasible. Nonetheless, once the recipe is figured out, I believe we’ll see this trend replicated in a variety of major cities throughout the US.” While not an easy problem to solve – many outdated buildings are unlikely to be candidates for revitalization due to issues with floorplates, vertical penetrations, HVAC/MEP, etc., even with subsidization – it represents the sort of creative thinking that could stem some pain in the sector, and may even spur a new capital investment cycle. The issue is simply value – matching old prices to a new world – and we’re currently in the process of that shakeout. As Annie Rice, managing director of JLL Capital Markets, put it: “There is another shoe to drop on pricing. But once those shoes start dropping, there is plenty of capital willing to step in at the right price to prevent the bottom from falling out.”

Putting things into context

While office CRE has garnered many of the more alarmist headlines and investor anxieties, it is worth putting the numbers into context. For one, per the Denver Post, the value of the entire CRE market is ~$21T, less than half of the $43T residential housing market (famously, the epicenter of the ‘08 crisis). Further, CRE is not a monolith. Office, which represents just 15% of the market, is struggling, but many other subsectors are doing well. For instance, as the WSJ recently noted, retail is thriving – “Retailers are on track to open 1,000 net new stores in the U.S. this year as retail availability hits record lows, in fresh signs of the sector’s resilience.” From the Denver Post again, “Industrial is doing well, hotels have recovered and…there is a longer-term housing shortage that should eventually soak up (apartment) supply.” Finally, even within the ~$3T office market, there is plenty of variance; Morningstar notes that, “Class A properties, which are often situated in densely populated urban cores, comprise less than half of all office space in the U.S. As of June 2022, delinquencies were still under 5%.” The market may need a reset, but many of the gloomier headlines are potentially overstating the downside impact.

The Local Impact

Louisville has not been spared from the issues of higher rates and post-pandemic shakeout, but as Nessenthaler notes, “Louisville is generally a diversified economic base comprised of major employers (in different industries), so it has the ability to absorb economic downturns more so than concentrated economies.” Strength in suburban office and retail should provide reprieve to local lenders with a higher percentage of office CRE on their books, and the economic strength seen at the national level can be felt locally, as well – for example, the Kentucky unemployment rate of 3.8% is lower than any time pre-Covid.

Louisville’s diverse economy, reasonable cost of living, and central location continue to offer advantages over other mid-sized peers. Nessenthaler again: “The pandemic has influenced a major shift in the supply of labor as it relates to remote work, which is requiring city centers to somewhat reinvent their identity. I see this as an opportunity, not a threat. As it pertains to Louisville, we have an excellent proxy on how to recreate downtown given the success of its neighbor, Nulu…we are in the process locally of executing on our city center’s new identity, (and) I am confident we have the leadership in place to ensure a prosperous future for Louisville over the long-term.”

Ultimately, a healthy city center is vital to a location’s long-term growth prospects. Downtowns drive tax revenue, employment, cultural integration, and social development, among many other things. And while office real estate issues will likely cause some near-term pain, there are still plenty of reasons to be optimistic about the forward outlook, both for Louisville and for the nation at large.

The opinions expressed are those of the author and not necessarily those of Baird. While Baird reviews real estate as a part of a financial plan, there are no direct real estate services. Robert W. Baird & Co. Incorporated.