Lease Expirations and CRE Property Performance 
The pandemic-induced shift to remote work appears to have led to a large and persistent decline in the demand for office space, especially in central business districts (CBDs). On the other hand, the deterioration in commercial real estate (CRE) loan performance has been relatively modest to date, as long-term leases have shielded commercial-property owners from the effects of diminished demand for space to a fair degree. To shed light on how these properties will perform in the longer term as more leases expire, this paper analyzes how lease expirations have affected property performance historically and investigates how these patterns have changed so far for leases that have expired since the COVID-19 outbreak.
Key Findings
- Before the pandemic, lease expirations tended to be associated with modest deterioration in a commercial property's financial performance––namely, declines in occupancy rates and net operating income (NOI) growth—over the next two years. These adverse effects largely reflect downside risk: Lease expirations have little effect on median or better property outcomes, but they are associated with notable declines in occupancy and income at lower performance quantiles.
- These effects of lease expirations are highly dependent on the strength of the local property market. In markets with minimal vacancy, expirations bring about little change in occupancy and even modest increases in income. However, when market vacancy rates are relatively high, expirations are associated with more dramatic declines in income and occupancy.
- Overall, CRE lease expirations during the pandemic have so far had only modestly larger effects on occupancy or income compared with the period before the COVID-19 outbreak. However, for office properties, the predicted effect of lease expirations on occupancy increased by about one-half during the pandemic, and the predicted effect on NOI rose by about one-third.
- These effects vary substantially across localities; the impact of lease expirations on occupancy or income roughly doubled for office properties in CBDs relative to the impact before the pandemic. Additionally, the effects of lease expirations have been much larger in counties where there has been a large and persistent decline in time spent at workplaces relative to before the pandemic.
- Relative to global systemically important banks (G-SIBs) and nonbank CRE lenders, regional and community banks have lower concentrations of office lending in CBDs and areas with a greater shift to remote work.
Implications
While the CRE market as a whole has remained relatively resilient since the COVID-19 outbreak, there are segments for which the outcomes of lease expirations point toward serious stresses that are likely to contribute to loan losses in coming years. Specifically, greater strains are likely to emerge in the office-property loan markets in CBDs or counties with a persistently larger shift to remote work as more leases expire and exert pressure on occupancy and income. On the other hand, office CRE loans secured by properties in CBDs or areas experiencing a persistently greater increase in remote work account for a smaller share (below 30 percent) of regional and community banks’ portfolios than for the GSIBs and nonbank lenders. All else being equal, this pattern should help mitigate the risk of bank CRE losses prompting a broad-based credit crunch, but banks also face additional headwinds from rising funding costs and lower fair values of fixed-income assets.
Abstract
This study analyzes how lease expirations affect the performance of commercial real estate (CRE) properties and how these patterns changed during the COVID-19 crisis. Even before the pandemic, lease expirations were associated with a notable increase in the downside risk to a property’s occupancy or income, particularly in weaker property markets. These risks became more pronounced during the pandemic, driven mostly by office properties. During the pandemic, the adverse effect of lease expirations on office occupancy increased more than 50 percent overall, and it doubled for offices in central business districts (CBDs). This amplified effect of office lease expirations serves as a harbinger of further deterioration as leases continue to roll over in coming years, especially among CBD offices. Across lender groups, nonbank and large bank lenders are more exposed than regional and community banks to office loans in those distressed CBDs. This pattern somewhat alleviates the concern that CRE portfolio credit risk will exacerbate the headwinds faced by this latter group of banks.