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Rising Expenses and Increased Risks for Commercial Real Estate

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In recent years, commercial real estate has been hit hard by a combination of inflation and a rise in natural disasters. This has resulted in a significant increase in insurance, utility, and operating expenses for commercial properties. According to a new report by Moody’s Investors Service, if the economy experiences a recession, certain commercial properties in the U.S. may face even greater risks with declining income and cash flow.

From 2017 to 2022, expenses for commercial properties have seen a dramatic rise of over one-third. Insurance costs alone have skyrocketed by 73% in the past five years, while utilities have become 40% more expensive. Additionally, property taxes and other operating expenses have gone up by 27% and 29% respectively. These increases have outpaced the 19% growth of the consumer price index during the same period.

One of the key contributors to the rising insurance costs is the increasing frequency and severity of natural disasters. This has forced insurers to withdraw from certain markets, leaving commercial borrowers in those areas with limited and more expensive options.

These challenging economic conditions are placing significant pressure on commercial real estate owners and operators. They must find innovative ways to manage these rising expenses and mitigate the risks associated with potential income decline and cash flow disruption. It is crucial for stakeholders in this sector to stay vigilant and adapt to the changing landscape of the commercial real estate market.

Rising Property Expenses in 2023

Fortunately, most commercial properties have been able to counter the growing expenses by generating more revenue. Even in the troubled office sector, revenue growth has successfully offset a notable 22% increase in expenses over the past five years, resulting in a commendable income growth of 23%.

However, if the economy weakens later this year, some properties may struggle to generate sufficient revenue to cover the mounting expenses. Specifically, for sectors like office spaces that are experiencing rising vacancy rates, there is a risk that expense inflation may outpace revenue growth. This scenario could potentially weaken asset values, increase refinancing risks, and even lead to defaults and losses in commercial mortgage-backed securities (CMBS), as emphasized by Wheeler.

As we move forward into 2023, it is crucial for property owners and investors to carefully monitor and strategize their financial decisions in order to mitigate risks associated with rising expenses. Building a strong revenue foundation will be essential to protect property values and overall financial stability.

Office Properties: A Harbinger of Crisis

The COVID-19 pandemic has profoundly impacted the way we work, with more people opting to work from the comfort of their homes. As a result, office properties have become one of the most affected sectors. According to recent data, the income growth for this sector in 2022 has dropped significantly to a mere 4%.

The hard-hit states such as Minnesota are already witnessing a decline of 1% in net income compared to the previous year, while Pennsylvania’s office properties experienced no growth. The gloomy forecast doesn’t end here – hotels and retail real estate, which are known for being highly sensitive to the ups and downs of the economic cycle, are also at a higher risk, as highlighted by a recent report.

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