What to Make of Commercial Real Estate?

In the wake of March’s flurry of bank runs, commercial real estate (CRE) has moved to the forefront of the financial news. We expect it to stay there as prices adjust to a new reality, creating opportunities for investors over the next 12–24 months.

A Confluence of Events

What drove the commercial real estate outlook to become page one news? A combination of three events—one secular, one cyclical, and one sudden.

The secular trend toward a more digital world already echoed through the retail landscape, as lower-tier malls across the country faced enormous challenges over the past decade. Now the post-COVID work-from-home repercussions in the office market, which we first noted in the pandemic’s early stages, may be coming home to roost.

At the same time, this economic cycle has stood out for the speed and magnitude of the Federal Reserve’s rate hikes. The CRE market was particularly vulnerable, since it aims for fairly stable cash flows over time—and relies to a large degree on debt financing to earn investors’ targeted equity returns.

To make matters worse, the sudden shock of the regional banking crisis suggests that banks are likely to pull back on lending. And because their lending currently underpins much of the CRE market, a potential financing gap may surface that will need to be filled.

Taken together, the risk is that commercial real estate values fall due to an imbalance between supply and demand, combined with materially higher financing costs. What does this commercial real estate outlook mean for investors? Prepare for ongoing stress that may ultimately lead to a shakeout, creating opportunities for new capital to enter at more attractive terms.

Plugging Banks’ Lending Gap

Roughly speaking, around $6 trillion of US commercial real estate debt remains outstanding. Around $2 trillion is multi-family (such as apartment buildings), while other property types account for the balance. Inside multi-family, half of the lending is done by government sponsored enterprises (GSEs) such as Fannie Mae and Freddie Mac, with the remainder coming from banks, insurance companies, and other investors.

Beyond multi-family, regional banks account for half of CRE lending (Display). Plus, the CRE market matters more to small banks than it does to larger ones (i.e., the top 25 by assets). It makes up 43% of small banks’ total loans but only 13% for their larger counterparts. Now, as they’re expected to become more defensive, the role of regional banks in the CRE lending ecosystem has come under scrutiny—both in absolute dollar terms and in their rapidly growing market share.

Thankfully, banks did learn from the Global Financial Crisis. Through this cycle, they’ve generally made the most secure loans (first lien) at 50%–60% loan-to-value (LTV) ratios. That gives them a fair cushion against deteriorating property values. And it should hopefully limit the feedback loop from the CRE market into the banking system and then back into the general economy—reducing systemic risks. With that said, there’s no escaping the almost $2 trillion of CRE-backed debt set to mature by the end of 2025, forcing a valuation reset for both owners and lenders.

A Frozen Market

Over the past several quarters, private CRE markets have mostly seized up, as buyers and sellers struggle to agree on pricing. With bid-ask spreads far apart, few transactions are closing. This has a cascading effect, making it difficult to assess the fair values of other properties based on recent deals and cap rates (a function of net operating income and property values).

Given limited valuation data, both owners and lenders are only gradually marking down their property and loan portfolios. Such reticence has caused a wide rift between the values of publicly traded and private real estate investment trusts (REITs), with the markets punishing public REITs much more swiftly than private REITs can adjust (Display). Notably, public REITs have fallen by around 26% since their high at year-end 2021 while private REITs have risen by 6% over the same period (and currently sit only 4% off their September 2022 peak).

Another contributing factor? Lenders have several ways to handle deteriorating loan portfolios. Even amid current strains, many may extend maturities in exchange for slightly better terms—rather than taking over the properties and sparking a sharp market reset. Yet going this route further contributes to the dearth of transaction activity.

All of this sets up a tougher lending environment ahead, which will pose a challenge for those already fully invested in real estate equity and debt. But stress also creates potential opportunities, and we expect the upcoming 12–24 months to stir up many attractive deals for those with fresh capital. In fact, we foresee substantially better terms—higher yields, tighter covenants, and more appropriate loan levels relative to the current values of the properties.

As the CRE market corrects, we expect opportunities to emerge across the spectrum and at different moments—whether in publicly traded REITs, private CRE debt, private CRE equity, or commercial mortgage-backed securities (CMBS).

The Good News

Despite the challenges from rising interest rates and tougher financing, the fundamentals of the commercial real estate outlook were strong entering 2022. Net operating income, the most important measure of earnings, reached an all-time high in mid-2022 and remained near that level as the year closed (Display).

This speaks to the resilience of the underlying assets and rents, which tie directly back to both GDP growth and inflation. At the same time, benign trends in net operating income complicate the valuation picture, as investors quibble over where levels will normalize going forward.

Perhaps unsurprisingly, office space remains the most challenged sector when it comes to the commercial real estate outlook. With work-from-home persisting, vacancy rates in major metropolitan areas in the US and other countries hover at or near all-time highs—and continue to rise. As a result, we’re still quite cautious when it comes to the office sector, as we’ll detail further in an upcoming blog. Yet even in office, many properties have benefited from built-in rent escalators tied to inflation, sending net operating income for publicly traded REITs to an all-time high at year-end 2022. Prime office space also continues to perform well, with high-quality properties maintaining their pricing power.

Another potential positive for the commercial real estate outlook? There’s substantial dry powder waiting to be deployed. According to data from Preqin, global real estate private equity fundraising totaled over $160 billion in 2022, and North American real estate private equity funds have around $240 billion sitting on the sidelines waiting to be invested. That should support considerable transaction volume and may limit the extent to which valuations fall.

On the Lookout for Opportunity

Astute managers are watching the CRE market closely, underwriting investments in the space carefully, and searching for attractive opportunities to deploy capital. For now, the cheaper equity valuations are on the public side, though we expect private values to “catch-down” toward those levels. In the CMBS space, we see substantial differentiation between assets, but overall, view higher-rated tranches as more attractive than lower-rated ones.

Generally, lenders have the upper hand right now. Until the market begins to trough, we expect more attractive risk-adjusted returns for those lending against real estate versus those buying it. More specifically, we see opportunities for established real estate capital providers who can provide solutions to other lenders—such as banks trying to shift challenging loans off their balance sheets—or to stressed owners searching for a financing reset.

More broadly, when it comes to the economy overall, we have our eyes on the banks. They appear to have decent reserves to handle any upcoming losses. But if they face balance sheet issues, the ramifications for the economy—and policymakers’ responses—will be critical to the rest of the market.

Ultimately, the commercial real estate outlook comes down to an uphill climb with the potential for falling values and higher financing costs. But this doesn’t mean investors should lose hope. The upheaval could also lay the foundation for new capital to enter the market at more attractive terms. Count on plenty of stress and uncertainty. Yet with careful planning and a long-term perspective, nimble investors can navigate this period and potentially reap the rewards of a market shakeout.