Turning Pain into Gain in Commercial Real Estate

It’s no secret that the commercial real estate industry has been facing some tough times lately. Real estate values across sectors have dropped by 15%–30% from their peak in 2022, and both supply and demand imbalances—and high rates—stubbornly persist. Meanwhile, an estimated $900 billion+ in debt backed by CRE maturing in 2024 will need to be paid off, refinanced, or further extended by lenders. Many capital structures that were put in place in a lower-rate world have become unsustainable, and this trend is only expected to continue.

Yet along with pain comes potential. And as we look at commercial real estate trends today, we see selective opportunities emerging amid a market capitulation that will likely unfold in the years ahead.

Rising Rates, Falling Values

How did we get to this point? Real estate owners have historically relied on higher levels of debt compared to other asset classes to boost asset-level returns. When used wisely, leverage can be a powerful tool for equity owners. However, when owners overextend themselves, the opposite can be true. That’s why the recent rise in interest rates has had such a significant impact on the commercial real estate market. Owners of levered real estate assets are now facing higher borrowing costs from floating rate loans, as well as increased costs to hedge interest rate risk. For some, this could create significant challenges.

To add to the woes, higher interest rates significantly impact real estate valuations more broadly. You can see the relationship between interest rates and cap rates (the primary metric for real estate values, arrived at by dividing net operating income by asset value) in Display 1.

Among the commercial real estate trends we’re watching, two aspects stand out. First, cap rates tend to move in tandem with long-term interest rates. And when cap rates go up, real estate valuations typically go down if cash flow growth does not keep pace. Second, the incremental spread for taking on risk in real estate relative to 10-year Treasurys has compressed for certain asset classes. This could be a sign that we’ll see even more cap rate expansion on the horizon if interest rates remain elevated.

Looming Liquidity Needs

In times of benign interest rates and predictable cash flow growth, commercial real estate can handle larger debt loads. That’s why so many borrowers took advantage of this dynamic in recent years, when rates were low and real estate cash flows were growing thanks to inflationary stimulus. But now? Those tracking commercial real estate trends note that a massive amount of CRE debt is set to mature over the next few years, and many borrowers have come under pressure (Display 2).

Refinancing the upcoming debt wall is going to be a major challenge, for two key reasons:

1. Many traditional lenders, including banks, have pulled back from the market due to delayed repayments and increased capital reserve requirements for loans that have soured. This means that there may be less capital available for refinancing than there was in the past.
2. We don’t believe that debt financing alone will be sufficient to address the impending maturities.

With declining values and higher interest rates, many properties won't be able to support their previous debt loads. As a result, equity investors will need to step in and provide fresh capital to replace some of the maturing debt. If not, foreclosure could be a real possibility, creating a headache for current property owners—but an opportunity for others.

Not Every Property Is an Office

When it comes to commercial real estate trends, many investors’ minds jump immediately to office space. However, other sectors account for the majority of CRE, with office ticking in at only around 16% of the total, according to Cushman & Wakefield (Display 3). These other sectors include multi-family housing, industrial properties like warehouses and distribution facilities, hotels and other lodging, retail properties, and niche sectors such as student housing, datacenters, and life sciences / R&D facilities.

While the stresses in the office sector are significant and notable, there’s a lot more to commercial real estate than just office.

Outside of office, multi-family has attractive long-term attributes. While the end of government stimulus dollars and pockets of oversupply have led to a slowdown in the post-pandemic rent boom, we still believe that the US housing market is undersupplied overall. That all adds up to an attractive secular backdrop for the multi-family sector. Of course, concerns about oversupply in certain markets remain. But we think these concerns will eventually even out with fewer new projects in the pipeline. As a result, we expect to see a normalization of rent growth over time.

Long-term commercial real estate trends in the industrial sector also remain favorable, in our view. While the hypergrowth in rent previously experienced in many markets has slowed—and certain markets still struggle with oversupply—industrial demand should continue to benefit from well-documented secular shifts like e-commerce and onshoring of manufacturing facilities.

Whether for multi-family or industrial, the devil is always in the detail. Not all markets are created equal, and asset-specific traits are paramount. The same holds true for other asset classes when assessing relative value and future performance potential.

Where Are the Opportunities?

The current stresses in the market have created a prime opportunity to generate attractive risk-adjusted returns. By capitalizing on special situations that arise out of the convergence of commercial real estate trends, savvy investors can create value by identifying specific levers in the business plan, rather than relying on general market performance. We see three areas in particular that we think are worth exploring:

Pockets of Illiquidity: Material liquidity gaps should allow well-capitalized investors to resolve situational distress. They may even be able to contribute fresh capital to existing owners to fix impaired capital structures.

Value-Add Repositioning: Fundamentally sound real estate often requires a capital injection or more thoughtful management to maximize the return on investment and cash flow. Opportunities to meaningfully reposition assets are especially compelling where assets have been neglected by prior capital-constrained ownership.

Mispriced Assets: Investors often fail to discern appropriately, overlooking attractive entry points due to noise or complexity. When assessing property potential, aligning with operators who have a strong local presence can provide an edge against out-of-town peers.

Collectively, we view the ongoing stresses and dislocations in the CRE market as a prime opportunity to acquire high-quality assets at significant discounts to replacement costs and long-term values. Recent years have tested the markets in general and the CRE market in particular. We believe a disciplined approach investing into strained or distressed opportunities could present opportunities that we haven’t seen since the aftermath of the Global Financial Crisis a decade and a half ago.