Investment Perspective: Commercial Real Estate – Where Do We Go From Here?
Stress & Distress
A steady stream of headlines highlighting distressed CRE assets and landlords paint a grim outlook for the asset class.
Stress and distress emerged in the office space sector, as post-pandemic work-from-home trends have altered the demand for office space, resulting in climbing vacancy rates. This has dislocated the sector and initiated a rationalization of historic values. Additionally, with a sharp increase in interest rates and lower debt availability, office loan delinquency rates have moved higher.
Certain assets in other sectors, notably apartments, bought at peak pricing and saddled with higher levels of floating rate debt (where interest rate caps are expiring), are also showing signs of stress and distress.
We believe there are real reasons for concern. However, the outlook for CRE, which is the world’s largest asset class, is more nuanced, and turbulence in CRE has the potential to create opportunities in both the private and public markets.
Highly Diverse Asset Class
CRE is highly diverse, comprising more than a dozen sectors with disparate demand drivers, growth trends, economic and interest rate sensitivities, pricing power, and lease durations, totaling an estimated $20.7 trillion total market capitalization in the U.S. alone, as of June 30, 2021, according to NAREIT.
While some headlines have seemed to equate CRE with the office sector, the office sector is an increasingly smaller part of the large and varied CRE market, accounting for approximately $3.2 trillion—or 5% of the market as of mid-year 2021, according to NAREIT.
Sectors like industrial, single-family for-rent, self-storage, and data centers have continued to benefit operationally from growing rents and strong secular and demographic tailwinds.
Further, assets and borrowers experiencing short-term stress or liquidity needs may be aided by guidance from regulators. The OCC, FDIC, NCUA, and Federal Reserve in June 2023 issued new guidance on real estate loan accommodations, encouraging short-term agreements that provide relief to a borrower experiencing a financial challenge.
Public & Private Markets
The speed and magnitude of the rise in interest rates resulted in valuation declines in public REITs in 2022 and year-to-date through the end of September 2023.
Historically, public REITs have tended to overshoot to the upside and the downside relative to private real estate. Private valuations lag public markets and may continue to experience declines in the quarters to come, given the material increase in interest rates and diminished debt availability. Sectors such as office space appear most susceptible to steeper declines.
Older vintage funds (2014 – 2016) have historically had higher traditional office exposure, as well as some retail exposure. In recent years, however, private strategies have tended to invest less in the office sector, in favor of sectors with stronger secular tailwinds.
Debt Maturities & Tighter Credit
The U.S. CRE mortgage market represents $4.9 trillion as of year-end 2022, with significant annual maturities expected in 2024 (approximately $500 billion) and beyond.
The banking crisis that occurred early in 2023, along with a pronounced pullback in lending from regional banks, has amplified concern in the real estate industry.
Banks play a significant role in financing the industry, accounting for 45% of all outstanding CRE mortgages. There is concern that tighter underwriting standards by, and less capital availability from, stressed regional banks, as well as higher rates, could put additional pressure on the CRE industry, with significant debt maturities set to occur in 2024 and 2025.
Troubled CRE loans could further stress regional banks, reducing office values even more. Additionally, this could strain local or state governments that rely on property taxes and real estate-related revenues.
CRE represents a meaningful percentage of bank assets, particularly midsize banks of $1–10 billion in assets, however CRE office loans remain only a small portion of bank assets.
If regional banks stay on the sidelines for a significant period of time, life insurance companies, agencies, and private credit may step in to fill part of the gap in available credit. While life insurance companies and agencies provide pricing that may be as attractive as banks, private credit lenders typically require higher yields than banks.
Some fixed income managers with CMBS exposure have reported maintaining positions in high conviction ideas, while paring back deals that they believe may have early signs of stress. Managers have also reported engaging in opportunistic buying in the office sector, as the many concerns over the sector’s outlook have created what some managers consider relative value opportunities.
Tighter lending standards and higher-for-longer rates are likely to result in increased stress and distress in the office sector, and other sectors where leverage and the current owner’s cost basis is high.
Private valuations for existing funds may continue to experience declines in the quarters to come. New development starts have declined, which could result in limited new supply a year from now. Depending upon demand levels, this could set the stage for stronger fundamentals in a number of sectors.
The decline in REIT valuations over the trailing 18 months may make for attractive entry points in the future. We believe measured rebalancing can be a prudent way to capture cyclical returns in the space.
A down cycle, combined with stress in the industry amongst higher-levered asset owners, could create significant opportunity for value-add private real estate funds.
- Historically many of the best vintage private real estate funds have emerged from periods of stress/market down cycles and we believe investors should make consistent vintage year commitments to the sector.
- Private value-add and opportunistic real estate funds will likely seek to acquire high quality assets which have poor/distressed capital structures (i.e. too much floating rate debt).
- Many of these groups also have experience investing in distressed debt, originating new loans and making preferred equity investments during market downturns, when these opportunities meet their return targets.
Medium & Long-Term Outlook
The future of the office sector is likely to remain uncertain for some time, and may play out similar to the retail sector’s path after it was first disrupted in the 2015 – 2016 period. Over-levered assets in other sectors may also experience an extended period of stress. Despite the potential for ongoing turbulence, the prospects for many sectors appear robust, given favorable secular dynamics. Favorable trends for certain sectors include:
- Housing continues to be chronically under-supplied, and home ownership is increasingly out of reach for many Americans, driving demand for a variety of rental housing.
- Industrial demand continues to grow with further ecommerce penetration, faster delivery times and on-shoring trends.
- Self-storage is expected to continue to benefit from growing consumer and business demand, due in part to work from home arrangements and baby boomer downsizing.
- Life science office, senior housing, and medical office sectors are expected to benefit from the aging of baby boomers and an increasing pace of new drug discovery.
- Data centers and towers are expected to accrue benefits from growing data consumption due to the roll out of 5G and growth in AI.
WRITTEN BY JESSE LYNCH — Principal/Senior Director, Research – Real Assets
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