Commercial Real Estate Faces ‘Staring Contest’

Even if interest rates stop going up, CRE investors face years of fine margins and crucial risk calculations.

Antonio Uve

The abrupt spike in interest rates over the past 12 months has been bleak for commercial real estate, which depends on relatively short-term financing strategies. Those cyclical headwinds have combined with secular ones—a possible new normal of half-empty offices, for example, and the continued decline of brick-and-mortar retail shops—to create a perfect storm for the asset class.


As redemption requests have poured in, behemoth asset manager Blackstone has had to cap the amount of money investors can pull out of some of its private, non-traded real estate investment trusts. Over the past few months, another giant real estate operator, Brookfield, has defaulted on roughly a billion dollars worth of mortgages for trophy properties from Los Angeles to Washington, D.C.


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“The last 12 months have caused a shockwave to the capital markets, valuations, rental rates and the lending environment,” says Christopher Okada, CEO of real estate advisory firm Okada & Co. “Business plans have gone awry.”


But analysts and investors are starting to coalesce around a view that the Federal Reserve is likely to pause rate hikes and possibly even begin cutting them: Trading on futures markets suggests a likely November decline in rates. Could it be the reprieve CRE needs?


The answer is a resounding, “It depends,” experts say. That is largely because any decline in rates will likely be accompanied by a much softer economy—and, as a result, less demand for space.


But the credit picture is more significant than rental revenues, say experts like Okada—and that one is likely to remain difficult for some time, even if rates soften. It all suggests we’re in for an extended period of uncertainty—a “staring contest,” in the words of Jim Costello, chief economist of the real assets team at information provider MSCI.


“In the last handful of cycles, when rates have declined, spreads have increased,” says Drew Thornfeldt, a managing director at Chatham Financial. “Borrowing costs are still going up, even as rates decline, and lenders are less willing to lend.”


Roughly $900 billion of loans are set to mature in the next two years, according to early April calculations from Capital Economics. For maturing loans that were made in a period of ultra-low rates, lenders will likely ask developers or property owners to contribute more money to get new deals done. “The question becomes, do we put more money into this project or are we sending good money after bad?” Okada says.


Capital Economics forecasts a 30% drop in prices for office buildings, of which 25% is still to come, with a recovery not due until about 2026 or 2027. The group expects valuations for industrial space—warehouses, mostly—to fall 14% by the end of 2023, as the dramatic lurch to e-commerce at the onset of the pandemic unwinds a bit.


However, the latest report from research group CommercialEdge, shows that average industrial rents—including warehouses—have increased every month over the last year and stood at an all-time high of $7.15 per square foot as of March. Vacancy rates are also extremely low at 3.9%. Nationally, 636.6 million square feet of new industrial space was under construction as of March, including warehouses, according to CommercialEdge data.


Retail space, which has already been beaten down by the generational shift away from brick-and-mortar shopping, is expected to decline 6.5% in 2023 yet be the only sector to enjoy “positive annual capital growth” over the next four years.


The residential sector remains a mystery. The acute shortage of housing, particularly more affordable options, seems to suggest the sector could be relatively insulated from any market declines—particularly in Sun Belt metro areas, which have pulled in many Americans searching for cheaper rents, sunnier weather and more space.


But in early April, a Houston-area developer lost 3,200 units to foreclosure as rates spiked, a sign that some seemingly safe sectors may not be immune.


Another consideration: If real estate that’s already cash flowing is having trouble, what about projects that are still being built? Most new-build loans are written to extend for the duration of the construction phase, MSCI’s Costello explains. But that leads to the uneasy prospect of developers stalling half-completed work until rates come back to earth, not to mention new buildings being opened in a period of slower take-up.


The big question for investors is whether the opportunities available in the sector are worth the risks, particularly if the “staring contest” lasts for the next few years.


“If we plateau at this range of rates, there will be short term agita, but once it resets, I think there are going to be people who do very well to buy now,” Okada says. “This is the most opportunistic time that I have seen in 14 years. 2023 is a once-in-a-generation opportunity to buy at 50% off with half the amount of competition.”


Chatham’s Thornfeldt describes a more selective environment than the froth of the past decade. “A lot of people have made money investing in real estate in the last 10 years,” he says. “There’s a segment of the universe of real estate investors excited to see a little more challenge in the market. Returns are going to be more contingent on who has the best business model, who has the know-how.”


Alex Pettee is president of Hoya Capital Real Estate, which manages a high-dividend yield real estate investment trust. “Distress for some is an opportunity for others,” he says.


For investors considering deploying capital, Pettee draws a distinction between public markets where REITs have historically operated with conservative debt levels using long-term fixed-rate debt, and private markets, which account for many of the high-profile stories of distress rippling through the sector now.


Kiran Raichura, Capital Economics’ deputy chief property economist, advises entering into any investments with a conservative view on revenues for the next few years. “It’s going to be a tough slog for the next few years.”

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