The Fog Thickens: The Commercial Real Estate Outlook After the First Quarter

By EisnerAmper

At the beginning of the year, we asked whether investors in the multifamily and commercial real estate sectors would have more clarity on market conditions as the year went on, or at least enough to understand the direction of property values and allow capital to flow again. As the first quarter results are being reported, we can safely say the waters are even muddier now than before. As predicted, deal volume has slowed to a trickle, due to that same lack of clarity on values and its corollary, a withdrawal of debt capital. If mortgage lenders were uncomfortable in January, they are even more reticent after March’s mini bank crisis. Let’s explore what transpired in the first quarter, and what it means for the remainder of 2023.

The Numbers

• Employment: Employment remained strong but revealed a hint of potential weakness. According to the U.S. Bureau of Labor Statistics, over 1 million jobs were created in the first quarter of 2023. While March job growth fell slightly from the prior month, the pace has been maintained and the first quarter results are better than fourth quarter 2022. The concern was the fall in JOLT (job openings and labor turnover) to 9.9 million from 11.2 million at the end of last year. However, the ratio between unemployed and job openings has remained steady between 50% and 60% since late 2021. For now, the job market still provides a tailwind for real estate demand.
• Inflation: The rising cost of building and operating properties has been a burden for the industry. CPI in March rose 0.1% from the prior month and 5% year-over-year. That continues its downward trend, but still way above the Fed’s 2% target. Many believe that over the coming months a number of factors will dampen inflation, particularly a slowdown in the growth of housing costs. At the same time, several inflation components remain remarkably stubborn. And wage growth in March was about 4.3% year-over-year, down from 4.6% in February, but still fairly high. Recent surveys of consumers show they anticipate inflation to stay around the current level, and expectations by themselves can drive continued price growth.
• Interest Rates: The good news is that the ten-year Treasury rate has fallen about 50 basis points since the beginning of the year, providing some reprieve to investors looking to finance their deals. Unfortunately, the opposite is true for SOFR, which has risen from about 4.3% to 4.8% in the first quarter and is used to price most floating rate debt. But if there is one glimmer of light bursting through the market’s fog, it is that we are likely nearing the peak of this upward interest rate cycle. The Fed has signaled that, given tighter credit markets, it possibly won’t need to continue to raise the Federal Funds target rate after the expected increase in May. And, as noted, the long end of the interest rate curve has fallen. That’s not to say rates will be going down anytime soon, but the rise in rates that has destroyed values in both residential and commercial real estate is most likely coming to an end.
• Recession: The Fed finally said it – we’re going to have a recession. Despite that announcement, economists are still hotly debating this issue – if and when a recession will start, and its duration and severity. Accordingly, we have no more clarity on this despite the Fed’s confession. At the same time, manufacturing and retail spending have been slipping. Businesses and households are acting like a storm is brewing, and the folks in the trenches are usually right.
• Property Transaction Volumes: While the numbers are still coming in, early indicators suggest that deal volume plunged in the first quarter. According to Co-Star, apartment transactions fell almost 75%. On the lending side, CMBS issuance fell 80% in first quarter 2023 compared with first quarter 2022, per Trepp. Buyers don’t know what to pay and sellers are not willing to accept the new reality. This stalemate is self-sustaining, and the lack of trades makes price discovery impossible. At the same time, smart money isn’t going to invest when values are falling, so capital remains on the sidelines.

Cloudy with a Chance of Defaults

The key reason for low transaction volume is that property prices have yet to adjust to the new interest rate regime. The current riskier environment requires higher risk-adjusted returns. But using historical pricing when the cost of capital has doubled derives even lower returns and new deals can’t work. Although it is clear capitalization rates are rising, they are still below debt rates, creating negative leverage. And with rental rate growth slowing, there is no way for investors to dig out of that hole. Unfortunately, the only way to get things moving again is for property values to fall.

All the real estate pundits are projecting how far those values will fall. The Green Street CPPI: All-Property Index indicates that, across property types, through March values are down 15% compared to the prior year. Not surprisingly, office is down the most – 25% – with multifamily a close second at 21% (an unpleasant surprise) and malls taking third place at 19%. Before this cycle is over many believe values will fall between 25% and 40%, depending on asset and market, with the office sector taking the hardest hit. That’s a lot for an owner to swallow, and as in past down cycles, it will take a long time to understand how far values will fall since no one will sell unless they absolutely must.

This gloomy forecast was turning off lenders even before the mini banking crisis in March. Based on the most recent Fed survey, 69% of domestic banks were tightening credit standards on construction and land development loans, and about 57% of banks were tightening credit standards on multifamily and commercial real estate loans. In contrast, a year ago banks were generally neutral-to-positive about lending to the sector. These surveys were taken before the mini crisis, which has made credit committees even more skittish about lending to any business, particularly loans secured by assets with falling values. To be clear, the episodes with Silicon Valley Bank and even First Republic and Signature had nothing to do with their exposure to commercial real estate. What we learned in that unsettling week was that in a world of extraordinary connectedness and social media, a run on a bank can happen faster than ever before and if management hasn’t stuck to the basic knitting (like matching asset and liability duration) really bad things can happen quickly. The upshot is that many banks on which our industry has heavily relied are hoarding cash.

Are we in the calm before the storm? Several prominent real estate players believe the second shoe is yet to drop and exposure to real estate could be a precursor to a significant banking crisis within the next year. We need to be careful about such predictions as they, like rushing to pull deposits, can become self-fulfilling. The exposure of the banks to the sector is significant as they hold about 50% of all multifamily and commercial real estate debt (not the 80% some have erroneously reported). But in thinking about the trouble yet to come from falling property values and a significant wave of loan maturities over the next two years, one could divide the distress between situations resulting in a problem for the equity – the owner(s) – and situations resulting in a problem for the debt – their lenders. And that all depends on how far values fall vis a vis the loan balance. In the last few years underwriting was strict, with most loans, particularly from banks, at a 60%-70% loan-to-value ratio (LTV). That means values could fall 25% and the problem is with the equity, not the debt. The owner either funds the deficit, calls capital from its investors, or seeks out rescue capital, which is out there in abundance albeit very expensive. These situations can be fixed.

But when collateral values fall more than 25%-30%, or the original LTV was higher, owners are no longer in the money and the only reason to further fund the deal is reputational. We are seeing weekly headlines about major players defaulting on their loans and giving the keys back to the lender, and the problem hasn’t been concentrated in one market or just in the office sector.

What situations are most likely going to be debt problems and lead to additional loan defaults?

• As we’ve written about extensively, the office market is still suffering from long COVID and there are no remedies known to mitigate the mega trends of hybrid office usage, tenant rationalization of space, and the desire to be in amenitized, wellness-oriented buildings to attract and keep talent. Predictions of value drops range from 30% to more than 40% depending on the age and location of the building, putting the office sector squarely in the debt problem bucket.
• Most bank and debt fund loans are short-term paper funding a sponsor’s value-add business plan, known as transitional lending. If the plan began a few years ago, it is likely the sponsor achieved the desired rents and improved the value of the property. With an equity infusion, the loan may be refinanced at current rates. But if that value-add play began just as the cycle was turning, the sponsor may not have had sufficient time to achieve the anticipated rent increase before the loan matures. Some banks may be protected by their strict underwriting, but some debt funds were providing 75% to 80% LTVs on transitional loans, and the probability of default is much higher.
• With interest rates still rising, those with floating-rate debt that is not sufficiently hedged are finding it harder and harder to make ends meet. Many are biting the bullet to pay for hedge renewals that wipe out distributions to the owner for the remaining term of the loan. Some are calling capital from investors in an effort to fund the equity gap as they refinance into new fixed-rate debt. But many floaters, depending on the leverage and the performance of the property, will become debt problems prior to their maturity.
• Another category of deals likely to move from equity to debt issues are private equity fund or syndicated deals where there is the potential to solve the issue through a capital call but the fund or sponsor promote is already worthless and they are unwilling to further invest time or capital in the deal. As in any downturn, the interests of general partners and their limited partner investors are not always aligned.

Owning leveraged real estate has aways been akin to owning an option to buy that real estate from the true owner – the lender. Once the option is out of the money, the lender may have to take control of the property. We are likely to see a lot of defaults strung out over the course of the next couple of years, as loans mature when property values are below their strike price.

The first quarter did little to bring clarity to the multifamily and commercial real estate investment market. On the contrary, more market participants who remained optimistic in January have now realized that the down cycle is here to stay and few are immune. The good news is that most properties, with the exception of office, continue to perform reasonably well. While rent growth has slowed and operating costs are rising, the real culprit is the higher cost of capital. With interest rates still going up and values a mystery, the fog is thicker than before, and transaction volume will likely remain low as property owners attend to their wounds.