Manus Clancy is head of data strategy at LightBox
The question on every CRE professional’s mind as we reach the end of Q1 2024 is ‘when will the market return to normal.’ As one market watcher noted earlier this month, ‘we’ve been pushing on a string since June 2022. That’s a long time to be grinding it out.’
We couldn’t agree more. Nearly 24 months is a long time to be stuck in first gear and everyone from lenders to brokers to property owners are clamoring for a return to the normalcy of 2019. Of course, everyone would love to return to the go-go times of 2021 and early 2022, but we will all settle for pre-pandemic levels of activity.
For those that spend time on the social media highways, the debate on when that CRE recovery may come is as divisive as the political environment right now.
On the bearish side are those that believe the problems in the office market have only just begun and the “noise” (to use Mohamed El-Erian’s term that was rolled out at MBA last night) will slow a recovery considerably.
On the other side – we can’t call them bullish…we’ll call them less concerned – are those that believe interest rate cuts are coming and distressed asset sales are already taking place. Some investors are starting to put their money to work, with Goldman Sachs Asset Management and Schroeders looking to deploy capital in U.S. commercial real estate, according to Reuters.
As we hit the end of Q1, we’ll peel back the reasons for both pessimism and optimism.
Reasons to believe a CRE recovery will take more time
There are several reasons that the CRE pessimists’ predictions for the rest of 2024 could be correct.
Conditions in Broader Financial Markets Have Not Done CRE Any Favors: Part of the reason for optimism for CRE is that interest rate cuts are coming. But those cuts are conditioned on U.S. financial data not running overly hot. This month’s CPI and PPI numbers – hotter than expected – will keep property on the Fed to be patient with interest rate cuts. In addition, the fact that unemployment was still below 4% as of February and the major U.S. stock indexes are regularly hitting new highs put pressure on the Fed to hold the line on interest rates.
The worst of all worlds for the CRE markets would be that every part of the U.S. market is humming along while distress is surging– giving the Fed no reason to cut rates and for CRE to be left to muddle through.
The “Noise” Isn’t Helping Either: In addition, we cannot dismiss the “noise” that El-Erian referred to. That noise is basically the drumbeat of negative headlines surrounding the U.S. office and multifamily markets. If those headlines result in U.S. lenders and potential buyers to perceive that they are taking career risk for betting on CRE, the recovery will be painfully slow.
Reasons to believe a recovery is coming
While there are ample reasons to be pessimistic about CRE, there are also several reasons to believe that now is the time to put money to work.
In Severely Distress Markets, Sales Are Taking Place and a Bottom Is Forming: There is no shortage of commentary now, that we are in the “early innings” – there’s a tired term for you – of the “office Armageddon.” To be fair, there may be many months of negative headlines surrounding the office market – headlines that may keep value from rebounding.
However, in many major cities, properties have moved from the discount bin to new ownership.
- Commercial Observer: D.C.’s Biggest Office Sale of 2024 So Far: PRP Closes On Market Square For $323M
That property sold nine years ago at $595 million - South Florida Business Journal: Miami-Dade Office Complex Takes Big Loss On $76M Sale
The Douglas Entrance office complex was sold in 2014 for just over $100 million. - Bisnow: Financial District Tower to Sell For 30% Of 2014 Price
The property at 222 Broadway in Lower Manhattan is ripe of office to residential conversion.
To be sure, no one is popping corks over prices that are 50% below peak levels. But the first part of any recovery is the forming of a bottom, and that has been taking place. Once would-be buyers start to see assets move, then confidence starts to build, creating more transparency and more confident buyers.
What can we expect from here? It would be Pollyanna to suggest the bottom forming is a precursor to a rebound in office values. There is likely no V-shaped recovery coming. A reverse check mark might be the best we can hope for – a sharp 45-degree decline on the left and a small uptick on the right.
The problems with office are, unfortunately, structural. Demand has evaporated thanks to the surge of remote work and quality of life concerns. So, any hope for a valuation bump is extremely premature. That means the recovery looks like an “L” – a sharp decline followed by a long stretch of flat.
But the fact that we are seeing properties trade means we are probably near the bottom of the L. That should mean more transactions are poised to place which will be music to the ears of brokers, lenders, appraisers and so on.
Lenders are Lending and Spreads Are Compressing: Another positive sign in the current environment is that lending has continued to take place. In the extremely painful CRE recessions (or depressions) of 1990 and 2008, lending dried up entirely for several years.
In the current CRE recession, lending – while constrained – has not stopped. The CMBS market has continued to push out deals, although at fraction of the 2021 pace.
Last week, Commercial Property Executive reported that BSP Realty Trust originated a $65 million loan to refinance the Wildwood Center office in Atlanta.
This goes to show that while there is fear, there isn’t panic.
In addition, in Q1 2024, CMBS risk premiums – spreads – contracted considerably up and down the credit curve. The tightening of spreads indicates that lenders are still willing to put money to work and is probably confirmation that as a group, they believe peak interest rates and risk premiums are behind us.
The availability of credit will be critical to any recovery.
Available Capital Seems Poised to Pounce: The combination of ongoing lending and distressed asset sales taking place is evidence that those with dry powder are eager to deploy their capital. It has been long noted that the amount of cash on the sidelines waiting to be deployed is at record levels.
This capital has started to be put to work via the distressed asset sales, and the pressure for those sitting on the sidelines to get to work will only grow as more sales are announced.
What about multifamily?
Those in the financial press have been conflating the problems around office with those of multifamily. They note the uptick in delinquent loans and conclude that the CRE crisis is metastasizing; the two are completely different issues.
Office is going through a 1,000-year drought. Demand is gone and there is no telling when it will come back.
The problems in multifamily are largely due to unforced errors. Yes, insurance premiums, labor costs, and utilities prices have skyrocketed, and buyers in 2021 could not have anticipated those factors.
But the use of floating rate debt, short-term maturities, and fanciful expectations for future rent growth were rookie mistakes (often made by rookies in 2021).
The good news for multifamily is that the problems are not structural. Supply is up, and that will keep a lid on future rent increases. But demand remains high. Unlike office, no one is expecting an epidemic of properties that are 70% occupied.
That means owners have good assets, but terrible financing and current cashflow, mostly as a result of using floating rate debt.
There is a readily available cure for this market: a reset in prices (which is already underway) and a replacement of floating rate, near-term maturing debt with longer fixed rate debt. Said another way, potential buyers don’t dislike these assets…they just are unwilling to pay what buyers were paying in 2021.
One more factor to think about in the multifamily sector is that peak buying mania occurred between July 2021 and January 2022. Most buyers that used floating rate debt used either a 2-1-1-1 or 3-1-1 maturity structure. This means – in the case of the former – that the borrower had an initial two-year maturity followed by three one-year extension options.
Locking in a rate cap at loan origination ensures protection against a run-away set of rate increases. However, as structured, that rate cap only lasts to the end of the first maturity – not for the entirety of the five-year loan. So once the two-year maturity is reached, the borrower has to pony up for another one-year interest rate cap – which could cost anywhere from 2% to 5% of the loan balance.
Since higher interest rates were eliminating all free cashflow, that meant a new cap had to be obtained via a capital call. Not only were all profits wiped out for GPs and LPs…they had to reach into their pockets to keep the property.
The good news is that anyone that bought in late 2021 and had a 2-1-1-1 has already been through the ringer. By the end of 2024, all 3-1-1 borrowers will similarly have either fought to keep their properties or thrown in the towel.
Once we get past the end of the year, there should be fewer and fewer borrowers left to be walloped by maturing loans and expensive rate cap costs. At that point, we should start to see the uptick in distress start to reverse. This will be even more true should the Fed cut rate two or three times in 2024.
So, a little love for both the bears and the bulls in our Q1 commentary.
