Banking crisis? Sky-high interest rates? Lessons for the commercial real estate sector.
Increasing interest rates, offices that can’t seem to get people back in, we thought the real estate sector had it all. And then, the banking crisis hit, started by SVB, but without an end in sight for now. What does that mean for real estate investors in the near future?
I spent the last couple of days at the PREA conference in Seattle, where leading lights such as Mohamed El-Erian and Ian Bremmer gave their view on the economy and geopolitics, together with some of the main real estate developers, investment managers, and pension plans. Here are my main takeaways:
1. The banking crisis affects the commercial real estate sector through more restricted lending, driving up the cost of capital, and potentially leading to refinancing issues. In the short term, this will lead to lower real estate valuations. In 2022, 22% of commercial real estate debt came from regional banks -- that source will become smaller, while large banks are getting more careful at the same time.
2. The banking crisis will especially affect real estate development lending, given that much of this lending is done by smaller, regional banks, that are now more constrained through a combination of reduced deposit inflows (if anything: deposit outflows) and reduced risk-taking in lending.
3. Inflation will remain high for the foreseeable future. The initial, post-COVID, demand-driven bout of inflation (wrongly assessed by the FED and other policymakers as “transitory”) has made way for supply-driven inflation. Think: deglobalization means we’re not getting the cheapest good anymore, companies are prioritizing resilience of supply chains over efficiency (as in: reshoring supplies, driving up costs), and the ultra-tight labor market means that wages will continue to increase. As such, inflation is now structural rather than cyclical.
4. Central banks are fighting on three fronts (going from a dilemma to a trilemma): reducing inflation, maintaining economic growth, and ensuring financial stability. While this week’s rate hikes in Europe and the U.S. still went through, the expectation is that the ECB and FED rates are near their peak, with potential room to be lowered in 2024. This, of course, is good news for real estate investors. But don’t start celebrating just yet: the mantra “lower for longer,” coined as recently as a year ago to describe the state of interest rates, has been replaced by “higher for longer.” As commercial real estate loans reset over the next years, investors will ultimately face significantly higher borrowing costs. Indeed, check out current commercial real estate borrowing costs from different types of lenders -- auch, that hurts!
5. The office market is in the doghouse, while tenant demand remains strong for retail, apartments, industrial, and more exotic property types such as cold storage. The decrease in office demand is estimated to be 35% (according to Hines), but that average hides the bifurcation of the market that delineates “good” from “bad.” Trophy assets in good locations, with green and healthy credentials, are performing well. But for the remainder of the sector, office today is where retail has been for the last decade…and that's not a pretty place to be.
6. The reset in commercial real estate values has yet to take place at a large scale, but is unavoidable given increased interest rates (the primary driver), in combination with decreased demand (in some places, including Seattle, one should be worried above the massive supply of office and apartment space that is still coming to market). Headline valuation decreases:
- Office: 30% for high-quality space in good locations, 70% (!) for space in secondary markets.
- Multifamily: 20% across markets, more in markets w/oversupply. Demand remains strong given that high interest rates prohibit access to capital for prospective homeowners.
- Industrial: 30% across markets. Even though cap rates are coming off record lows (3% for good quality space), forcing a revaluation, the good news is that robust demand for space keeps increases in rents at double digits. For ARES, a behemoth industrial owner, the average year-over-year increase in rents is >15%.
- Retail: Stable. Much of the pain has been taken in this sector, and positive leverage can still be had for most types of retail.
7. The current environment means opportunities in the real estate sector are starting to appear. Think: developers with difficulty in refinancing projects. Investors that need mezzanine financing to bridge the financing gap (values have decreased, debt service is higher), pension funds have to dispose of assets due to liquidity or overallocation, office assets defaulting on loans due to extensive vacancy (office-to-resi transformations are the name of the game, challenging as it may be).
8. Sustainability is a word that investors, even the most aggressive private equity folks, now dare to say. But as in the equities and fixed income, “ESG” has become convoluted. Reducing carbon emissions is on everybody’s mind, driven by regulation, capital providers, and sometimes tenants. Beyond that, diversity, equity and inclusion (DEI) remains an important topic, that is in need of well-defined metrics. The same holds for the “S” in ESG.
One more thing: where are things going beyond the next 12 months? The head of machine learning of Nvidia gave some stellar insights into the impact of AI on our lives. While we will always need space to work, live and play, the type of space we’ll need is constantly changing. The rise of ChatGPT and regenerative AI means that demand for office space will continue to decelerate, as lower-level office jobs will disappear. The good news is that, as AI moves from the online world to the “real” world, some of the labor shortages plaguing the commercial real estate market may be reduced. Think: robots in stores (Seattle features Artly coffee stores operated by robots), robots in senior housing, and perhaps, the robotization of real estate construction.