Time for a Commercial Real Estate Reset
I recently listened to a “CRE Insights” webinar with the chief economist for the CCIM institute, K.C. Conway, where he discussed the chilling effects that 10-interest rate increases in less than 18 months is having on the real estate and banking industries. Higher interest rates and larger mortgage payments put pressure on real estate prices which leads to lower real estate values. In addition, KC points out that there is $1.5 trillion of commercial real estate that will need to be refinanced over the next 18 months at higher rates. At these new rates many borrowers will not be able to make their payments based on the existing cash flow, especially in sectors that have increased vacancy rates, such as the commercial office market. Many banks have more loans at risk than funds available to cover these loans, as can been seen by their Texas Ratios over 5% (a measure that tracks bank’s credit troubles). These banks are at risk of failing for the same reasons as First Republic Bank. When Cap rates increase from 4-5% to 6-8%, then 25-40% of the value of a property is wiped out causing higher payments for borrowers, shrinking lines of credit, and an increased number of businesses failing in the past 3 months—creating a fairly bleak outlook for the economy.
Conway points out that there has been a decline in job openings, an increase in layoffs recently, and said that we are in a tough time, tougher than 2009 or the 1970s. He calls for action to let the Fed know rates need to come down and that they cannot raise rates 5% in less than 18 months without destroying the economy.
While Conway’s point of view is extreme, it does give one pause when considering real estate investment. However, if we look at long-term expectations, a dip in the economy can present many positive opportunities. The first positive outcome of a recession is to cool off inflation, so goods and services do not become unaffordable for lower income earners. It also forces some workers back into the labor pool, thus increasing the availability of the workforce, allowing businesses to have enough employees to meet demand. Additionally, any dip in real estate values creates a buying opportunity for investors with a long-term investment horizon.
The office market in urban areas will be the hardest hit by rising interest rates. We are already seeing the effects of workers not returning to the office causing large vacancy rates and increased borrowing costs that in return are causing some large real estate investors to walk away from their buildings and turn the keys over to their lenders. These companies and investors owe more than the building is worth and are mitigating their losses by forfeiting their assets to the bank. This puts pressure on banks to sell these assets to alleviate their losses and shore up their balance sheets. Since these assets are worth a fraction of what they were worth a few years ago, a new group of investors can buy them at pennies on the dollar and use the savings to rehabilitate the office space into residential space, or another use that is in higher demand.
While defaults and foreclosures can be financially devastating for investors, the economic cycle provides an opportunity for properties to be repurposed for their highest and best use based on current demand. If a significant percentage of workers continue to work from home, it is natural that we will need less office space and workers may look for larger homes with more room for a home office. A dip in the economy provides for a needed reset and could be a boon to current investors with a long-term investment horizon.
We can all agree that the world is changing more rapidly than it ever has. Advances in technology have led to increased food production, taller and more efficient buildings, and the global distribution of resources, all of which have allowed the population to grow to densities that our planet has never seen before. Technological advances have also led to new social habits, remote working environments, and changes to the way we gather and send information, messages, and news.
As society adapts to these new experiences, commercial real estate must change too. With more on-line shoppers, we have seen a decrease in big-box retail stores and an increase in warehouses to support storage and distribution of e-commerce. Many bricks and mortar stores that have closed have been repurposed for personal services and experiential businesses that consumers cannot partake in remotely. As we move towards a shifting economy, keep in mind that the difficulties we have today will lead to the change we need for tomorrow, a concept that holds true for many more areas of life than just real estate.
Dan Stiebel, CCIM