Archives for August 2023

Signs are emerging that the market is bottoming, and sales volumes will increase moving forward. There is a lag between offerings and closed transactions, so this recovery is likely another quarter away, according to a market update report from Colliers.

Multifamily volume increased slightly quarter-over-quarter, suggesting it has bounced from its low point, Colliers said, while “the tailwinds of demand and undersupply of housing remain strong drivers of a multifamily investment thesis.”

Nonetheless, it remains the top asset class for volume, though it has seen the most significant pullback in activity year-over-year.

However, San Francisco and San Jose are trending higher volume-wise.

Office sales activity picked up marginally in Q2, but levels remain below pandemic-era lows.

“While investors are avoiding this asset class, savvy ones have opportunities to capitalize on the market dislocation,” Colliers said.

Investors are targeting stabilized returns in the 10% to 12% range. Some are acquiring assets on a price-per-pound basis. Central business districts have declined the most in price due to “higher uncertainty.”

Average cap rates are at 7.1%, the highest they have been since 2013.

Transactional cap rates are settling closer to 8%-10% for stabilized, non-trophy assets.

“High vacancy properties are trading at substantial discounts to prior valuations due to a lack of income,” Colliers reported.

Industrial volume has normalized, following a strong run. Relative to other asset classes, industrial is the most liquid, with volume topping office and retail combined in the quarter, according to the report.

In Q2, volume was 11% higher than the previous quarter.

“Strong fundamentals and significant mark-to-market rent upside continue to attract investors,” Colliers said.

Los Angeles and the Inland Empire now boast first and second place, with volume down 17% and 10%, respectively, as Dallas fell from No. 1 to No. 5 after it dropped by 70% in the second quarter.

Retail is ahead of pandemic-era lows, coming in at $9.5 billion for the quarter as cap rates have been more stable across retail than other asset classes, Colliers said.

“Despite decades-high inflation, growth has consistently outperformed expectations, and retail spending has been robust,” according to the report.

This will last as long as the US stays out of a recession, Colliers said.

Hospitality is overperforming, with price appreciation quarterly and annually, per MSCI. Travel demand remains robust, propping up fundamentals and driving RevPAR and ADR.

Nonetheless, its sales volume overall is the lowest among CRE asset classes at $5 billion, which is below its Q1 number.

“Hospitality offers compelling fundamentals, with daily rates mitigating inflation as opposed to long-term leases,” Colliers said. “Financing constraints are significantly reducing near-term supply additions. Lodging remains a unique asset class that’s performed well through a volatile market.”

Source: “CRE Sales Volumes Show Signs of Life in Q2“

How high CRE debt costs became the norm

Commercial real estate participants that have enjoyed a long run of abundant low-cost capital are now facing a new reality. Owners, investment managers and developers across North America are reeling from a shifting landscape where debt financing is more expensive and more difficult to source.

Central banks around the world began hiking key benchmark borrowing rates in 2022 in an attempt to cool high inflation. In the US, the Fed moved aggressively, raising rates 11 consecutive times over the span of 17 months. The result was a seismic shift in the federal funds rate from near zero to between 5.25 and 5.50 percent at the end of July 2023. The Bank of Canada has been on a similar pace with a series of increases since March 2022 that have raised its key interest rate to 5 percent.

The challenge of higher debt costs has been compounded by banks pulling back on lending. With the failure of Silicon Valley Bank, Credit Suisse and others early in 2023, US banks are coming to terms with the potential credit quality deterioration that could come with a potential recession, expectations of more stringent capital requirements from the Fed, or the unanticipated exposure from CRE loans they would have considered to be stable a year ago. According to Oxford Economics, banks that have begun to sell off loans over the past several months are an indicator of the impact from tighter credit conditions and concerns about the CRE concentration risk within their loan portfolios which represent about 40% of the commercial and multifamily mortgages in the US. The firm’s economists believe there could be a stronger pullback in CRE lending in the second half of 2023.

Managing higher CRE debt costs

CRE industry participants are now dealing with the pressures of higher capital costs and tighter liquidity in managing existing portfolios and sourcing capital for acquisition and development strategies. Altus recently surveyed several CRE finance professionals to hear more about the specific financing challenges they’re facing, and how they’re adapting to market conditions.

Cost of carry taking a big bite out of returns

A significant challenge for CRE firms is maintaining portfolio performance in a higher interest rate environment while managing exposure to other market risks. According to one CRE Managing Director, “Lately, our main obstacle has been ensuring that our portfolio meets the targets set for our investors, especially with the rise in interest rates over the past year… It’s been a large challenge in the general steepness of the yield curve, and the cost of carry for the portfolio has not helped either. So while our investments have performed, we’ve lost a significant amount of return.”

To mitigate the risks associated with higher interest rates, CRE firms are exploring various strategies to enhance performance. By analyzing market scenarios and sensitivity at different levels of the portfolio, financing teams are getting a better understanding of how interest rate fluctuations and other market risks affect their investments. This data-driven approach allows them to make more informed decisions, adjust their debt management strategies proactively, and optimize financing.

Weathering floating rate debt

CRE firms that have a high proportion of their portfolio financed by floating rate debt have taken a bigger hit from rising rates, especially if they did not have interest rate caps in place or their rate caps expired. “We’re refinancing a fair bit of our floating rate debt when spreads have widened up or the Canadian prime lending rate is up. But it’s becoming increasingly difficult to secure no matter what type of loan, although we can pursue numerous avenues. So, I think the challenge of dealing with those maturities is weighing,” said one EVP of Finance at a large CRE firm in Canada.

CRE firms are now keeping a closer eye on the balance between fixed-rate and floating-rate debt in their investment portfolios to lessen the impact of increasing interest rates. By strategically managing the mix of fixed and floating rate debt, they can mitigate their vulnerability to interest rate fluctuations. This approach is crucial in safeguarding the portfolio’s performance and financial stability during dynamic market conditions.

Refinancing maturing debt

The ability to refinance maturing debt is a growing concern. Some industry research estimates that a staggering $1.5 trillion of US commercial and multifamily debt matures before the end of 2025. “Our biggest challenges as it relates to debt management from a holistic, high-level perspective is refinancing maturing debt that is coming due in the near term given the volatility that we’ve seen in the capital markets and the rising interest rate environment,” said one Senior Corporate Finance Director.

During uncertain recession forecasts on a macro level, it becomes even more challenging to find lenders and secure refinancing options. For the CRE firm, an additional hurdle is that some of its secured debt is backed by properties that haven’t fully recovered from the pandemic. The executive added, “We’re limited to a certain extent, working with our existing relationship banks to understand what’s out there from a fixed and floating rate perspective, balance sheet lending, securitized lending, and then also looking to tap the high yield institutional markets from a corporate level.”

To tackle these challenges, some CRE firms are calculating benchmark rates for their debt portfolio. This helps them figure out the ideal approach for refinancing their debt as it reaches maturity. By comparing their rates to relevant indicators and market trends, they can assess their funding options more efficiently and make informed choices about the most appropriate financing structures. This ultimately enables them to better navigate the punishing debt management landscape.

CRE sector searches for solutions to manage new debt financing challenges

In an interest rate environment where every basis point can move the needle on returns. CRE owners, developers and investment managers are trying to proactively manage debt by seeking new funding avenues, exploring various financing structures, and staying vigilant about market conditions. These crucial steps are helping CRE loan borrowers to survive and thrive in these dynamic and ever-changing market conditions.

Source: “Challenges with managing CRE debt in North America“

The good news for office landlords is that lease signings have been increasing this year.

More than three years after the beginning of the COVID-19 pandemic, the shift to remote work for many office workers has put the future of commercial real estate, and potentially city government budgets, on shaky ground.

One data and analytics group estimated that commercial property values are down 12 percent over the past 12 months, putting today’s values on par with those in May 2018. In comparison, residential home values are about 50 percent higher than in mid-2018.

The divergence in commercial and residential property values makes it hard to predict the fiscal consequences for local governments broadly. Total property tax revenue accounts for 30 percent of local general revenue, but the pain from this transition will likely be concentrated in major cities with big commercial districts.

For example, the decline in office values is projected to cost the District of Columbia $464 million in combined tax revenue over the next three fiscal years. Similarly, San Francisco could lose $150 million to  $200 million annually by 2028, about 5-6 percent of all current property taxes. In Boston, almost three quarters of its current total general revenues comes from property taxes; of that, more than half comes from commercial, industrial and tangible personal property (22 percent comes from office buildings alone).

Changes in workers’ expectations about the location of work and declines in urban population suggest these recent trends could be here to stay.  A recent academic study estimated that New York City could see a long-run decline of 44 percent in the value of office buildings, which equates to about $50 billion. This has prompted worries beyond the office real estate market. Overall, the authors approximate a destruction of over $500 billion in office value in the US.

Property tax data challenges 

Based on data from some large US cities, the property tax base of both commercial and residential real estate grew between 2019 and 2022, with the notable exception of New York. In Austin, Dallas, and Miami, the tax base for commercial real property actually grew faster than residential property.

However, commercial valuations can be a lagging indicator. Many leases are long-term contracts, so some leases signed before 2020 will be renegotiated over the next decade; a drop in demand for office space could further lower their value.

Although more workers have returned to the office, recent data suggests office occupancies hover between 40 and 60 percent in the largest cities. And local governments assess values on different schedules. Many governments have not yet accounted for recent changes in commercial property values in their tax data.

Cities also use different assessment methods that can limit the decline in tax collections from declining property values. New York, for example, uses net operating income submitted by owners of commercial buildings, rather than recent sales, to determine assessed value, and phases in those changes over five years. The city comptroller estimated that a “doomsday” scenario where office values decline by 40 percent between 2023 and 2029 would lead to a decline in property tax levies of 3 percent in 2027.

All of this could make it harder for cities to map out their fiscal futures.

Which cities are most likely to suffer from declining office values?

Of the 12 major cities I analyzed, Boston has the highest reliance on commercial property taxes. Taxes on commercial property account for almost 36 percent of its total general revenues. Dallas (26 percent) and Atlanta (19 percent) also have high reliance on commercial property taxes. In contract, commercial property taxes are less than 10 percent of general revenue in Phoenix (3 percent), Chicago (7 percent), and Charlotte (8 percent).

This analysis focuses on city-level government only, but school districts and county governments also rely heavily on property taxes, and could be even more impacted by a decline in commercial property values.

How will local governments react?

Unlike the federal government, cities face strict budget constraints and can usually only borrow to fund long-term capital investments, such as infrastructure. City governments will have three traditional choices.

One, they could increase the tax rate on commercial properties. This might raise revenue, but it could also increase the tax burden of commercial tenants and put further downward pressure on demand, exacerbating the core problem.

Two, they could curtail spending and services. This might help cities balance budgets, but it could potentially harm the city’s most vulnerable residents and make it a less attractive place to live and do business.

Third, they could make up for the shortfall by increasing tax revenues from other sources, such as residential property, sales taxes, or fines and fees. However, this could make these local tax systems more regressive.

Cities may get creative and try something new. But to do that, they must start planning now. We don’t have perfect data, but we know office values are falling, so major cities must find ways to become less reliant on commercial property taxes.

Source: “The Future Of Commercial Real Estate And Big City Budgets“