Archives for October 2023

Banks — historically the primary lender to commercial real estate — are pulling back significantly on their lending activity within the sector.

It’s creating ripple effects that are already dampening a broad range of activities within commercial real estate, including new development and refinancing.

Compared to August 2022, loans on nonresidential properties declined 3.8% in September 2023, CoStar Group Inc. (Nasdaq: CSGP) recently found.

After reaching 18.2% annual loan growth in the first quarter of 2023, the pace of expansion in the past six months has declined rapidly, especially among smaller lenders.

That comes at a time when an estimated $1.9 trillion in commercial real estate loans will mature in the next four years — 47% of which are on bank balance sheets, according to CoStar.

Some 20% of that $885 billion on bank balance sheets maturing soon are tied to office properties, which’ve seen their values slashed in the wake of higher interest rates, sluggish new demand for office space and tenants downsizing or exiting office buildings entirely.

Several banks have stopped lending to office real estate while others are preparing for losses in commercial real estate.

Chad Littell, national director of capital market analytics at CoStar, said banks are most acutely concerned about their office loan portfolios, with some buildings seeing as much as a 30% value erosion since the pandemic.

“That’s a property type they don’t want to touch right now,” he said.

But, Littell continued, it’s likely banks will raise their scrutiny on other property types, too, including multifamily and industrial, which were red-hot real estate sectors throughout the Covid-19 pandemic.

That’s because, especially in multifamily, the underwriting for acquisitions in the past couple of years was based on double-digit rent growth — seen during the height of the pandemic — continuing into the future. But rent growth has slowed considerably this year.

RealPage Inc., which closely tracks the apartment market, found effective asking rents fell 0.3% in September from the month prior. Year-over-year rent growth that month was only 0.1%, compared to 9% in the prior one-year period. In the West and South regions of the country, rents have actually declined — 1.1% and 0.8%, respectively — on an annual basis.

Flatlining or rent declines are attributed in part to the record amount of new construction coming to market, especially in places like the Sun Belt. New apartment completions in the third quarter totaled more than 128,000 units, the highest level in more than three decades, according to RealPage.

“Banks are starting to say ‘We need to watch this, let’s be more cautious about the loans and the refinancing we’re doing,'” Littell said, of the multifamily sector.

How banks are reacting to CRE slowdown

While there have been some examples of banks selling off parts of their commercial real estate loan portfolios, there haven’t been a lot of those deals so far, he added. Most banks are still focused on how to manage the loans on their books right now, Littell said.

There also remains some dislocation with pricing, particularly within the office sector, as few buildings — especially ones facing rising vacancy and value deterioration — have sold since the pandemic.

Mike Santomassimo, chief financial officer at San Francisco-based Wells Fargo & Co. (NYSE: WFC), referenced a lack of office trades during the bank’s Oct. 13 third-quarter earnings call.

“There’s a few in certain cities, and they’re all a little bit different in their complexion,” he said. “So you still have somewhat limited information in price discovery in a lot of places. And so we’re doing … we do a lot of our own work to try to evaluate each of the underlying properties and what they could be worth in a bunch of different scenarios.”

He continued, saying it feels like the appraisal market is starting to catch up, with appraisals that are “more realistic and more updated.”

“So that’s certainly bringing in different data points as we look at it,” Santomassimo continued. “And, as we looked at the quarter, we sort of look at all those data points and the underlying loans and try to do our best to come up what we think the different range of loss could look like.”

Wells Fargo’s allowance for credit losses increased $333 million in the third quarter, primarily for commercial real estate office loans.

Another major commercial real estate lender, New York-based The Goldman Sachs Group Inc. (NYSE: GS), reported net losses of $212 million in equity investments in the third quarter. The bank attributed that largely to markdowns on investments in commercial real estate.

The bank also said it’s either marked or impaired down its commercial real estate exposure by about 50% this year.

Denis Coleman, CFO at Goldman, said during the bank’s Oct. 17 earnings call it started 2023 with about $15 billion of commercial real estate alternative investments, which have since been reduced by about $5 billion. He said the bank intends to continue to move down its exposures.

Since the fallout from the pandemic, many lenders have opted to give short-term extensions to their borrowers to give time for the economy and the office market to recover. But there’s skepticism about whether many office buildings facing distress will ever recover.

With banks pulling back from commercial real estate, borrowers are instead having to consider debt funds or preferred equity as stopgap measures at refinancing, Littell said. But higher interest rates mean higher borrowing costs, including for those short-term solutions.

To get the full picture of fallout for banks from commercial real estate, and vice versa, will take many quarters, if not years. Leases and debt on commercial properties are typically long-term deals, and — in the event more lenders move to foreclose on properties — those processes take a long time to work through.

Littell pointed to the global financial crisis, when commercial mortgage-backed securities delinquencies didn’t peak until 2012, years after the onset of that economic recession.

“The reality is, these are multi-year processes,” Littell said. “(We’re at) the beginning stages of this, but I don’t think any property type will be spared from a commercial real estate downturn.”

Source: “Banks have pulled back from office real estate but no CRE sector ‘will be spared‘”

Multifamily remains the most attractive asset class in commercial real estate, with industrial and self-storage not far behind, according to Leo Leyva, co-chair of the Litigation, Real Estate and Real Estate Special Opportunities departments at the law firm Cole Schotz.

“Multifamily is your ‘favored nation’ asset class for investing. Lenders of all types — institutional, private equity, banks — offer construction and exit loans,” Leyva tells GlobeSt.com. “Industrial and self-storage are also performing well, but their growth has slowed a bit lately.”

Key multifamily markets where we’re seeing continue growth are the familiar ones: the Southwest, Carolinas, Tennessee – “places where people want to move to and live and get away from all the craziness in the blue states. Jersey City has also been hot along with some boroughs in New York.”

Jersey City has also been a top performer, along with some boroughs in New York, Leyva said. “Offices and condos in New York have been a sugar show. The world is upside down.

“Loans are maturing and there are few investors who are there to pony up the money to take them on. If they do, it’s a short-term arrangement and a hope and a prayer.

“You see landlords like Brookfield, Blackstone, RXR, CIM and others giving buildings back. Other Investors/Owners are thinking, ‘Hey, I can do that, too.’ ”

Restructuring deals have also once again been involved in lender traunch warfare, Leyva said. “You can have Lenders in the capital stack fighting among each other to gain leverage,” he said.

Lenders today, for the most part, including platform lenders, are taking a wait-and-see approach, he added.

“You hear people talking about foreclosures creating good opportunities, but we’re not seeing that, yet,” Leyva said. “We’re seeing a little bit of chaos here and there, where pieces of deals get done on an asset-by-asset basis, but nothing is moving in big ways.”

For things to get better, “we need real changes, overdue changes in zoning, use, and regulations,” Leyva said.

Source: “Multifamily Remains a ‘Favored Nation’ CRE Asset Class“

Like many investors, your clients may have concerns about the current economic landscape. Persistent inflation has been frustrating, and higher interest rates have increased the cost of borrowing. Many forecasters have predicted a recession in late 2023 or in 2024, an economic downturn that would surely impact investment portfolios.

Clients may be asking questions (even if they’re not asking you), wondering if they should be making adjustments to their portfolios. Preparing clients for the three risks of inflation, volatility and recession is something you can address. In these “moments that matter,” it’s wise to have a plan designed to protect client portfolios.

Risks facing investors today

Persistent inflation has likely affected nearly everyone in the United States. But it also has an impact on investment portfolios.

Inflation can reduce real returns on fixed-income investments like corporate and municipal bonds. These investments provide a fixed-income stream in the form of interest payments. Because the income stream remains the same until maturity, the purchasing power of the interest payments declines as inflation rises.

Persistent inflation challenges the traditional 60/40 portfolio allocation approach, a strategy based on the relationship of stocks and bonds. During inflationary periods, lower risk asset classes like bonds may actually offer less diversification. Bonds can become more closely correlated to stocks when inflation persists, as investors experienced in 2022.

Inflation can also contribute to volatility in stock prices. Because stock prices are influenced by companies’ future earnings, rising costs can hurt corporate profit margins, resulting in falling stock values.

As inflation creates uncertainty about the direction of future interest rates, market growth can become impeded. As we’ve seen, inflation may prompt the Fed to raise interest rates. As higher interest rates discourage business borrowing, fears about the economy can contribute to reduced capital investment and negative market outlooks. Inflationary pressures and the aggressive pace of monetary tightening by the Fed also raise the risk of an economic downturn.

Persistent inflation and rising interest rates could ultimately drive the economy into a recession—which likely means decreased stock values, as companies struggle to maintain profitability. Recession-driven poor results and lackluster corporate earnings can result in negative investor sentiment, and a flight to safety by investors, pushing stock prices down.

All these developments conspire to weigh on investor portfolios, which could result in potentially negative returns. When markets are performing poorly, clients’ portfolio values can decline, giving clients the sense that they aren’t making progress toward goals and those goals seem harder to achieve.

Manage the risks with enhanced diversification

One effective response to concerns about economic uncertainty—whether inflation, volatility, or recession—is to diversify. Specifically, diversify across asset classes beyond traditional, publicly-traded stocks and bonds.

Proactively adjusting portfolios and reallocating assets to enhance current diversification may be a prudent strategy to consider. The idea is to combine multiple asset types—in other words, going beyond the 60/40 portfolio—in an effort to reduce volatility for a target level of return.

The potential benefits of private multifamily real estate in protecting a portfolio

In our opinion, risks like inflation, volatility and recession make real assets, such as real estate, more attractive as a source of returns and a means to diversify a portfolio. While some commercial real estate sectors, like office buildings, have struggled with challenging market headwinds, multifamily real estate has enjoyed strong fundamentals that enable it to continue to outperform.

Multifamily real estate can provide a counterbalance to market volatility, a hedge against inflation, and help recession-proof a portfolio. And the sector is benefiting from steadily growing demand and a limited supply pipeline, which is generating a higher cash flow outlook and better overall performance than other asset classes.

Advantages that are intrinsic to multifamily properties have the potential to make them one of the strongest and most attractive alternative asset classes. And as the multifamily real estate sector has demonstrated resilience during times of market stress, investing in multifamily real estate can be an attractive way to help diversify client portfolios and enhance returns while seeking to grow long-term wealth.

Private multifamily real estate provides several advantages that may be valuable for investors:

• Inflation hedge. Historically, multifamily real estate has been a strong portfolio buffer against the effects of inflation. As the cost of living rises along with workers’ salaries, rental prices also typically rise. Because multifamily uses relatively short lease terms (typically 12 months) that are renewed on a rolling basis throughout the year, operators can raise rents as needed to adjust to inflation, resulting in an increase in cash flow that keeps pace with inflation. The U.S. Bureau of Labor Statistics’ CPI data shows that, since 2017, apartment rents have significantly outpaced overall inflation rates.
• Recession protection. A recessionary environment increases the attractiveness of multifamily investing. Even in times of economic distress, people are likely to prioritize their housing costs. Shelter is a basic human need and multifamily occupancy rates have historically remained steady throughout all market cycles. The average occupancy rate for multifamily properties over the last five years, for example, has averaged 94%. Renters are disinclined to relocate amidst economic uncertainty and remain in rental housing longer. As people look to rebuild credit following a recession, there can be a prolonged demand for multifamily rentals. As renters are priced out of homeownership by high real estate costs and rising mortgage rates, rental housing becomes more in demand.
• Enhanced diversification. Commercial real estate, including multifamily, has historically low correlation to the stock and bond markets. As a result, during market stress, while other investments may be experiencing heightened volatility or sharp declines, multifamily income streams tend to hold steady. And within multifamily investment structures that hold dozens of properties in different geographic locations, diversification is further enhanced, lowering overall investment or portfolio risk profile.

Don’t overlook this diversification strategy

As inflation persists, markets become volatile and forecasts threaten a potential recession, seeking investments that provide consistent, reliable income becomes critically important. Multifamily real estate investing has the potential to provide a variety of benefits that make it an attractive addition to a well-diversified portfolio.

Source: “How Advisors Can Address the Risks Currently Facing Client Portfolios“

Interest rates play a pivotal role in commercial real estate, as they have a profound influence on investment decisions and market dynamics.

The commonly held belief suggests that low interest rates are favorable for investors because they often reduce borrowing costs and increase the feasibility of real estate projects. However, through my work in the commercial real estate investment space, I’ve found that higher interest rates, despite their initial deterrent effect, can offer advantages for savvy commercial real estate investors as well.

The Common Perception Of Low Interest Rates In Real Estate Investing

In the realm of real estate investing, there exists a widely accepted belief that low interest rates are the ideal conditions for investors. This consensus is rooted in the fundamental economic principles that govern the real estate market. Low interest rates, as I mentioned above, can help reduce borrowing costs for investors. As a result, they often encourage more individuals and businesses to seek financing for real estate ventures, thereby stimulating demand within the market.

Additionally, I’ve found that low interest rates tend to propel property values upward, which creates an environment where real estate assets appreciate in value over time. The historical context of low interest rates plays a pivotal role in shaping this perception. In my experience, periods of historically low rates tend to coincide with surges in real estate investment, as investors often seize the opportunity to leverage their capital for maximum returns in a climate of reduced borrowing expenses.

Additionally, I’ve found that low interest rates tend to propel property values upward, which creates an environment where real estate assets appreciate in value over time. The historical context of low interest rates plays a pivotal role in shaping this perception. In my experience, periods of historically low rates tend to coincide with surges in real estate investment, as investors often seize the opportunity to leverage their capital for maximum returns in a climate of reduced borrowing expenses.

The Underestimated Benefits Of High Interest Rates

It is imperative to acknowledge the often-underestimated advantages of high interest rates. I find that high interest rates can actually contribute to a stable investment environment. They act as a natural deterrent to speculative behavior and discourage investors from engaging in risky endeavors that might inflate property prices to unsustainable levels. Consequently, this can help mitigate the likelihood of market bubbles and abrupt crashes, which fosters a healthier and more balanced real estate market.

Additionally, high interest rates tend to influence pricing and market conditions by restraining excessive demand, which can prevent property prices from soaring to unaffordable levels for most investors. While initially perceived as unfavorable, high interest rates can serve as a safeguard against market volatility and excesses, which helps ensure a more sustainable landscape for commercial real estate investors.

Risk Management In High Interest Rate Environments

Investing in commercial real estate during periods of high interest rates necessitates a strategic approach to risk management.

One key strategy is to prioritize conservative financing practices. This might entail employing financing structures that shield investors from interest rate fluctuations, for example.

Proper due diligence is paramount in such environments as well. Conduct a meticulous examination of market conditions and property fundamentals to help identify investments that are resilient in the face of higher borrowing costs. I want to emphasize the importance of stress-testing investment scenarios to assess their viability under potential interest rate hikes.

Notably, I’ve observed that experienced investors often see high interest rate environments as opportunities rather than obstacles. They might capitalize on distressed asset sales or negotiate more favorable terms with motivated sellers, leveraging their expertise to identify value and capitalize on market inefficiencies.

Balancing Act: The Investor’s Perspective

Investors in commercial real estate operate within a dynamic landscape where interest rate fluctuations are a recurring theme. Their approach is often a delicate balancing act that requires a nuanced understanding of the market. Successful investors recognize the significance of comprehending market cycles and adapting their investment strategies accordingly. They appreciate that low interest rate periods can offer attractive financing opportunities but may entail higher property valuations, while high interest rate environments can present challenges and opportunities for value acquisition and income generation.

Real-world examples abound of investors who have navigated these fluctuations adeptly. Some have diversified their portfolios to hedge against interest rate risks, while others have strategically timed their acquisitions and dispositions to maximize returns. This adaptability, coupled with a keen understanding of the broader economic landscape, underscores the art of commercial real estate investment. Striking the right balance between risk and reward is paramount to long-term success.

High Interest Rates And Portfolio Diversification

High interest rates can play a pivotal role in diversifying an investor’s portfolio. By embracing the challenges posed by higher borrowing costs, investors are often motivated to explore a broader range of investment opportunities. This might include considering properties with varying financing terms, such as shorter-term loans, or properties that have already been paid off. Diversification across different property types, locations and financing structures can offer multiple benefits.

Firstly, it spreads risk, which can help reduce the potential negative impact of interest rate fluctuations on the entire portfolio. Secondly, it can enhance the resilience of the portfolio against economic downturns, as different properties may perform differently in varying market conditions. Lastly, diversification can create a more stable income stream by balancing properties with different lease expirations and rent escalations. Over the long term, a diversified portfolio can provide investors with more stable and consistent returns, making it a valuable strategy in the realm of commercial real estate investment.

The Role Of Economic Factors And Future Outlook

Economic factors and government policies wield significant influence over interest rates, making them pivotal variables in the commercial real estate equation. Central banks often adjust interest rates as a tool to control inflation, stimulate economic growth or curb speculation. Consequently, understanding the interplay between these factors and interest rates is crucial for real estate investors.

Looking ahead, potential future scenarios for interest rates remain uncertain. For investors, this uncertainty necessitates a proactive approach to risk management. Strategies such as maintaining flexible financing options, staying well-informed about economic trends and diversifying portfolios can help buffer the impact of changing interest rate environments. By carefully monitoring economic developments and adapting investment strategies accordingly, investors can navigate the evolving landscape of commercial real estate and position themselves for long-term success.

Source: “What High Interest Rates Mean For Commercial Real Estate Investors“