Archives for November 2023

Not long ago, industrial was the CRE darling. Valuations were high, as was demand. Rents kept escalating as problems with global supply chains and a rapid expansion of e-commerce drove unending demand.

Well, unending until now. Unusual situations that act as drivers are almost by definition temporary and will begin to relax. When they do, the extraordinary demand will probably slack. JLL’s Q3 U.S. industrial outlook observations of a collapse in capital market activity suggests that finally might be the case.

Year-to-date industrial transaction volume at $50.7 billion is down 52% from last year’s $106.3 billion at this point. And that’s with the second quarter seeing the Prologis $3.1 billion acquisition of assets from Blackstone. Without it, the drop would have been 55.2%.

Without that consideration, because big transactions regularly appear on the market, the annual transactions through the third quarter in 2023 was the lowest since 2017.

“Transactions with three to five years of WALT [weighted average lease term] remaining with a mark-to-market opportunity for rents continue to be in favor,” JLL wrote. “Core assets generally continue to have shallower bidder depth given the disconnect between going-in yields and appraisal marks. Transactions of scale (generally $150 million+ deals) without accretive existing debt are still more challenging in the market.”

JLL saw the runup in the yields of 10-year Treasurys as a big reason. Values have descended since the 4.98% high on October 19, but they still stand at 4.44% as of Friday, November 17. However, that represents nearly a 4.5% annualized return with as little risk as might be found in any investment. That creates uncertainty among investors, who “are evaluating their underwriting assumptions, with an increased focus on market rent and rent growth projections.”

Aside from the clear monetary influence, another factor is the realization that investors watch the performance of assets. Last week, Moody’s Analytics CRE noted an industrial slowdown in Los Angeles. In the third quarter of 2023, after months of there was a warehouse and distribution effective rent dropped by 0.6% quarter over quarter. “While no market took as big of a dip as Los Angeles in the third quarter, a few others on the West Coast have seen rent growths grind to a relative halt,” they wrote.

That is minor compared to what JLL observed, not in the sense of an overnight change, but in the picture of an ongoing trend.

“There was a notable decline in leasing volume in Q3 as only 90.1 million s.f. of leases were executed,” they wrote. The amount was the lowest not since the pandemic or immediately before, but since 2015. “Around half of the leases signed were new leases, with major markets like Chicago, Inland Empire, Los Angeles, Columbus, Atlanta, Phoenix and Baltimore all recording over 3 million square feet of new leases. Leasing decision timelines are being extended as occupiers are extremely judicious in decision-making while considering all options and outcomes before executing a deal.”

As leasing slowed and occupiers became more careful, the average contracted lease size dropped by 19.7% year over year. Subleases were up quarter over quarter, which was 8.1% of Q3 leasing figures, probably because there’s been an influx of sublease space, JLL says.

Source: “Industrial Sales Lowest Since 2017“

Data is starting to show that the multifamily segment is facing more pressure than perhaps many realized. Moody’s Analytics CRE recently brought up the question of whether it was time to worry about multifamily, based on September’s CMBS payoff rates.

“We were quite surprised to see a particularly poor September showing for Multifamily in our analysis of other property types,” they wrote. “Multifamily has had a very high payoff rate all year. Prior to September, only February (82.8%) and April (92.8%) have payoff rates below 95%. September came in at a stunning 71.7%. This was especially surprising on the heels of 3 of the 4 best payoff months of the year.”

Now Trepp, in a different approach, explains how multifamily, in addition to office, might have become a challenge to regional banks.

“Based on the Fed Flow of Funds data, Trepp estimates that $351.8 billion in multifamily bank loans will mature between 2023 and 2027,” wrote Emily Yue, a research analyst for the firm. “In this analysis, Trepp examines trends in criticized loans across U.S. multifamily markets, considering the impact of new developments on rental growth, along with factors like higher interest rates, tighter liquidity, and increased bank regulations, which have cast a shadow on refinancing options.”

Rating default risks from 1 to 9, where 1 is the lowest risk and 6 or above is considered a “criticized loan,” Trepp looked at metropolitan statistical areas (MSAs) and picked 10 MSAs with the largest outstanding balances of multifamily loans.

“There is significant variation in the share of criticized multifamily loans across geographies in the U.S., with some regions that have remained strong through the pandemic starting to show weakness on the fringes, and other regions that were heavily impacted by the pandemic showing signs of recovery,” Yue wrote. “Three multifamily markets saw decreases in the percentage of criticized multifamily loans from Q4 2021 to Q2 2023, and the rest saw increases. The majority of these metros have seen a delinquency rate that has hovered near 0.0%, with others showing increases or decreases in the rate.”

In a reversal of fortunes, some of the metros hit hardest during the pandemic are now showing strength while others that had strong rental demand there are showing weakness. And banks hold more than 30% of all the multifamily debt.

New York had a 31.0% rate of criticized loans in 2021 Q2. By the same period in 2023, the percentage was 16.3%, the largest drop off of any. Though this alone isn’t a guarantee of safety, as the delinquency rate rose from 0.9% at the end of 2021 to 1.9% in 2023 Q2.

An example of the second dynamic is the Phoenix region, which was a hot market during the pandemic. Asking rents in the first half of 2023 have been dipping compared to 2021 and 2022. Overall vacancies were at 9.3% at midyear, compared to the national figure of about 6%. Delinquency is still 0%, “but with over-supply and looming concerns of a recession, the spike in the criticized loan share is indicating perceived risk coming down the line for these loans.”

Source: “Multifamily Loans Pose Risk to Regional Banks“

Many office property owners are heading for the exits amid weaker demand and looming debt maturities, while opportunistic private equity groups are leaning in to capture what could be once-in-a-generation buying opportunities.

“This is a moment in time where there is a lot of distress and more distress coming. But that distress is going to create opportunities for capital to step [in], make some bets, and get really good risk-adjusted returns,” says Mike McDonald, a senior managing director in the Dallas office of JLL Capital Markets, Americas. The house view from JLL is that there will be opportunities to generate alpha returns in the office sector over the next five years.

The caveat is that it is a “stock picker’s” market, meaning that investors need to be very cautious and selective in choosing deals that have the potential to deliver outsized returns. “It’s not like it was coming out of the RTC [Resolution Trust Corporation], where you could have literally bought anything and made money,” says McDonald.

Investors tend to be cautious about buying assets in the right location and with qualities that not only meet the demands of today’s tenants but also the demands of capital from a liquidity standpoint. Buyers also are paying close attention to such basics as current cash flow, creditworthiness of tenants, and weighted average lease term. And the basis, or purchase price, is more important than ever.

One of the frustrations in the office market is the difficulty of finding good sale comps, because pricing ranges across the board, from deep discounts to sales that are generating records in their respective markets. “The story is a little bit of a mixed bag,” says Victor Gutierrez, vice president at Ten-X Commercial. In terms of what buyers are willing to bid on office properties, Ten-X is testing the market every two weeks, and results vary widely. “I usually pride myself in being able to predict what’s going to happen at auction, and I am so wildly off today [that] it’s not funny,” he says.

The final pricing and the number of interested bidders is very asset- and market-specific. Gateway markets still seem to be experiencing plenty of demand. For example, Ten-X has seen success for those office property sales located just outside New York City in suburban New Jersey, downtown D.C., and suburban Virginia. “When you go into secondary or tertiary markets, or even suburban office buildings, it’s very tough right now,” Gutierrez says.

Sharp drop in deal flow

Commercial real estate transaction activity is down across the board, and office sales are taking a bigger hit. At the end of the third quarter, office sales so far this year totaled $36.6 billion, which represents a 62 percent drop in activity compared to last year and a bigger step back than the 55 percent decline in total transaction volume. The $10.6 billion in office sales that occurred in the third quarter marked the weakest volume since the first quarter of 2010, according to MSCI Real Assets.

Despite the focus on distress, properties are coming to the market for various reasons. “There are definitely some ‘must sell’ situations involving distressed assets or those looking to beat maturing loans. However, there are also plenty of want-to-sell motivations,” says Russell Ingrum, vice chairman, capital markets at CBRE. Some owners are looking to get ahead of potentially bigger pricing declines or are facing pressure from a loan maturity, tenant turnover, or major cap-ex event. Some funds are reaching end dates, and some owners want to sell solid office assets to raise capital or rebalance portfolios.

According to McDonald, the early part of 2023 brought more sales activity driven by institutions that were selling higher-quality, tier-one office assets to balance portfolios, reduce their weight in office, and remove from risk their balance sheets. Since then, the market has evolved to include owners who were selling because they faced distressed situations and loan maturities. “Right now where we are is early stages in terms of where we’re going. It’s like the third inning of a baseball game, but the game is a day-night doubleheader,” he says.

Finding a bottom on pricing

Most office buyers are private equity groups, family offices, and ultra-high–net worth individuals who bring cash to the table or can negotiate seller financing. Private equity groups see a real opportunity because of the dislocation in the market. Although some exceptions exist, institutions have largely moved to the sidelines for now and could remain there until early to mid-2025.

Across the board, a tough market endures due to higher interest rates, uncertainty on pricing, and tighter liquidity for commercial real estate. Some listed or auction properties are struggling to meet reserve prices in a market that is shifting quickly. “The debt market is inefficient, and the outcomes are variable,” Ingrum says. “You can have a willing seller and a willing buyer, but if you don’t have a lender, the deal doesn’t get done.”

Ten-X quantifies transaction activity on its platform by its trade rate, with a typical goal of achieving a 60 percent trade rate. That trade has drifted lower for office, from 66 percent in 2021, to 52 percent in 2022, and now to 45 percent, year-to-date, in 2023. Effectively, that means sellers are not hitting their desired price target or reserve price. A disconnect exists between the price a seller wants to achieve and what buyers are willing to pay. The view that office prices will move lower over the next 12 months, as loans mature and the volume of distress in the sector rises, exacerbates that gap.

Although buyers and sellers are trying to get a better read on pricing, there is a broad range in sales comps across the country. According to MSCI, the average price per square foot on office sales occurring during the third quarter dropped 11.1 percent to an average of $220 per square foot ($2,315.35 per sq m). The top three markets that experienced the biggest declines in pricing on a percentage basis are:

• San Francisco, which dropped 39.8 percent to average $448 per square foot
• Manhattan, where prices declined 24.4 percent to average $549 square foot
• Orange County, California, where prices fell 17.2 percent to $298 per square foot

Meanwhile, some markets are reporting office sale prices that are holding steady or even inching higher on a year-over-year basis. The top three markets that reported the biggest gains in sale prices during the third quarter are:

• Houston, where office property prices increased 7.7 percent to average $194 per square foot
• Cincinnati, which had prices climb 4.7 percent to $130 per square foot
• Nashville, where office properties rose 4.1 percent to $328 per square foot

More distress ahead

The expectation is that distress and loan maturities will continue to drive more transaction activity in the coming year. According to MSCI, office is now the leading sector in the amount of current and potential distress ahead. At the end of the third quarter, there was $32.5 billion in distressed office assets, including both financially troubled and bank-owned assets. MSCI estimates potential distress in office to be an additional $50.3 billion. The research firm quantifies that potential distress as having—if not reconciled—the potential to become full-blown financial trouble.

The latest data from Trepp shows that office stress is continuing to rise. In September, the volume of delinquent CMBS office loans increased to 5.58 percent, and the volume of office loans now with special servicers jumped to 8.34 percent. The MSA with the largest amount of delinquent office space is New York-Newark-Jersey City, with $2.3 billion in office delinquencies, followed by the Washington, D.C., MSA at $1.3 billion.

Although there are different ways to track distress and impending distress, actual distressed trades are still quite low, notes Abby Corbett, senior economist and head of investor insights at Cushman & Wakefield. Over the last 12 months, distressed sales have accounted for about 1.6 percent of total transaction activity, with distressed office at a slightly higher level, 2.6 percent of total office transactions. “Ultimately, this speaks to the fact that we are still very early along in the price discovery period,” she says. It’s also worth noting that distressed trading activity unfolded over the course of seven years following the Global Financial Crisis, and we expect this distress cycle to unfold in a similar manner, she adds.

On the buy side, many different strategies are in play. Some investors are hoping to pick up quality office assets at bargain prices, while other buyers may have a repositioning, redevelopment, or conversion plan for a property. Income-focused buyers want strong tenants and are trying to avoid near-term repositioning risk, given the current market challenges related to elevated vacancies.

“There are still investors out there that like the office product and are willing to take a chance or make a contrarian bet on office,” says Gutierrez. Buyers with an opportunistic view believe they can buy a distressed office property at a lower basis and drop their rents to attract tenants and stabilize the asset. Their goal is to generate positive cash flow and, ideally, also raise the value of the asset over the hold period. “I think the office market definitely has its challenges, but I also think environments like this [one] create a lot of opportunities to buy nice, well-located buildings that will have an office demand and an office use in the future,” he says. “If you can find those deals as an investor and you’re willing to take a chance, I think now it’s actually a really good time to buy.”

Source: “Office Market Braces for Growing Pipeline of Distressed Sales“