Refinancing To Be Much Harder For CMBS This Year

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A CMBS report from Fitch Ratings projects that the refinancing prospects of the category will be ‘materially weaker” in 2024 than in 2023. It’s one of the main reasons that the firm said that CMBS delinquencies would hit 4.50% in 2024 and 4.90% in 2025.

“Over $31.2 billion, or 1,473 of non-defaulted and non-defeased conduit and agency loans in Fitch-rated U.S. CMBS multiborrower transactions, excluding loans to which Fitch has assigned a credit opinion, are scheduled to mature in 2024,” they wrote. “An additional $37.9 billion or 2,437 loans, mature in 2025. Combined, this is approximately 15% of the Fitch-rated conduit and agency universe by balance and is higher than the $26.5 billion that matured between October 2022 and December 2023.”

Fitch used two different scenarios to see if a loan would meet debt service coverage and loan-to-value ratios to gain refinancing “at higher interest rates relative to in-place weighted average coupons (WAC) and at market capitalization rates.”

Although it didn’t reveal details of the estimates, the two scenarios involved having particular minimum DSCR or LTV values.

For the 2024 maturities, Fitch calculated a likely lower refinance rate than the 73% for maturing loans in the 15 months since October 2022. Currently, under 48% can satisfy the minimum DCSR of 1.75x for an interest-only loan or 1.40x for an agency loan. Only 46% can satisfy a maximum 55% LTV (remembering that properties have seen significant drops in valuation while the interest-only loan won’t have seen reduced principal).

In total, about 50% of the $15.6 billion in maturing loans in 2024 wouldn’t be able to refinance. Borrowers would need to add an average of almost a third of the debt in additional equity and 25% under the LTV scenario requirements for refinancing.

“A slowing economy, elevated borrowing rates and negative lender and investor sentiment will pressure CRE property valuations, capitalization rates and loan performance in 2024,” they wrote.

In 2025, refinancing should improve, according to Fitch. Under the DSCR scenario, 75% of maturing properties should be able to refinance, and under the LTV scenario, 51% should. But about 25% of the maturing loan volume, or $9.3 billion, in 2025 wouldn’t be able to refinance. That would mean additional equity of 15% or 10% of the existing debt under the DSCR and LTV scenarios, respectively, would be needed from owners to pass refinancing thresholds.

 

Source:  GlobeSt.

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Maturing Loans Will Bring More Clarity To Capital Markets

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Even the experts appear reluctant to predict what 2024 holds for the commercial and multifamily mortgage markets, though they hope the year will bring more clarity.

The just-released Mortgage Bankers Association’s 2024 Commercial Real Estate Finance Outlook Survey describes an unsettled market for borrowing and lending – but anticipates conditions will stabilize in the new year.

One thing is clear. Even though borrowing has declined, the level of outstanding mortgage debt has continued to rise. “A decline in sales transaction and refinance volumes has meant less new debt being extended, but it also means that fewer loans are paying off than in many earlier periods. The result is that debt levels continue to rise, but at a pace that is roughly half of what was seen last year,” the report stated.

“The level of commercial/multifamily mortgage debt outstanding increased by $37.1 billion (0.8 percent) in the third quarter of 2023 to $4.63 trillion. Multifamily mortgage debt alone increased $26.8 billion (1.3 percent) to $2.05 trillion from the second quarter of 2023.”

Virtually every type of lender increased the dollar volume of its holdings of commercial/multifamily debt.

This has happened even though CRE mortgage borrowing plummeted 53% in the year to date. Loan originations fell 7% between 2Q 2023 and 3Q 2023 and 49% year over year – a slump that affected all major property types.

Mortgages that mature in 2024 could bring more clarity to the prospects for the CRE market – “and could force the issue for many owners,” the report stated.

“Many maturing loans have and will refinance easily – providing new ‘marks’ for the market. Maturing loans that have difficulty refinancing at terms the borrower hopes for, as well as loans that are facing challenges during their terms, may end up being another key to unsticking the markets.”

Underlying these problems are questions about property fundamentals, uncertainty about property values, and higher and volatile interest rates. “Greater certainty around these conditions is a key prerequisite to breaking the logjam of transaction activity” that has left many participants on the sidelines, the report commented, noting that the recent drop in long-term interest rates could bring relief to both cap rates and financing costs. At the same time, it pointed out that the Fed’s tight money policy could still have impacts in the future and tightening of credit is also possible.

Meanwhile, different analysts produce different conclusions on how property values are being affected.

“Most series show cap rates increasing but the pace lags the growth in broader interest rates that many look to as a base comparison,” the report said.

RCA found apartment cap rates rose to 5.2% in 3Q 2023, industrial cap rates to 5.9%, retail to 6.6% and office to 6.9%. MBA’s own models predicted a more substantial rise but said market uncertainty makes the situation unclear.

Each sector of CRE faces difficulties. Offices are grappling with how hybrid work will affect demand for office space, leaving owners to figure out which properties will be most affected. Quality of buildings rather than age, is said to be most important. Industrial and multifamily properties are facing a supply glut that outstrips demand and slows rent growth, though industrial vacancy rates remain low and rent growth remains positive. Retail, especially general purpose buildings, is seeing demand but some malls are experiencing negative net absorption.

As CRE markets confront these challenges, there has been a slow and steady uptick in delinquency rates, the report found. The share of properties with outstanding loan balances that were current or less than 30 days late fell from 97.7% at the end of 2Q 2023 to 97.3% at the end of 3Q 2023. Loans backed by office properties were largely responsible, with delinquent loans up from 4% to 5.1%. However, all sectors saw delinquencies rise, though for multifamily and industrial property the hike was less than one percent. And every capital source saw an uptick in unpaid principal balances.

The findings are based on a survey sent to leaders at 60 of the top commercial and multifamily mortgage origination firms, with a 40% response rate.

“CRE markets are entering the new year relatively stuck,” summed up Jamie Woodwell, MBA’s head of CRE Research. “Leaders of top CRE finance firms believe that a host of factors may continue to act as a drag – rather than a boost – to the markets. However, they do believe that overall uncertainty will dissipate over the year, helping to boost borrowing and lending above 2023 levels.”

 

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Frivolous Lawsuits Found Not To Be The Cause Of Insurance Premium Surge In Florida

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Homeowners’ lawsuits against insurance companies did not cause record losses and rapidly escalating insurance premiums in Florida, according to a new study.

But frivolous litigation has made a bad situation worse, with a disproportionate amount of lawsuits filed in Miami-Dade, Broward and Palm Beach counties. That confirms what the insurance industry has said for years — to a certain extent — the Miami Herald reports.

The Florida Legislature tasked the state’s Office of Insurance Regulation with completing the report. Last year, lawmakers passed legislation making it harder and more expensive for consumers to sue their insurers, in response to the repeated claim that superficial lawsuits were driving the rising cost of premiums.

The report found that litigated claims in the tri-county region in 2022 were six times more expensive than claims that did not result in a lawsuit. The more than 58,000 claims that were litigated in 2022 made up less than 8 percent of claims closed that year, and less than 1 percent of the policies in effect at the time. Insurance companies spent about $580 million on the litigated claims out of nearly $16 billion that Floridians paid in premiums, according to the Herald. That also amounts to less than 1 percent.

State Rep. Erin Grall, a Republican, said that the insurance industry “fabricated their arguments and data over the past few years to manufacture a crisis and push for various legislative reforms,” according to the Herald.

Policyholders were more likely to sue the longer it took for their insurer to close a claim, suggesting that some lawsuits were filed because of insurers’ modi operandi.

Insurance regulators collected the data from insurers under a 2021 bill that Gov. Ron DeSantis approved. Many insurers missed their deadlines or produced insufficient or incorrect information, Florida Insurance Commissioner Mike Yaworsky told the Herald.

Insurance premiums have doubled, tripled or quadrupled for some owners of commercial and residential real estate in recent years, hampering sales and forcing some to sell their properties at a discount or risk forgoing coverage if they’re able. Some insurers have stopped writing new business, scaled back or gone out of business across Florida.

 

Source:  The Real Deal

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Money Markets Expect Rates To Stay High For Years

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Listening to discussions about what will happen with interest rates in 2024 is like walking into an open house at The Oxford Union of the namesake university. Debates to the right and left with the audience voting on the most compelling argument.

One of the loudest collective voices in the rate debate are the money markets, and they’re nowhere near as optimistic as those cheering a soft landing of the country’s economic airplane, according to Reuters. Financial markets are expecting interest rates to remain high for an extended period of time — 3% for years — with inflation still higher than the Fed wants and government spending driving new heights of public debt.

The former means the Fed could limit cuts and the latter will mean more U.S. borrowing at higher yields to attract buyers. The yields, especially for the 10-year, create an attractive place for investors to put money with relative safety, boosting the rates other outlets must get to provide risk-adjusted returns and compete as investment opportunities. In other words, don’t expect the decade of near-zero rates to return.

“Traders have in recent weeks doubled down on bets for steep rate cuts next year, encouraged by slowing inflation and a dovish shift from the U.S. Federal Reserve,” Reuters wrote. “Expectations that rates will drop at least 1.5 percentage points in the United States and Europe have boosted bond and equity markets.”

The Federal Reserve’s most recent collection of economic expectations show the projected federal funds rate range to be 4.4% to 4.9% this year, 3.1% to 3.9% next year, 2.5% to 3.1% in 2026, and 2.5% to 3.0% in the longer run.

The warnings aren’t coming only from money markets. There have been polar takes on the edge.

As Stephen Stanley, chief US economist at Santander, told the Financial Times, “You couldn’t draw up a more perfect economic scenario than the FOMC’s forecasts. If it happens, that would be tremendous. But there are only downside risks.”

As Jeffrey Gundlach — founder, CEO, and chief investment officer of Doubleline, and money management firm that is a big player in the bond market — told CNBC in an interview that when the yield level of the 10-year Treasury market goes below 4%, it sounds “almost like a fire alarm.” And the 10-year has been hovering under 4% since mid-December. If Gundlach is right and lower 10-year yields are portents of a recession next year, the Feds might raise interest rates as a way to drive down price hikes.

In other words, near-zero interest rates may be long out of play no matter how you look at current conditions.

 

Source:  GlobeSt.

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We Are No Longer In A ‘Rising Tide Lifts All Boats’ Market

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It’s going to be tough for apartment operators to maintain occupancies in a slowing economy, although property fundamentals should hold up in 2024 among a few challenges, according to a new report from Yardi Matrix.

Among the challenges are the wave of deliveries, limiting expense growth, rising mortgage rates, and dealing with more expensive and less liquid capital markets.

“We are no longer in a rising-tide lifts-all-boats market,” Yardi Matrix said.

“The traditional property acquisition pipeline will likely remain stalled through most of the year, so near-term opportunities will be concentrated in debt investments and providing capital for property restructurings.”

One big and growing issue will be maturity defaults as loans come due and properties qualify for proceeds that are less than the existing mortgages, according to the report.

On the other hand, the challenges are not insurmountable for owners with a long-term perspective, but they will take skill and expertise to navigate, according to the report.

The higher-for-longer interest rate scenario will bring a market reset with higher acquisition yields, higher financing costs, and lower leverage and values.

“We expect rent growth will be positive in 2024 but diminished by slowing absorption, supply growth, and declining affordability after extraordinary gains in 2021-22,” Yardi Matrix said.

It said rent growth will be found in the Midwest, Northeast, and smaller Southern and Mountain areas where demand remains consistent, and deliveries are subdued.

Strong demand and weak supply growth in markets like New York and Chicago should lead to strong recoveries while the Sun Belt and West markets will see a temporary pause in rent increases. The long-term prospects there remain bullish, however.

The rise in construction financing is putting a lid on new starts and 2024 is expected to be a peak year for deliveries.

Insurance labor, materials, and maintenance will continue to take a bite out of budgets.

Yardi Matrix believes that activity is likely to remain weak in 2024 “but could rebound later in the year if rate hikes have ended.”

It’s not just that property values are down, but that buyers and sellers can’t agree on how much.

Meanwhile, lenders will continue to be cautious, and borrowers are reluctant to lock in loans at high rates, according to the report.

 

Source:  GlobeSt.

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Another Disaster Prediction Because Of Treasury Yield

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Trying to follow the economy at the moment is like watching a ping-pong game sped up for viewing whiplash. Last week the Federal Reserve held interest rates steady and indicated three possible cuts in 2024. CBRE had some optimistic capital market projections for next year.

And then? Jeffrey Gundlach — founder, CEO, and chief investment officer of Doubleline, and money management firm that is a big player in the bond market — said in a CNBC interview that when the yield level of the 10-year Treasury market goes below 4%, it sounds “almost like a fire alarm.”

“They believe, I think, that they’re done,” he said in the interview. “The Fed has been on hold for four of the last five meetings, so it’s a trend.” He added that his firm’s model suggests that headline CPI could be 2.4% by June. “If that’s the case, I think the Fed cuts rates.”

Gundlach also said he thought the 10-year yield would drop to the low 3s by sometime in 2024.

“I think we’re talking about a recession next year,” he said, also saying that there may be a breakdown of the correlation of strong bonds and strong equities.

That point is interesting and historically strange. Start with the old rule that a yield curve inversion — when the yields of short-term Treasury instruments are higher than long-term yields. The standard interpretation is that bond traders think that rates will be lower in the long term, which is usually associated with recessions.

While inversion has been a fairly reliable predictor of recessions in the past, it’s been far less certain recently. There was a period in 2019 when an inversion happened but the recession that would come was due to the pandemic and implosion of the supply chain. Not exactly what anyone might have expected.

And after? The curve inverted in early July 2022 and hasn’t returned to normal. But it was larger many times from 2022 on until now.

When the Fed announced the likelihood of cuts next year, stock prices shot up. But then yield prices started falling on 10-year Treasurys, which is odd, because typically, when equity prices go down, bond prices go up because investors move to what they feel is safer. As prices go up in bonds, yields come down.

What the market is showing is the exact opposite of what you might expect. Stock prices rose and bond prices rose, because yields dropped.

All this is to say that there seem to be some odd reactions across caverns that investors have come to trust.

 

Source:  GlobeSt.

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Financial Stability Oversight Council Says CRE Is Big Financial Risk

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In its 2023 annual report, the Financial Stability Oversight Council — a legacy of the Dodd-Frank Act that includes a broad array of federal banking regulators and others — pointed to multiple financial risks for the U.S. First on the list, commercial real estate.

At the top of the CRE section, $6 trillion in loans as of 2023 Q2, with half sitting on the balance sheets of banks, because these don’t get sold off to government agencies the way residential mortgages do. CRE loans are also the largest loan category for almost a half of all U.S. banks.

The concentration makes for a systemic weakness, especially as “the CRE market faced a rise in vacancy rates and declines in value for some property types, elevated interest rates, heightened CRE loan maturities, inflation in property operating costs, and an increase in CRE loan delinquencies.”

None of this should be a surprise to anyone who has been monitoring the market.

The agency’s concern is the one many in CRE have expressed.

“High interest rates increase refinancing costs for borrowers and can lead to decreasing property values across CRE sectors,” the report said. “If the decline in property value is significant relative to the time of financing, then the borrower may not be qualified to refinance the loan at maturity without an additional injection of equity. Thus, the loan may need to be restructured or entered into default, causing losses for the lender. As losses from a CRE loan portfolio accumulate, they can spill over into the broader financial system.”

That can cause banks to dump loans and properties, driving down values further and creating a vicious circle and also tightening credit availability. There are already signs of loan distress, with the delinquency rate for banks up 0.74 percent in the second quarter of 2022. CMBS delinquencies are also up.

Another concern is that bank stress could spread through interlinkages among banks, insurance companies, REITs, and private lenders.

The FSOC has some recommendations, that “supervisors, financial institutions, and investors continue to closely monitor CRE exposures and concentrations, and to track market conditions.”

The suggestions include ongoing evaluation of loan portfolios’ “resilience to potential stress, ensure adequate credit loss allowances, assess CRE underwriting standards, and review contingency planning for a possibly protracted period of rising loan delinquencies.”

 

Source:  GlobeSt.

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The Nightmare Scenario for CRE Bank Loans

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A lot of discussion in business and economic circles is around whether 2024 will bring a soft landing or some degree of recession. The optimists have been out in force for some time and are expecting a Federal Reserve rate cut as soon as the first quarter of next year.

But there are still those who think a recession could happen and that victory is far from clear. If that proves to be true, Yale School of Management’s Professor of Finance and Management Andrew Metrick says to prepare for some serious trouble for commercial real estate and the banks that hold the loans.

“Historically, for every one percentage point increase in the policy rate from the Fed, banks take 1% hits to their capital over the next eight quarters,” Metrick said in an interview with Yale Insights. From the zero-interest rate to the current baseline federal funds rate range of 5.25% to 5.50% has been a large and rapid leap. “If banks lose 5% of their capital, there are going to be a lot of banks in trouble.”

“If we manage to avoid a recession and get a soft landing, the banks will recover,” Metrick says. “Past commercial real estate downturns have been slow moving things,” he explained. “We spent 10 years after the global financial crisis working out a whole lot of problems.”

At issue is the deep intertwining of banks and commercial real estate. As Metrick notes, the banking system holds about $3 trillion in CRE loans on their book sheets, $2 trillion of which is held outside the largest 25 financial institutions. To date, the loans have performed because their interest rates have been low. Refinancing is drastically changing that.

If a soft landing skips and slides into a recession, the processing of CRE loans would kick into high gear because banks don’t typically sell them on as they do with residential mortgages. Under a 2016 change in accounting standards called Current Expected Capital Losses (CECL), “banks are supposed to take seriously what they think the probability is of something paying off in the future, even if it’s current,” Metrick says.

His “nightmare scenario” starts with banks as yet having to provision adequately for potential losses. In a recession, banks are even more reluctant to lend into commercial real estate than they have been. Many loans don’t get refinanced, and some bank somewhere becomes the “Silicon Valley Bank of commercial real estate” that suddenly fails. Congress investigates and finds that the bank not only failed to have reserved enough, but also didn’t warn shareholders.

“That next quarter, every accountant in the world is going to tell their banks, ‘I’m not going to be the one blamed if you fail.’ They’re going to get very tough on CECL, and what looked like a slow-moving downturn suddenly crystallizes as an expected value disaster that everybody has to put in their balance sheets at the same time,” Metrick says.

Many banks, maybe hundreds, now become insolvent, creating a wave of closures not seen since the very worst of the Global Financial Crisis.

“Not to leave you super scared, but you should be a little scared because I’m a little scared,” he says.

 

Source:  GlobeSt.

 

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4 Trends That Will Shape Florida Real Estate In 2024

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As commercial real estate markets across the U.S. cope with rising costs and slowing demand, Florida has been a rare bright spot. The Sunshine State has welcomed a record number of people and businesses in recent years, and that activity is driving strength and stability across asset classes.

Florida is home to six of the country’s top 20 most competitive multifamily markets, its tourism sector set a new visitation record in 2022, and office market dynamics from Miami to Tampa are outperforming national averages.

As 2024 approaches, the burning question is whether Florida’s commercial real estate landscape will remain resilient. Bilzin Sumberg, which has one of the largest and most active real estate practices in the state, is tracking the following trends heading into the new year.

1. Lenders will become even more selective

Developers have been grappling with escalating costs on multiple fronts throughout 2023, and this is unlikely to ease as interest rates, inflation, wage growth and insurance costs mount and lenders have been grappling with valuations and pricing. As a result, capital for commercial real estate investments will be increasingly hard to come by, as lenders will be more selective about the deals they choose to finance. The more expenses and interest rates rise while uncertainty prevails, the more difficult it will be to complete deals in 2024. Developers will become even more strategic about the projects they pursue, and more proactive in getting ahead of potential challenges.

The good news for South Florida is that developers are still building, according to Bilzin Sumberg’s real estate practice chair Suzanne Amaducci. The demand for the South Florida lifestyle remains strong from both domestic and international buyers. Condo construction projects financed in part with upfront buyer deposits have obtained financing and are now underway with more projects to start in the near future, Amaducci reports.

“Our team is on track to close at least four condominium construction loans with a combined value of more than $600 million before the end of the year,” Amaducci said. 

2. The Live Local Act will spur development in metro areas

Against the backdrop of a housing affordability crunch and tight financing environment, one Florida law enacted in 2023 is becoming an important vehicle for developers and investors looking to get shovels in the dirt.

The Live Local Act is a statewide housing strategy designed to create affordable and attainable housing opportunities, allowing more of Florida’s workforce to live in the communities they serve. The act offers funding and tax credits, and mandates that local governments administratively authorize multifamily development on certain sites if at least 40% of units will be affordable for people making up to 120% of the local area median income.

The Live Local Act could become a blueprint for other states to follow as cities across the U.S. contend with an affordability crisis.

“This is Florida’s most significant land use policy change in 20 years to address the biggest problem we have had in 100+ years,” said Bilzin Sumberg partner Anthony De Yurre, who is advising on more than 40 projects advancing under the law. “The Live Local Act is crucial for teachers, government employees and other pillars of Florida’s economy, many of whom have been priced out of the best employment centers, resulting in long-distance commutes. It’s also a game changer for developers. In many cases, this law will be the difference between a project getting done or shelved.”

3. Condo redevelopment deals will grow in popularity

Florida is home to 1.5 million condo units, and 925,000 of those are more than 30 years old, according to Bilzin Sumberg real estate partner Joe Hernandez. Nearly 50% of those units are in Miami-Dade and Broward, making South Florida fertile ground for condo terminations that pave the way for redevelopment.

As Florida’s population grows, aging condo buildings emerge as prime targets for buyouts that pave the way for redevelopment. The impetus behind this trend is twofold: the imperative for costly repairs mandated by state regulations enacted in 2022, and escalating construction and insurance costs.

Condo associations at aging properties are dealing with the worst of all worlds, as expensive repairs required under state regulations passed after the collapse of South Florida condominium Champlain Towers in 2021 are colliding with mounting costs. Compounding the problem is Florida’s insurance crisis, which is resulting in fast-rising premiums, decreased coverage amounts, and some insurers becoming insolvent or exiting the state altogether.

“The confluence of factors in Florida creates fertile ground for developers seeking to breathe new life into aging condominiums – and with a surge in population, the demand for housing is more pronounced than ever,” said Bilzin Sumberg’s Joe Hernandez. “Condo terminations represent a strategic move in response to higher maintenance costs, rising insurance premiums and tightening regulations.”

Florida is likely to see even more of these deals in 2024 as condos struggle with higher maintenance and insurance costs, and tighter regulations.

 

4. Initial signs of distress will emerge

For all of Florida’s strengths, there is no escaping the fact that almost $1.5 trillion in commercial real estate debt comes due by the end of 2025. For the time being, distressed properties are hard to come by in Florida, but that may change as pressure mounts on owners whose assets currently benefit from low financing costs.

“The CMBS market is cyclical, and many property owners took advantage of the prolonged period of low capital costs that ended in 2022,” said Karyl Argamasilla, co-head of Bilzin Sumberg’s CMBS and real estate capital markets practice. “We anticipate a wave of loan maturities in 2024 and 2025. In some instances, these loans will not be able to be refinanced or paid off, which could trigger an uptick in workouts.”

 

Source: JD Supra

 

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What CRE Industry Insiders Are Thinking Might Happen In 2024

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Commercial real estate professionals agreed in the Fall of 2022 that 2023 would have a healthy serving of uncertainty, with falling transaction volumes leading to a lack of price discovery and rising interest rates putting pressure on financing.

Still, people thought that by the second quarter of 2023, things would be getting back to normal. No one had a clue how long inflation would hang in, how high interest rates would go, and how much macroeconomic trouble there would be with banks being closed, many lenders pulling back, falling valuations, the ongoing impact of higher interest rates, major strikes by unions, political division, and more.

CRE pros are being much more careful and circumspect now.

As Jeff Klotz, founder and CEO of The Klotz Group of Companies, says, “The only certainty we’ve added is that it’s more uncertain.”

Welcome to the future. Here’s what industry insiders are thinking might happen this year in key areas.

PRICE DISCOVERY AND VALUATIONS

With all other problems, discovery of many types is maybe the biggest, because it holds important answers, if only that discovery gets to happen.

“For the next 12 months, the theme will be a discovery of the result of all the mistakes made over the last several years,” Klotz says. On the transaction level, he thinks that “the divide between buyer and seller is larger and wider today,” and “it hasn’t shrunk as we had expected at this time last year,” Klotz says. His company buys, sells, owns, operates, consults, borrows, lends, and develops with 12 different wholly owned subsidiaries.

Klotz gets excited over the potential for buying “some discounted and cheap real estate.” His big worry is his own portfolio.

“Let’s face it, I can’t control the market. I can’t control what it’s worth because the market does that.”

PRIVATE MARKETS HAVE YET TO PRICE IN CHANGES

Going hand-in-hand with a lack of price discovery is the opacity and potential over-valuation of private real estate values.

“The public REIT markets have already priced in the impact of higher debt caps and are trading at the 6% cap rate,” says Uma Moriarity, senior investment strategist and global ESG lead for CenterSquare. “For core private real estate funds, we look at the NCREIF ODCE Index. The valuation across those funds is still close to a 4.2% cap rate. If you don’t have transactions, you don’t have comps and you don’t have the right data feed appraisers need. In terms of the 4.2 cap rate, those ODCE funds are doing transactions in the 5% cap range. We think the public REITs are on the slightly cheap side of fair because the private market is still overpriced.”

According to research from CenterSquare Investment Management, REITs historically outperform private real estate and equities in the periods of time after rate hiking cycles end. If the Fed does stop the upward march of its rate hiking cycle, 2024 could see REIT outperformance.

INTEREST RATES

If there is any single number that is a meaningful metric for the industry, it’s the federal funds rate, the benchmark interest set by the Federal Reserve, with its enormous impact on financing costs.

“I think you could argue very convincingly that the 30-year bull run is over,” Nancy Lashine, managing partner of Park Madison Partners, says. “I don’t think I’m ever going to see a 2% Treasury rate again. I don’t think we’ll ever see a 3% or 4% mortgage rate again. You could argue there’s no good deal. There’s plenty of capital but no good deal.”

 

“I would say we’ve enjoyed cheap money for a very long time, but it’s led us to a lot of pricing perhaps that was reliant on that cheap financing,” says Tess Gruenstein, senior vice president, acquisitions and portfolio management, real estate at Bailard. “When it goes away, things shift. We’re back to a more normalized environment and people won’t do deals because they’re optimized for leverage.”

That means a lot of real estate — and not just office — is going to be underwater.

“We have a lot of groups coming to us because we raise private equity capital. The best thing anybody can say to us is we have no legacy assets,” says Lashine. “If you were in this business over the last 15 years and you heard someone say, ‘I sold everything in 2005, 2006, and 2007,’ not only is he a good operator, but he has good timing. That was the best story anyone could tell and you’re going to hear those stories again.”

LENDERS PULL BACK

“This is kind of a doom and gloom moment,” says Stephen Bittel, chairman and CEO of Terranova Corporation. “The real challenge is that, whether they admit it or not, most banks are pretty much out of the lending business. There are a handful that will continue to dip their toes in the water for best customers with good equity and balance sheets.”

Many banks are worried about depositors seeing some assets, whether long-term Treasuries and mortgage-backed securities, or CRE-backed loans, as suspect, as happened with bank closings in 2023. Depositors pulled their money. For the first time, bank deposits contracted, by 4.8%, in the first half of 2023. Banks are worried that CRE loan values could drop in the face of falling property valuations, cutting asset values and making it harder to cover further worried withdrawals.

“If the small and mid-sized banks stop lending, which they effectively have — they’re pushing deals with high rates — businesses will shrink and cause a recession,” Bittel adds. “Banks are nervous about the future because it’s uncertain.”

 

Adam Fishkind, a member of law firm Dykema Gossett, says his “loan origination practice has definitely fallen off a cliff” — not just with banks, but other sources. “When I do borrower representation, I don’t see a lot of CMBS deals coming through these days.

“A lot of that has been replaced by private equity lending” with “the overall loan transaction is more akin to hard money lending.” Rates are higher and generally include points on the front and back ends, with larger spreads, shorter terms, and higher interest rate floors.

 

“Our expectations is that we’re not going to see an early improvement in 2024,” says David Cocanougher, president of multifamily at Leon Multifamily, part of Leon Capital Group. “I think there’s a tendency to want to be optimistic, but the longer this continues, the more down to earth everybody becomes.”

OFFICE SPECIAL SERVICING AND DEFAULTS

Ongoing data from multiple sources have shown that defaults, workouts, and special servicing are all on the rise, especially for office.

“We’re seeing some large office product defaults in the CMBS special servicing stuff that I do,” says Fishkind. “A lot of these buildings, they have a couple of major tenants that have left. If you have an A property and a great location, you probably still have a pretty good asset. But if you have suburban office or older office, you might have trouble again. It’s one of those opportunities where people are probably reducing space and putting the money in their pocket because they’re nervous about the possible recession, or they’re reducing space and going to a better environment.”

 

DISTRESS

“There are more distressed situations and transactions happening because of the way projects were structured because of floating rate debt or even pressure from equity partners to get a faster exit,” Cocanougher says.

 

“A lot of people say things because they want to move the market,” Jason Aster, vice president at KBA Lease Services, says. “The truth of the matter is my business exclusively relies on tenants taking office, but other than highly liquid companies poised to take advantage of distress, I don’t see anyone jumping in to invest in office assets, or any commercial assets.”

GlobeSt.com has previously reported signs of a secret distress market — increased bank CRE charge-offs and higher levels of distressed CRE loans — largely being handled privately and that has not broken out into a fully obvious run on distressed properties.

“What you’re seeing in leases is a focus on how a landlord or owner could apportion reinvestment,” Cocanougher adds. “What you’re seeing in leases are ways for the landlord to take back space originally designed for tenants, but then” charge back the costs or possibly even the lost rents. “While super high quality, trophy office assets will be fully booked and retain their value, landlords will hand the keys of distressed assets back to the lenders at a greater frequency in 2024. This will be particularly prevalent in the older Class A and Class B office product in dense cities like NYC and San Francisco.”

Klotz refers to the current distressed market as “private” and “embarrassing.” No one wants to talk about it publicly because they don’t want to draw attention to having made a mistake and losing money. Or, on the other hand, they don’t want others to realize that they bought some distressed properties and got a good deal. And the data lags because these events are in real time.

But it’s also attractive. “If you’re a core buyer, you can look around and say, ‘Would I take a 7% interest rate on a core investment?’ I think so,” Gruenstein says. “If you have a long-term perspective and patient capital, it’s very easy to make a case that now is the time to be out in the market, picking up some of these great pieces of real estate.”

Many with capital in their back pockets may still be waiting, though.

“I think there’s possibly a lot of equity being kept out,” says Tere Blanca, chairman and CEO of Blanca Commercial Real Estate. “It’s eroding if you had any, with values being hit as much as they have been. You wake up to higher interest rates and to much higher costs of operating your property and values are getting impacted. It’s a difficult time to navigate.”

 

“We’re still being patient, for sure, especially when it comes to investing in hard assets,” says Matt Windisch, executive vice president at Kennedy Wilson, which bought PacWest’s CRE loan portfolio for $2.4 billion back in June. “We continue to think that the construction lending space is extremely interesting. We have committed capital partners to fund an expansion.”

CONSUMERS PULL BACK

While consumer spending has appeared to continue strongly, it may not be all it seems. When the Census Bureau reports on consumer spending, it doesn’t take price differences into account. In other words, these are nominal and not real changes in spending behavior. To top it, the changes in spending are to only a 90% confidence interval that generally includes zero, so there is no way to tell if there’s been an actual change.

“I think part of why the pickup in transaction volumes didn’t happen this year is the Fed kept raising rates,” says Moriarty.

The translation from monetary strategy to the rest of the economy isn’t working as it has in the past.

Moriarty says she’s seen a rolling recession across the economy, but that it hasn’t hit the consumer. “That lasted a lot longer than any of us anticipated,” she says. “If you listen to what we saw from a lot of the consumer-oriented earnings this past earnings season, listening to what the hospitality REITs were telling you or the apartment REITs were telling you, you were seeing a pullback from the consumers.”

Credit card debt is at an all-time high and credit card and auto loan delinquencies are on the rise.

“The other new big thing to watch relates to student debt payments coming back online,” she adds “It seems difficult with the lack of credit availability overall to see that level of tightening without an impact.”

Consumers had built-up liquidity from Covid, but estimates, including from the Federal Reserve Bank of San Francisco, suggest that is likely gone. Not what you want to see when you’re hoping to avoid a recession, but consumer spending is 68% of GDP.

 

Source:  GlobeSt.

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