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Transcript
The commercial real estate market is in a state of disarray – public securities are wrapped up in the broader public market volatility, lenders are retrenching, and equity buyers and sellers are paralyzed with uncertainty around cap rates, recession risks, and higher debt and construction costs.
With this backdrop, traditional transactions are dead and there’s limited visibility into pricing, but regressions and our ground-level experiences suggest pricing is down as much as 5-20%+, depending on the sector.
That said, a lot is happening beneath the surface, as CRE owners needing liquidity have turned to much more specialized solutions.
For commercial real estate, this is the biggest downturn since the Global Financial Crisis of 2008, and we see this downturn following the same general stages as past downturns.
The first stage is characterized by public market dislocations, which we’ve certainly seen this year. REITs are down over 25% year-to-date, and CMBS BBB spreads have widened by over 200 basis points.
Now, this public volatility has hit private commercial real estate, as REITs are forced to the sidelines, CMBS originators have disappeared given the volatility in the fixed-income markets, and even balance sheet lenders have tightened due to increased regulatory pressures and limited paydowns this year.
As a result,we’re now entering stage 2, or, the special situations stage.
Over the past month, we’ve seen a dramatic shift from traditional buyer/seller deals to more complex and often under-the-radar restructurings.
Examples include multiple rescue capital situations where CRE owners now need bridge capital to finance upcoming loan maturities or existing projects.
On the lender side, we’ve seen a tremendous pickup in loan sales from banks looking to get ahead of risk downgrades.
With central banks tightening aggressively, we expect this special situations stage to persist for at least the next 1-2 years.
A likely global recession would eventually push us into the final stage of a CRE downturn beginning in late 2023, where deeper distress builds as a recession leads to tenant defaults and downsizing.
These fundamental pressures will collide with ballooning loan maturities starting in 2023, foreshadowing a second wave of loan defaults and non-performing loan sales.
With dislocation comes opportunity, particularly for those who can provide creative structuring solutions and/or move across the four quadrants of public and private CRE debt and equity.
On the public side, given the broad and somewhat indiscriminate public market selloffs today, we see tactical opportunities in both CMBS and public REITs.
On the private side, it’s a great time to be a solutions provider. With nearly all forms of lenders shut out of the market, we’re seeing an explosion of opportunities in these stage 2 situations ranging from senior loans that can generate yields in the high single digits, to junior debt or preferred equity positions that offer mid-teens+ returns.
As CRE lenders look to reduce risk, we see a number of opportunities to provide solutions, including discounted loan purchases from banks facing regulatory pressures, as well as rescue loans to non-bank lenders facing margin call pressures.
In addition to the obvious macro pressures, commercial real estate faces another tail risk in the form of redemption pressures that could overwhelmopen-end core funds and create an unprecedented technical pressure on the commercial real estate market broadly.
As rates have reversed, these core funds face the risk of a significant reversal in capital flows from a confluence of factors:
First, the “denominator effect” is impacting allocations to CRE broadly, as the drop in public securities implies an over-allocation to commercial real estate for large pools of capital, including pension funds.
Secondly, despite implied commercial real estate values being down 5-20%+ this year, core fund marks have barely moved.
This is astounding when you consider the nature of a typical core fund portfolio, which includes substantial exposure to long-term, fixed-rate leases which have undoubtedly repriced in the private markets given the dramatic move in rates.
Logically, many investors in these funds are starting to anticipate that core fund marks will drop in the coming quarters and are heading for the exits.
Considering the speed and scale of the rate moves this year, this wave of redemptions could be even worse than what we saw in the global financial crisis.
Core funds will eventually need to shed assets, which portends yet another negative pricing pressure for commercial real estate in the coming years.
Disclosure
All investments contain risk and may lose value. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Collateralized Mortgage Obligations (CMOs) may involve a high degree of risk and are exposed to risks such as credit, default, market, interest rate, prepayment and extension, and certain classes or series may have more or less volatility depending upon the predictability of cash flow for such class or series. Investors may lose some or all of the investment and there may be periods where no cash flow distributions are received.
Statements concerning financial market trends or portfolio strategies are based on current market conditions, which will fluctuate. There is no guarantee that these investment strategies will work under all market conditions or are appropriate for all investors and each investor should evaluate their ability to invest for the long term, especially during periods of downturn in the market. Outlook and strategies are subject to change without notice.
The MSCI US REIT Index is a free-float adjusted market capitalization weighted index that tracks the performance of 136 equity REITs that trade on public markets.
The FTSE NAREIT All Equity REITs Index is a free-float adjusted, market capitalization-weighted index of U.S. equity REITs. The 208 constituents of the index include all tax-qualified REITs with more than 50 percent of total assets in qualifying real estate assets other than mortgages secured by real property.
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