3 problems with U.S. CRE today
Three issues that are today conspiring to bring about a CRE recession
The Federal Reserve has decided not to raise the federal funds overnight rate. This gives investors some reprieve after 10 consecutive rate hikes, starting in March of last year. Perhaps this was in response to the lowest CPI reading in the U.S. in the last two years. Or maybe Chairman Powell sees other paths to lowering the inflation rate. Quantitative tightening measures are in full effect. The Fed hopes to trim is $8.5Tn balance sheet by just shy of $100 million per month. By ceasing to buy treasury bills, the Fed will bring demand down; this will lower bond pricing and raise the yield. Per the last meeting in May, Chairman Powell remains committed to bringing inflation down to a 2% annual level. Though good for the economy overall, the measure required to get there may involve some hurt.
Some investors are waiting on the sidelines for distress to proliferate into the market. When low-interest loans mature, commercial real estate owners will have to refinance at much higher rates and some just won’t be able to afford that. That means some of those owners will be forced to sell, the thinking goes. To put real events into context, A&E Real Estate, a large landlord in NYC, took advantage of record low borrowing costs in 2021 to refinance approximately ~3,500 apartments. The interest rate cap on the $506 million loan restricts the interest rate from climbing above 3.66%. The loan matures in June 2024. Unless interest rates come down in the next year, A&E will have to a) renew its debt at a rate that is close to 2x its prior rate, b) do a loan modification/extension, or c) sell the asset.
The strain of the debt-induced distress is being seen most clearly in floating rate debt for value-add projects. Fundrise CEO Ben Miller sees a “great deleveraging” where “owners will have to pony up fresh capital or walk away from their holdings.” Houston based syndicator Jay Gajavelli recently defaulted on a $230 million floating loan covering 3,200 units. Is this an isolated case, or an ominous bellwether for what’s to come?
The distress isn’t only happening because of the run up in interest rates. Insurance costs have also grown by staggering levels. According to Danielle Lombardo, an insurance broker at Lockton companies, insurance costs are averaging 30% increases YOY. In coastal regions of Florida and Texas, increases can range from 100% - 200% over prior years. The wildfires in Canada that lead to smoky skies in New York are doing nothing to assuage climate change concerns to insurers.
Finally, lifestyle shifts are also playing a role here. The migrations away from large cities and towards the sunbelt states is slowing down, if not reversing, per some Census Bureau data. Office vacancies appear to be steadying in the mid-teens in NY, at 24% in Chicago, and at 31% in San Francisco.
Some unknown forces to contend with as it concerns office buildings:
What is the durability of widespread hybrid work arrangements and their influence on future office demand?
What will business appetite be for entering the NY market? DFW, Miami have been competitive.
How well can existing office buildings be re-purposed to non-office buildings (adaptive reuse)?
Where does rent per /sf settle in the NYC market?
How far the pendulum swings from work-from-home back towards in-person-work will have far-reaching consequences. Data from the Metropolitan Transportation Authority (MTA) shown below showcase the rebound in activity across transportation channels in NYC since the start of Covid-19. Subway ridership, which by and far exceeds any other form of transport in NYC by number of users, is still down 35% from pre-covid levels. Reduced commuting means fewer workers are in offices (in theory, we could ask, what share of subway riders work in offices?). As an aside, the office crisis has prompted the Comptroller’s office in NYC to analyze the potential decline in tax revenue from lower valued office buildings. In their worst-case scenario, based on this study, vacancy levels would settle at 40%, and total NYC tax revenue would drop by 3%.
For investors, the concern of the day should be around office building lenders. There is a pre-existing fear that multifamily loans in NYC are worth less than par when marked to market due to interest rate risk, and the advent of tighter rent regulations in 2019 in NYC. That puts multifamily lenders at risk. For office lenders, the concern is even more poignant. As office occupancy levels tanked, net incomes for office properties followed suit. Valuations have gone down, with the expectation of sustained declines. For office lenders, this means creating loan extensions or taking back keys (see RXR, Related, and Blackstone’s recent office building defaults). If this happens at scale, lenders could significantly slow their office lending. If things get bad, those lenders could tighten the strings on all lending, across asset classes and even pause lending. That would cause a real slowdown in real estate activity and create what some are calling a real estate recession.
Higher interest rates, declining office valuations, and climbing insurance costs due to climate concerns are conspiring to slow the market and reduce transactional activity. Instead of up and to the right, commercial real estate is starting to pull back for the first time in close to 10 years. How long do you think this downward slope lasts?
Sources: Bloomberg, Comptroller’s Office of NYC report, Twitter
Great Piece!