US offices are under pressure, but real estate may still offer a hedge for investors
Commercial real estate – and office buildings in particular – are going through a challenging transition: Climbing interest rates are rippling through the sector at the same time occupants are seeking out newer, more sustainable architecture in new parts of the country.
“There is broadly an obsolescence issue in commercial real estate right now, where you have a significant amount of legacy, old stock, and that's most pronounced in office,” says Miriam Wheeler, head of Goldman Sachs’ Global Real Estate Financing Group in Investment Banking. At the same time, over the medium term, the sector is poised to attract capital from around the world as investors seek out assets that are better insulated against inflation and geopolitical turmoil, says Neil Wolitzer, a managing director in Real Estate Investment Banking at GS.
We spoke with Wheeler and Wolitzer about the rise in extra yield (spreads) that investors are demanding to buy commercial mortgage-backed securities instead of risk-free Treasuries, the large amount of debt that will mature in the coming years and their expectations for losses and distress.
What’s your view on credit valuations in commercial real estate?
Miriam Wheeler: Let’s take the commercial mortgage-backed securities (CMBS) market, because that’s the most liquid market: We started to see real spread widening and credit contraction in the first quarter of 2022, when the Ukraine invasion happened, and following a record amount of CMBS supply in 2021. Spreads reached a wide in the fall of 2022 amidst continuing rate volatility and questions around future credit performance. We subsequently saw some firmness in the market in January and February of this year. Part of that was the fact that there was very little supply — CMBS supply was down more than 80% in Q1 2023.
But following the regional bank crisis in March of this year, the CMBS market began to significantly underperform other corporate credit products, retracing the wides of the fall of 2022 whereas investment-grade and high-yield credit are relatively flat. And so I think what you're seeing broadly is that investors have concern around commercial real estate valuations and are starting to price in some either extensions or losses in that market.
We're also watching the regional bank market quite closely, as those banks have been very large lenders to commercial real estate. According to GS Research, they account for about 70% of overall CRE lending by banks, and the smaller the bank, interestingly, the more commercial real estate exposure they tend to have. And so we’re concerned that, as the regional banks face more regulation and likely start to moderate their CRE exposure, it will at a minimum become more expensive for borrowers and more likely some of those banks will pull back entirely. We think that's going to be especially impactful in the construction market where regional banks are very active and where there isn’t an efficient backfill (versus the market for stabilized assets where we think CMBS can pick up some share).
At the same time, we think it's going to be a very attractive environment for some of the debt funds and private capital that's been raised, as you see some of the more traditional banks pull back and as there continues to be dislocation in the CMBS market.
There's concern about the wall of maturating commercial real estate debt. How do you see this playing out?
Miriam Wheeler: It's important to think about the maturities by asset class. So about 23% of those maturities are office assets, and I do think that there is going to be significant distress around those office maturities. A number of those loans will get extended, but I think there are also borrowers who no longer have positive equity in those assets and therefore are not incentivized to contribute more capital.
Away from office, there’s a lot of capital available for the remaining maturities. Just look at how strong revenue performance has been in multi-family and industrial properties, in self-storage and in hotel. Valuations are off a little bit as a function of the rates and liability side of the balance sheet, but there are still assets where there's enough cash flow and where folks want to lend. I'd also note there's been a tremendous amount of private capital raised to fill in gaps in those situations. You will see a lot of demand for multi-family, industrial, storage and hotel properties.
How does that compare with the state of office real estate?
Neil Wolitzer: I don’t think we have an office problem – I think we have a ‘b office’ problem. We saw a similar pattern emerge around regional malls in the U.S. While many ‘b malls’ struggled operationally and ultimately transitioned into some other use, the best quality malls continued to thrive and the sector saw overall consolidation. Today, the remaining regional mall players are some of the best public real estate companies with fortress balance sheets, tremendous free cash flow generation and continued strong operating performance. I believe the same pattern will emerge with office assets, where high levels of amenities and well-located office buildings will continue to command attractive rent growth, while assets that are older with poor levels of amenities will struggle to retain tenants and grow net rent.
The office sector’s moment is now happening against a significantly more volatile macro backdrop than what the regional mall sector experienced over the last several years. Not only is the office sector significantly larger than regional malls, but the cash flow characteristics also significantly differ from malls and can be quite volatile in periods of diminished tenant demand.
I think it could take a significant amount of time for office to return to being a preferred asset class for institutional investors. Recent memories around the regional mall sector may contribute to this extended duration for this capital allocation cycle. Regional malls tended to be owned by highly-sophisticated long-term institutional investors — pension plans, insurance companies, etc. Many of them experienced write-downs due to over-exposure to the wrong kind of regional malls, and now they're cautious about allocating capital to a sector with both real and perceived challenges.
Miriam Wheeler: I’d add to that banks and institutional capital are now very concerned around the office exposure they already have, so getting a new loan — even on a good office asset — is incredibly challenging.
We've seen in the CMBS market that if you look at the conduit product — which is a product where lenders pool together loans backed by different property types, different borrowers — historically, we used to have 30% to 35% office concentrations. That's already been reduced in recent deals to 15% to 20% based on investor demand. I think there's going to be further downward pressure on office percentages and so there just aren't many available outlets to finance office right now.
What other real estate trends do you think are important?
Miriam Wheeler: One shift that’s noteworthy is a preference for newer, higher quality assets as noted by our research colleagues. You have a significant amount of legacy, old stock right now, and that's most pronounced in office. But I do think that it's true broadly, and so when we look at our lending, we’re focusing on institutional quality assets that are newer and have what tenants of today want.
Neil Wolitzer: I couldn't agree with Miriam more. Debt and equity market participants are being very selective about deploying capital into the office sector and are not only focusing on higher quality assets but also focusing on population and job growth centers such as Dallas, Charlotte, Austin, Nashville, etc.
How long do you think it’s going to take for losses to hit the commercial real estate market?
Miriam Wheeler: If you look at our Goldman Research colleague’s view around the great financial crisis, they suggest that peak losses in commercial real estate were not until four years after the crisis. I actually think it's going to be a little bit quicker this time, for two reasons: One is that there's been a tremendous amount of floating-rate debt done in the market — much more than in prior cycles. And when you think about that floating-rate debt, it's typically a five-year term, but you're only rate hedging for the first two years. So the market's been dramatically underhedged, and borrowers are going to have to make the decision to re-hedge or not in year two, which is the requirement under the loan. So I think that is going to bring some of these conversations to the fore earlier.
And then to Neil's point, it's all going to be about capital. A lot of these office assets that are under distress need capital. And so, particularly if you had a floating rate loan, I think borrowers in this higher rate environment and higher-capital-need environment are going to have to make decisions around supporting assets sooner rather than later, which could accelerate some of the distress, at least in office.
One other point I think we should make, though, is how strong top line fundamentals still are in many of these asset classes, because I do think there's a little bit of throwing the baby out with the bathwater. Commercial real estate is rate sensitive, but it also historically has been a good inflation hedge. We've continued to see strong growth in a lot of asset classes, albeit maybe moderating a little bit now.
Neil Wolitzer: Real estate is highly interest rate sensitive and given the recent rate changes and volatility, it is going to take some time for market participants — lenders and borrowers alike — to get comfortable with what exactly constitutes the ‘new normal.’ Real estate has weathered many historical storms and will likewise weather this period of uncertainty and volatility. However, what seems to be a bit different about this cycle compared to prior is that it’s driven by a significant decrease in available credit.
If you think about it, the current real estate ecosystem has been built upon decades of very low cost and readily available credit capital. This credit capital was quite effectively distributed to real estate borrowers via both the bank lending markets as well as the growth of distributed structured finance markets such as CMBS. Today those means of credit capital transmission are not effectively functioning to appropriately serve the real estate/real asset sector — some of this is caused by policy-driven bank regulation and some is driven by the capital markets demanding significantly higher risk premiums for allocating capital to the asset class. I believe we may be in the early innings of experiencing the ‘whiplash’ of quickly transitioning from a decades-long credit expansion cycle to what could prove to be an elongated credit-contraction cycle.
Here is the good news. People still pay their life insurance premiums every day. Pension contributions continue to be made by public and private sector unionized employers. Those investors are seeking an actuarially determined return target that is typically 7% to 10% per annum. In the prior low-interest rate environment, those actuarial investors were receiving quite minimal returns for senior loans, mortgages and investment grade bonds, which is why they had to stretch into higher-return, higher-risk equity-oriented private investments to blend into their targeted returns.
Those same pension and insurance investors can achieve their targeted investment hurdles with significantly lower risk and volatility by focusing on plain-vanilla real estate lending. However the real-asset ecosystem had so heavily relied on banking and capital market channels for such a long period of time that it will take time and energy for this new source of capital supply to adequately meet the significant demands of real estate borrowers facing debt maturities over the next several years.
Another positive take is that as we are going through this period of real estate credit capital contraction, new building supply should significantly slow down. For instance, a significant amount of construction lending came from the regional bank space — that capital supply is expected to significantly diminish given the operating and regulatory changes underway in regional banks. Less construction lending means reduced new supply which should result in greater pricing power for landlords in the medium-term, especially for newer, higher-quality assets located in markets experiencing population and job growth (ie, the Sunbelt, Texas, etc.)
Going up to 30,000 feet, I remain quite bullish on North American commercial real estate as an asset class over the medium term. We seem to be experiencing a world that’s undergoing greater geopolitical uncertainty. I am not a foreign affairs or geopolitical expert, but it seems to me that we experienced, past tense, a very unique period of expanded global trade and relative geopolitical stability over the last three decades.
If we are indeed shifting away from this period of expanded globalization and geopolitical stability to a world that is bit more uncertain and dangerous, people around the world are going to be looking very carefully where to park capital over the long-term. We certainly have our own challenges here but if you put yourself in the shoes of a global capital allocator, North America has a lot of good things going for it, particularly in a more volatile and rockier world — natural resources, infrastructure, protective oceans and reasonably stable demography (ie, we have young adults where a number of countries are lacking that key population group). I couldn’t think of a better long-term geopolitical hedge than hard assets in North America. If you can look past the near term volatility caused by the sudden shift from credit capital expansion to credit contraction here in the U.S., I think commercial real estate in North America is a great place to allocate capital over the medium and long-term.
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