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Out of the Office: Second Quarter 2023 Multifamily and Commercial Real Estate Investment Update

Jul 25, 2023

In our real estate outlook for 2023 we tweaked the third component of the tried-and-true guidance to property investors, suggesting instead “Location, Location, the Fed.” Indeed, considering the actions, and potential actions, of the Federal Reserve have become integral to any investment strategy. After all, it was the rapid increase in the Federal Funds rate by 5% (so far) that swung commercial real estate into a down cycle and caused a haze of uncertainty to settle over the market. After the first quarter we believed there was more clarity in the Fed’s intentions, and that interest rates were near their peak. Only such clarity would restore the conviction necessary to bring capital back to the sector. But during the second quarter it instead became clear that the Fed’s war on inflation was not over, with many predicting further increases in rates in the third quarter. Property values are falling, but owners, their investors, and their lenders don’t know how far they will fall. As a result, first half 2023 transaction volume fell an astonishing 70% from the first half of 2022.

Downturns are both painful and opportunistic times. If anything became clearer in the second quarter, it is that this new cycle will be longer that hoped for. While early in the year many were optimistic that by the end of 2023 values would stabilize and capital would return, continued stubborn inflation and the likelihood of even higher interest rates have dashed those hopes. Reality is setting in: It may take another twelve or eighteen months to restore normalcy. In the meantime, property and mortgage brokers are spending more time with their families, property owners are hoarding cash in preparation for loan maturities, lenders are monitoring collateral performance, deal sponsors are nervously determining whether there is any life left in their promotes, and distressed debt investors are dusting off their workout playbooks.  

Here are the economic and property market trends we are following as the industry wades into the second half of 2023:

Distress Is in the Air

Let’s get this out of the way: There is a lot of distress in the system right now and it will continue to build. On the one hand, many brokers are reporting that now is the best time to invest in real estate, while on the other some private equity firms and even some newspapers claim the real estate sector is an unmitigated disaster. The truth, of course, is somewhere in the middle. Apart from office properties, fundamentals remain strong and net operating income (NOI) continues to grow. And let’s not forget that multifamily and commercial mortgage underwriting has been remarkably strict, particularly on leverage. 

But as loans mature, borrowers are having to write checks to bring the balance down to a currently acceptable level. The size of that check is all about timing. When a ten-year loan matures, the property’s NOI has likely grown significantly and the borrower has some cushion to push through a refinance even at a much higher interest rate. On more recent value-add deals where the business plans’ execution got cut short and the investors were relying on a cash-out refinance to achieve their yields, negotiations could get messy. Receiving a capital call notice is an investor’s nightmare, especially when there are few prospects for seeing a return on that new capital. The result is an extraordinary number of borrowers “giving back the keys” to the lender, which is quickly becoming a hallmark of this downturn. Of course, taking back a property is a lender’s worst nightmare (unless they are an opportunistic debt fund). These competing nightmare scenarios are bringing parties to the table to negotiate extensions with capital-light infusions, and also prompting an increasing volume of bank loan sales. With all of this noise it’s important to remember that the many successful refinances do not make the headlines.

Unfortunately, the data shows that more and more loans will be difficult to refinance, and there is almost $1 trillion of maturities in the pipe. Analyses have demonstrated the sensitivity of debt coverage when using a range of future mortgage rates between 5.5% and 7.5%, and the likelihood of defaults at the upper end of the range. Again, the fate of these borrowers and lenders is in the hands of the Fed. 

Will They or Won’t They?

The 30-day Fed Funds rate futures market has a 96% probability that the Fed will raise rates again at the end of July, bringing the benchmark to 5.25%-5.50%. The real question is whether that will be the last increase, which no one can reliably predict. As described further below, there is progress on inflation but achieving the Fed’s 2% target still appears miles away. SOFR is currently about 5.05% compared with 4.30% at the beginning of the year and 1.50% one year ago. The ten-year Treasury rate, the key index rate for fixed rate debt and therefore the rate most borrowers track who don’t want the risk of a floating rate loan or the cost of its hedge, is currently around 3.8%. The rate fluctuated widely during the second quarter starting around 4.00% then falling to a low of 3.30% in April before rising back to 4.00% in early July; its average for the period was 3.50%. According to The Wall Street Journal economist survey in April, the ten-year Treasury rate is expected to fall to about 3.4% by the end of this year, and then settle in around 3.3% until the end of 2025. That’s pretty close to the average rate since January 2000. They predict the Fed Funds rate to fall to about 3% by then. These forecasts, if correct, suggest that long rates will stay in the 3.0% to 3.5% range for the foreseeable future, so no big decline once the Fed pulls back, and that the yield curve will stay inverted through at least 2024. Unless credit spreads tighten, property investors will have to accept this level of higher mortgage rates for the foreseeable future.

Mind Your Covenants

If rates are staying high for a while, it’s important for property owners to be reading their loan agreements, with particular focus on the covenants. The performance of some properties has deteriorated as inflation has boosted operating expense and reduced NOI. Most loans have debt service coverage ratio (DSCR) covenants that require the property to generate a level of cash flow to support a multiple of annual debt payments, and lower NOI means lower coverage. For borrowers with floating rate debt, the rapid rise in commercial mortgage rates, due both to higher interest rates and wider credit spreads, is further eating into DSCR. Accordingly, carefully monitoring this ratio is key to prepare for when the bank comes calling. . And the sneaky part is that a number of DSCR covenants are based on the actual loan rate rather than the capped rate, so even if you are easily meeting your payments you could be in technical default on the loan. That would allow a lender to sweep cash or require a partial principal paydown to restore covenant compliance. 

The Employment Tailwind

The extraordinary cycle of employment growth continues, but things are slowing down. According to the Bureau of Labor Statistics, an average of 278,000 new jobs were created in each of the first six months of 2023, totaling an impressive 1.67 million jobs. But these gains are less than the first half 2022 growth of 2.7 million jobs and second half growth of 2.1 million jobs. Even considering the post-pandemic pent-up demand for talent, the job market is decelerating. May job openings were 9.8 million, down from almost 11 million a year ago. The ratio of job openings to unemployed is still a very healthy 1.68x. The upshot is the job market remains strong and a tailwind for consumerism and real estate demand, but at a slower pace. And that slower pace is an important consideration for the Fed in determining when to halt rate hikes.

Speaking of Inflation

Inflation is anticipatory. It reflects business and consumer expectation of future costs. Historical measures are only indicators of a trend. According to the Bureau of Labor Statistics, the Consumer Price Index (CPI) fell to 3% in June as compared to 6.4% in January and 9.1% last June. That’s a very clear trend line that is giving a psychological boost to businesses and consumers. Average hourly earnings rose 4.2% in June, a rate finally higher than the CPI. Less rosy was the 4.8% increase in Core CPI in June, which was similar to the Bureau of Economic Analysis Core Personal Consumption Expenditures (PCE) Index that rose 4.6% in May. Unlike CPI, Core PCE, the preferred index of the Fed, hasn’t budged in the last few months. 

Again, the key is perception of what’s going to happen. Those Wall Street Journal economists believe the CPI and Core PCE are both headed down to about 2.5% by the end of 2024. That projected disinflation and waning recession fears are likely drivers of the 9% rise in the University of Michigan’s Consumer Sentiment Index in June, an improvement in sentiment that was shared across demographic segments of the population. The Conference Board Consumer Confidence Index also rose in June. Despite inflation, the American consumer is ready to sustain our economic growth.

Retail Outlook Shifting from Red to Yellow

We are nearing the end of the long journey to recalibrate supply and demand in what was traditionally an overstored retail sector. Some types of retail, particularly neighborhood centers, are performing well, while Main Street retail, particularly in urban centers with low office occupancy, are experiencing significant vacancies. Many malls have been taken out of service and converted to new, more productive use. However, the pain of working out the debt on these malls lingers. A recent analysis by Trepp of 35 troubled CMBS mall loans found that the most recent appraised values of these malls had fallen an average of 62% from the appraised value when the loans were originated. 

Yet consumers appear eager to shop in stores. Consumer spending has been bumpy but on an overall positive trend. According to the Census Bureau, June retail sales were up 1.5% year-over-year, beating analysts’ expectations, and e-commerce has held between 14.5% and 15.0% of retail sales since the beginning of 2022. The lack of e-commerce growth, in relative terms, reflects consumer desires to shop in stores again. And overall sales have been supported by continued wage growth and the diminishing probability of a recession. Additionally, many economists believe the stimulus bills signed into law in the past two years will further pump up the economy. That could offset the rapid reduction in excess savings in the system from the pandemic stimulus packages, which some estimate has fallen from $2.5 trillion to $1 trillion, evidenced by rising credit card debt (about $1 trillion at the end of the first quarter) and a recent increase in 90+ day delinquencies, per the New York Fed.

Office Outlook Shifting from Yellow to Red

As described more fully in our recent article on the office market [], while retail is completing its supply-demand realignment, the office sector is just beginning that process, and it will take a long time. Just as retail demand was negatively impacted by behavioral change, that is, consumers shopping online and preferring experiences to the things typically bought in shopping centers, office is suffering from a structural change in demand caused by their tenants shifting to a more permanent hybrid work schedule. Job growth can no longer sustain office demand because the previously strong correlation between having more employees and needing more space no longer applies. As a result, the evidence is clear that tenants are reducing space and moving to higher quality office buildings. And they are not waiting. According to Co-Star, sublet space nationally has reached a staggering 250 million square feet. 

The office problem, while varying in degree from market to market, appears location agnostic. Vacancies have risen in almost every market in the country, and the national rate is now between 17% and 20% depending on the study you choose. An analysis by Yardi Matrix in April indicated that cities with vacancies well above the national average included not just San Francisco and Seattle but also Atlanta, Austin, Denver, Houston, and Phoenix – the areas benefiting most from demographic growth. In fact, Austin and Phoenix have experienced the greatest increase in office vacancy in the past year.

The question is how to resolve the supply-demand imbalance when most of the office stock in the country is approaching obsolescence at the same time tenants are focused on amenities and state-of-the-art environmental and wellness programs. The answer will vary by property, but it is likely that while some small percentage of buildings will be converted to housing, many will ultimately be demolished to make way for more productive use that better enhances the community. In the meantime, owners are facing tough decisions as their loans mature and lenders ask for major paydowns. According to Trepp, over $20 billion of office loans are maturing this year in the CMBS market alone. An analysis by CBRE Econometric Advisors estimates the equity gap in the office sector to be $73 billion between now and 2026.

O My Darling, O My Darling

For years multifamily and industrial investments have been called the darlings of real estate property types. And for good reason. Multifamily demand has been fueled by demographic and migration trends and, more recently, the continued lack of affordability of home ownership in America. This month the 30-year mortgage rate rose to 7%. Warehouse distribution centers have benefited from e-commerce, improved last mile delivery demand, and more sophisticated inventory management and intermodal transportation.

Despite the great performance of these properties, multifamily and industrial investors are subject to the same refinance and floating rate loan mess as the holders of any other property type. Consider that airtight investment in a state-of-the-art warehouse with a triple net lease to a credit tenant. The rents are being paid and the floating rate debt was fully hedged. But the DSCR loan covenant was based on the actual rate and the lender is now sweeping all the cash, wiping out investor distributions. Or the amazing value-add multifamily opportunity in a fast-growing Sun Belt market that investors bought when rents were on a tear. There was supposed to be a cash-out refinance after three years to return capital to investors and boost their yield, but rental rate growth has cooled, the projected NOI has not been achieved, and higher rates and lower leverage requirements have made the refinance impossible. 

Fundamentals in the industrial sector remain strong. But continued development of warehouse distribution centers is starting to put a strain on absorption and occupancy in some markets. According to CBRE, almost 275 million square feet were delivered in the first half of 2023, 83% of which was speculative. Nonetheless, CBRE reports that, nationally, rents were up a healthy 4.6% in the second quarter. Co-Star reported that second quarter net absorption was positive but fell 60% year-over-year suggesting the boom period is waning and even the industrial sector is returning to historical norms. 

The multifamily sector could be more vulnerable to the substantial increase in new unit construction. Analysis by Berkadia indicates that almost 550,000 units will be delivered in 2023 and almost 590,000 units in 2024, with the most units being built in Dallas, Phoenix, Austin, and Houston where household growth should facilitate absorption. These new projects will lease up, but many developers are having trouble finding affordable permanent debt to take out their relatively cheap construction loans. Slower rent growth, higher than planned construction and operating costs, lower leverage, and higher mortgage rates are all taking a bite out of project economics.

The new supply, and the unsustainable run up in rental rates during the pandemic, are now putting downward pressure on multifamily rental rates. While there was a brief period earlier this year when rent actually declined in some areas, markets have stabilized at somewhat higher vacancy rates and rental rate growth has returned to historical norms. Yardi Matrix predicts national rents will rise 2.5% for the year, with no markets achieving the previous outsized growth (e.g., Miami – 2.4%, Dallas – 2.1%, Phoenix – 1.5%). The higher rent growth markets are now in the Northeast and Midwest. Lower growth prospects in a new interest rate environment have impacted multifamily values. Yardi Matrix reports that the average unit prices of 2023 sales through May was $181,000 per unit, down from $210,000 per unit in 2022, a 14% drop in value to date.

It's Too Darn Hot

You can be forgiven for focusing on interest rates and inflation instead of climate change during the past two quarters. But record global heat waves and dangerous air quality levels in much of the country have put climate change front and center again this summer. Owners and managers need to focus on the potential impact of climate change on their market (think property access) and the physical vulnerability of their properties. The list of cities requiring action to reduce carbon emissions and improve water usage and waste management is growing each month, and many proposals would require full electrification of properties.

Inflation has increased construction and operating costs during the past two years, but those costs are starting to moderate. The one cost that is continuing to rise, and faster than all the others, is hazard insurance. According to a Trepp study, “in Florida, Texas, and California, the average property insurance per unit in the multifamily property type grew about 37%, 43%, and 35%, respectively, from 2020 to 2022.” Insurance costs are rising across the board and in markets particularly vulnerable to the increasing instance and severity of storms, heat, fire, and wind, insurance is becoming less available. This has been particularly pronounced in the single-family sector, where a lengthening list of well known companies including Farmers and State Farm are pulling out of the Florida market.

The Regulators Weigh In

A lot of time will be spent in the next two years negotiating loan restructures. Those with long memories are aware that at the cusp of each downturn the regulators issue a policy governing how lenders manage distressed debt. The guidance encourages lenders to work with borrowers and provides examples of workout strategies. At the onset of the pandemic the regulators went further, providing extraordinary accommodations for lenders to forbear payments or extend loans without having to downgrade or impair the credits. Those accommodations have burned off as this new period of distress caused by higher interest rates is beginning. Many in the industry have lobbied the regulators to reinstate similar accommodations to facilitate workouts and ease the transition to the higher rate environment. 

At the end of the first half of the year the regulators issued a joint Policy Statement on Prudent Commercial Real Estate Loan Accommodations and Workouts to replace the guidance issued in 2009. While the Covid-19 accommodations were not reinstated, new guidance is offered on short-term loan accommodations to address temporary disruptions in property and loan performance. While there is no explicit mention of any distress in the real estate sector, these policies are always issued when the regulators know the lenders are likely facing a significant increase in sub- and non-performing commercial mortgage debt. 

Opportunities in Every Phase of the Cycle

Falling property values translate into headaches for some and bargains for others. The May RCA CPPI commercial property price index declined 11.2% year-over-year with the largest drop in multifamily (12.5%) and the second largest drop in office (8.9%). Because transaction volume is so low and these statistics reflect closed sales, they serve only as directional indicators. But the direction is clear and the true change in property values will emerge as sellers are forced to sell. As noted, the distress is triggered when a mortgage matures, a major tenant moves out, or a hedge on a floating rate loan expires. What these situations have in common is the need for more capital, and the owner must determine the cost of and potential return on that new capital as well as potential ownership dilution. The funds could be sourced from existing investors, from mezzanine lenders, or from opportunistically priced rescue capital. 

Lenders are performing a similar analysis, ascertaining whether to stay in the deal or move on. More lenders have begun to sell those loans they believe will be difficult to work out or that may end in foreclosure. For opportunistic players such as private equity, debt funds, and even family offices, the investment landscape is getting broader and deeper. They are providing capital directly to owners and also buying distressed loans from banks and negotiating with the owners from the other side of the table. For debt funds there is also the opportunity to fill the gap left by traditional lenders who have greatly reduced their origination volume. 

Not all opportunities are in distressed situations. Property performance across property types (even some office) remains strong and there are always deals to be found, even the popular value-added deals, albeit without that third-year refinance. The difference is the deeper level of due diligence investors must perform to truly understand the property and its competitiveness in the market, develop a strategy for working through negative leverage, and identify and get paid for the risk. Potential deals need to be carefully modeled and the assumptions should be stress tested for market conditions we can’t currently predict. Today’s uncertainty prevents us from knowing what cap rates will be in six months let alone five-to-seven years.

Real estate investors have seemingly unlimited capital. Estimates of global dry powder exceed $800 billion, and Blackstone just raised the largest real estate private equity fund in history. In the short-term, that capital will likely continue to be idle until there is more clarity on the direction of interest rates, inflation, and recession, and the duration and severity of asset deflation. In the long-term, equilibrium will be restored and capital will flow freely, and rapidly. Between now and then both the challenges and opportunities will grow.


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