Uncovering opportunities in stressed commercial real estate

Despite the doomsday headlines, supply/demand fundamentals and leverage levels look solid across most commercial real estate (CRE) sectors. But it’s no secret: The most aggressive Federal Reserve (Fed) rate hiking cycle in 40 years has raised the cost of capital and lowered property valuations, especially for property owners grappling with a higher cost of debt.

Yet even as CRE owners regroup in a more challenging business environment, investors anticipate promising opportunities in stressed CRE markets—if you know where to look.

Higher rates, scarcer credit

Higher rates mean that CRE investors and developers accustomed to borrowing money at low single-digit rates must adjust to much higher interest payments. What’s more, loans are harder to come by. Links between lenders in the interconnected CRE industry have sped up “contagion” effects as credit conditions have tightened. The U.S. regional banking crisis earlier this year exacerbated the problem, inevitably, given that small and regional banks account for 26% of CRE loans.¹

In such an environment, investors willing to provide “rescue capital” to struggling property owners may be able to extract favorable terms from borrowers, and thus potentially attractive returns on their investments. Many outstanding CRE loans will come due over the next three years, potentially providing a good entry point for investors. While we are generally steering clear of the troubled office sector, we find interesting prospects in the residential, hospitality and industrial sectors of the commercial real estate industry.

What might this mean for you? Depending on your family’s goals and investment choices, the CRE market may offer the potential for income, capital appreciation, inflation protection and portfolio diversification.

A massive, interconnected industry

First, a brief overview of the U.S. CRE industry. Among the key sectors: office, hospitality, retail, industrial (including data centers) and residential. Definitions of “stressed” properties vary but essentially describe a property at risk of financial collapse. For example, its debt might be at risk of default.

Across the CRE industry, the various stakeholders—commercial banks, investment banks, private lenders, property owners, federally backed mortgage providers (Fannie Mae and Freddie Mac)—are closely linked and often interdependent. It’s an interconnected web in many ways. For example, approximately $4.5 trillion in outstanding CRE debt is held across a variety of lenders, from the largest banks to life insurance companies. About $1.5 trillion of this debt is due to mature in the next couple of years, a specific point of concern for many industry participants.

The interconnected web seemed strong in 2021, when lenders made CRE loans at a rapid pace and values peaked in many markets and sectors. Post-pandemic trends, notably the rise in remote work and changes in urban migration patterns, were already taking a toll in 2021. But their effects on real estate values were relatively modest.

Wider CMBS spreads, fewer bank loans

Then came the Fed’s first rate hike in March 2022, which occurred a few weeks after Russia invaded Ukraine. Around this time commercial mortgage-backed security (CMBS) spreads, defined as the excess yield over comparable Treasuries, widened dramatically. Higher rates and wider spreads translated into a higher cost of capital for real estate loans.² As rates rose—the U.S. policy rate jumped from zero to 5% in just a year—and real estate values began to deteriorate, banks moved to sell off some of their loan portfolios. Adding to the challenge for real estate owners, CMBS originations declined through 2022 and the first half of 2023.

The regional banking crisis in the spring of 2023 gave banks fresh impetus to move CRE loans off their balance sheets. Many regional banks, which experienced the most acute stress during the crisis and consequently faced the prospect of heightened regulatory scrutiny, hold a significant amount of CMBS on their balance sheets. In fact, several regional banks are some of the largest holders of agency CMBS holdings as of 2Q 2023.³

But even as banks moved to reduce their CRE loan exposure, they struggled to meet bank capital regulatory standards. As a result, CRE loan origination volumes fell further.

To illustrate the particular pain that high interest rates inflict on the CRE industry, consider the impact of higher rates on an office building originally valued at USD 100 million. A key industry metric—the cap rate, a measure of a building’s profitability in relation to its value —is relevant here. When the cap rate (net operating income [NOI] divided by the building’s value) rises, that’s worrisome in real estate, implying the building may not be able to generate sufficient income in relation to its value, which lowers the property’s value.

Higher interest rates can lead to higher cap rates because the cap rate represents the potential rate of return of a CRE investment. So as risk-free rates rise, the required rate of return of a risk asset would also be expected to increase. Higher interest rates increase borrowing costs, decreasing overall demand for CRE properties, resulting in declining property values. Cap rates thus rise to compensate owners and investors for the higher risk and increased cost of holding CRE. Even when NOI remains constant, higher cap rates imply that a property’s value is eroding.

And average U.S. cap rates have indeed moved higher over the past year.⁴

Higher cap rates naturally affect a property owner who needs to refinance. Imagine a USD 100 million building whose cap rate rose from 4.5% to 6.25%. By the unchanging arithmetic of the cap rate’s ratio, the increase means the USD 100 million building’s valuation has been pushed down to USD 72 million—assuming a constant net operating income.

Assume the building owner in this hypothetical scenario is seeking to refinance, while not taking on more debt and thus keeping constant the loan-to-value (LTV) ratio. That borrower would have to contribute an additional USD 18 million in equity to refinance this loan at the property’s new lower valuation.

Higher interest rates are especially onerous for property owners with floating-rate debt. In lieu of repaying their loans, some landlords effectively handed over the keys to the front door. These last-ditch measures became more commonplace after two regional U.S. banks, Silicon Valley Bank and Signature Bank, suddenly collapsed in March 2023, further straining the CRE market.

A deeply troubled office sector

Perhaps no part of the CRE market is more troubled than the office sector. Vacancy rates well above historical averages (the inescapable fallout from remote work) translate into lower rental income and depressed property values.

Not surprisingly, the pace of new construction has slowed dramatically. Less than 5 million square feet of new office space has broken ground in the U.S. year-to-date, while 14.7 million square feet of office space has been removed from the market, according to a recent Jones Lang LaSalle report. The net removal of almost 10 million square feet of office space represents the first net decline since 2000.⁵

Across the CRE industry, property owners with mortgages coming due in the next few years face a pressing challenge. According to a Mortgage Bankers Association survey, approximately 16% of all outstanding commercial mortgages will mature in 2023 and another 15% in 2024. In all, some USD 728 billion of commercial mortgages will mature in 2023 and USD 659 billion in 2024.⁶

To be sure, some property owners with debt maturing in the next few years may be able to negotiate new terms with their debt holders. Given the state of the CRE market, many lenders are hesitant to take ownership of a property that would be nearly impossible to sell, tough to lease and costly to maintain.

Investment opportunities

How much damage might commercial real estate cause in the broader U.S. economy? We expect it will be limited. We do not think that stress in the CRE market will spark a broader recession.

And in the meantime, the U.S. commercial real estate market continues to offer a wide range of opportunities. As mentioned, we are avoiding the office sector, at least for now, but we find interesting prospects, and at attractive valuations, across the retail, hospitality, industrial and residential (multifamily, senior housing, student housing) sectors.

Across the CRE industry’s interconnected web, we see the potential for compelling risk-adjusted returns in both equity and debt markets, with a focus on key access points:

Buying CRE loans from bank balance sheets: As more bank-originated loans come under stress, more banks may sell loans to strengthen their balance sheets. In addition, many U.S. banks may also seek to create balance sheet liquidity to meet new regulatory capital requirements. In both scenarios, real estate debt investors may be able to purchase non-performing loans or loans experiencing stress at a discount.

Capitalizing on volatility in the securitized CRE debt markets: If spreads widen materially in securitized CRE debt markets (CMBS or collateralized loan obligations), investors with expertise in the properties underlying those securities may be able to take advantage. Opportunities may emerge in deeply discounted loans which are not performing due to overleverage, higher interest expense or a struggling business strategy. A broad-based sell-off in securitized markets may create openings to pursue “pull to par” trades: An investor acquires an asset that is pricing in distress but the investor projects it will be redeemed at par.

Acquiring loan-to-own: Investors experienced in asset restructurings may acquire discounted, non-performing debt to lead a restructuring—and thus become the equity owner of a property at a deeply discounted valuation.

Privatizing publicly traded real estate companies or REITs: To the extent that public equity market volatility creates a wide gap between public market valuations and fundamental value, real estate investors with scale may be able to take-private a publicly traded company at a price far below the value of the underlying property portfolio.

Buying equity at a discount: The impending wall of real estate loan maturities may create growing ranks of motivated sellers seeking an equity infusion or the outright sale of high-quality assets at a discount. Potential buyers may find less competition than they might expect, as investors with perpetual capital pools (REITs, open-ended core real estate funds) have less capital to deploy. In other words, real estate equity investors with dry powder may benefit handsomely from market dislocations.

The day may come when we decide to invest in the battered U.S. office market. But we think it will take some time. Until then, we focus on sectors that are more secular in nature, particularly residential and medical offices. In a challenging environment, we continue to uncover diverse opportunities across the U.S. CRE market – from medical offices and multifamily housing to data centers and hotels.

¹Federal Deposit Insurance Corporation, Moody’s Analytics, Mortgage Bankers Association. Data as of April 2023.

²There are several types of CMBS transactions. Agency CMBS transactions include multifamily loans originated by GSEs (government-sponsored enterprises) such as Fannie Mae and Freddie Mac. The loans are guaranteed by the respective GSE. Non-agency CMBS transactions include conduit CMBS, which are deals that contain a number of diversified loans across types of stabilized properties, usually in the form of 10-year fixed rate loans. Another type of non-agency CMBS transaction, single borrower CMBS, are transactions backed by a single high-quality or “trophy” property for a single borrower. These are typically 2-3 year floating rate loans. Separately, CRE CLOs (collateralized loan obligation) are funding vehicles used by debt managers that are typically short-term, floating rate bridge or transition loans issued against a pool of CRE properties.

³BofA Global Research, S&P Market Intelligence. August 8, 2023.

⁴Bloomberg Financial, L.P. Data as of August 7, 2023. Cap rates measured using the Average Cap Rate National Index from Bloomberg, which uses 3 month rolling average for cap rates and PPU/PSF, 3 month sum for sales volume, # of units, # of properties excluding refinancing transactions. Based on independent reports of properties and portfolios $5 million and greater.

⁵“U.S. Office Outlook Q2 2023: Cyclical challenges persist but tentative green shoots emerging in second quarter,” Jones Lang LaSalle. July 24, 2023.

⁶Mortgage Bankers Association. Data as of March 10, 2023.