The Latest on Commercial Real Estate

The Latest on Commercial Real Estate

Everyone keeps asking about default risk from CRE loans. How worried should we be? It is true that the office sector faces a particular set of challenges; however, other sectors within CRE have stronger fundamentals, such as properties in the industrial sector and Class A retail properties. From a GDP perspective, the office sector represents a small part of the overall economy—office construction has a 0.4% share of the overall U.S. GDP.

While we don’t underestimate the challenging outlook for the sector, we also identify a unique opportunity set for private investors.

The challenges.

1. Vacancy rates: Worse for the office sector. Rising rates are piling pressure on the troubled office sector. Vacancies soared in the early stages of the pandemic, and have kept rising since. Today, the office vacancy rate is above where it was in 2010, one year out from the global financial crisis (GFC). Office sales volume is depressed as well. Essentially, only Class A office properties with great amenities are being sold in today’s environment.

Why? Blame it on the rise of remote work (combined with an abundance of office supply). While more employees have recently returned to the office, the outright level of remote work remains more than four times higher than it was in the pre-pandemic era.

2. Tightening of credit availability and higher rates will spell trouble for some borrowers. Although the liquidation rate in the office sector is low at present, we expect cumulative liquidations of commercial mortgage-backed securities (CMBS) for the office sector to rise significantly over the next 10 years. In terms of CMBS delinquency rates, rising delinquencies are concentrated in the office sector and for regional malls. The stress hitting regional malls is not new: Delinquency rates shot up in the early stages of the pandemic due to a collapse in retail foot traffic and the associated surge in online shopping. As with the office sector, the regional malls sector is struggling with an abundance of older properties that were built decades ago.

3. Rising rates can quickly erode valuations. CRE assets are very long duration in nature, so their values are particularly sensitive to interest rates. But how, exactly, do higher interest rates—holding everything else constant—erode the value of a particular building? In short, a higher capitalization rate (cap rate) translates into a lower property valuation—assuming Net Operating Income (NOI) is constant. Ultimately, when cap rates rise, if the borrower were to look at refinancing the loan at a lower valuation (keeping the loan-to-value ratio constant), the borrower would have to contribute an additional tranche of equity to get the refinancing done. This is a primary challenge today, as cap rates have reset higher across the CRE markets, but especially so for the troubled Central Business District (CBD) office sector.

Latin America suffers from the same malaise: Office. From Mexico City to Buenos Aires, there have been similarities within the CRE space. And just as in the United States, it comes down to a subsector basis: a challenging office sector while industrial property demand is booming.

Same as in the rest of the world, vacancies across Latin America’s commercial real estate rose during the pandemic. Between 1Q’20 and 1Q’21, unlet space rose by 1.034 million square meters. The recovery, though, has been up to the particular country and sector—with the office sector broadly lagging the industrial sector.

The office rental segment began to show signs of incipient recovery from the pandemic lows, particularly driven by markets such as São Paulo, Mexico City, Bogotá and Medellín. And this trend has continued throughout 2023. There’s a lot of ground to be recovered, though—much like in other geographies, as return to in-person work, project reconfigurations and new labor demands are making it hard to return to prior occupancy levels. In Mexico, particularly Mexico City, Monterrey and Guadalajara, there’s been low demand for office space coupled with an oversupply, which has pushed vacancy rates to 23.5%, 22.3% and 14.8%, respectively. Very much in line, Lima saw its office vacancy rate reach 28.7% after the office market recorded the delivery of two new buildings during the first half of 2022.

Then we have the “flight to quality” phenomenon, where inventories have been primarily within the premium segment, indicating companies have been focused on location, technical specifications and internal space distribution to generate efficiencies. Markets such as Colombia and Peru have been boosted by companies within the Business Process Outsourcing (BPO) sector, while Mexico has been propelled by companies looking to do more business in the region on the back of the nearshoring trend.

In Buenos Aires, a booming real estate sector masks economic deficiencies, as companies are investing in real estate to safeguard their capital amid the country’s deteriorating economic environment and difficult exchange rate system—after all, nothing like real assets to protect yourself from hyperinflation. In fact, in the last two years, operations worth more than $500 million have been registered.

The other side of the story involves industrial commercial real estate, and the spotlight here would be Mexico and the nearshoring trend. Demand for industrial space reached ~400,000 square meters in 1Q’22, representing half of the annual demand of 2021 and total demand in 2020. Said simply, nearshoring net demand rose to a record high of 40% of total demand in Mexico, compared to 21% last year. Demand is coming from China, but the United States is rapidly gaining market share as well. As it can be expected, 90% of the demand is directed to the northern markets, mainly Monterrey and Tijuana, where rents have increased ~20% year-over-year, and vacancies are at historical lows of 2.4%. Nearshoring projects under development include LEGO’s $500 million investment (33.8km2 expansion) and MATTEL’s $50 million investment, overtaking hubs in China, Vietnam and Malaysia—both in Monterrey.

The opportunity set for investors comes from a collapse in financing for properties that have strong economic fundamentals. We can see this opportunity by considering the apartment sector, which generally still exhibits strong economic fundamentals in the context of the national shortage of housing units in the United States. Apartment vacancy rates have risen recently; however, this is more of a normalization to pre-pandemic levels than anything else. Rent growth in the apartment sector continues to be solid, rising 7% over the last year. Meanwhile, financing conditions for apartments have deteriorated significantly, as banks have pulled back.

Here’s where private lenders come in. Ultimately, reduced bank lending translates into slower economic growth. Remember: Lending acts as oxygen for the economy. If companies can’t finance their operations, or consumers can’t finance their big ticket items, then sales, the relevant gauge in this case, decline. We have seen this when it comes to CRE properties, along with CMBS spreads widening materially (now significantly in excess of high yield corporate bond spreads).

What does this mean for your portfolio? Ultimately, CRE is a complex asset class in which decisions are made on a property-by-property basis. The external managers on our platform have deep expertise when it comes to investing in CRE, and they are uniquely positioned to take advantage of the financing stress we are seeing today in the asset class.