The Commercial Real Estate crisis | What you must know

The commercial real estate industry is facing a reckoning. With rising interest rates, declining property values, and stressed owners, the conditions are ripe for a wave of foreclosures and distress sales. While unnerving for some, for others this may also represent a generational buying opportunity. 

In this comprehensive article, we’ll explore the key elements causing the emerging commercial real estate crisis, how we got here, and what’s likely to happen next.

The perfect storm brewing in commercial real estate

A collision of factors has brought the commercial real estate industry to a precipice: 

1. Cheap debt fueled a buying frenzy: Historically low-interest rates over a decade after the financial crisis and substantial easing during the pandemic led to an explosion of loans to acquire commercial assets. With high leverage and easy money, investors bid up property prices to unsustainable levels.
2. Rising rates are now stressing property owners: As central banks raise benchmark rates to combat inflation, floating rate loans are repricing drastically higher, sometimes more than doubling monthly payments. This is compressing returns and leaving owners’ cash flow negative.
3. Property values are declining: Cap rate compression from the buying frenzy has sharply reversed as incomes decline and capitalization rates increase, resulting in value reductions that make refinancing difficult.
4. The Fed Won’t Rescue the Market: Don’t expect the Fed to reverse course and lower rates. They have strongly signaled a commitment to an aggressive regimen of hikes to defeat stubborn inflation.

This confluence of factors has left the market on the edge of a correction. Next, we’ll explore how we got here.

Stage 1: How It Started

To understand the onset of the current commercial real estate crisis, we have to go back to March 2020 at the start of the pandemic.

The Fed drops rates to zero

With the economy in freefall as a result of the Covid lockdowns, the Fed took unprecedented action to shore up growth. They reduced the target fed funds rate to effectively zero percent. This made the cost of capital extremely cheap.

Bridge loans become popular

With benchmark rates near zero, floating-rate bridge loans became very attractive. Some bridge loans offered very aggressive terms:

• Higher leverage — up to 80% loan-to-value ratios.
• Interest-only payments.
• No recourse.
• Streamlined underwriting.

This type of cheap financing opened the floodgates for investors and speculators.

Stage 2: The Buying Frenzy

Flush with easy money, transaction volume exploded higher in 2020 and 2021:

• Global commercial real estate investment reached a record annual total of US$1.3 trillion in 2021—up by 55% from 2020 and 21% from 2019 (CBRE).
• CMBS issuance surged to $109.1 billion in the U.S. in 2021 — nearly doubling from 2020 levels (TheRealDeal)

With plentiful leverage available, investors engaged in bidding wars to acquire assets. This pushed prices to all-time highs and compressed capitalization rates.

The law of supply and demand

A key driver of the rapid asset inflation was a supply-demand imbalance. There was a huge appetite from investors but a relatively fixed supply of commercial real estate. With too much capital chasing too few deals, prices are detached from fundamentals.

The downside of compressed cap rates

Cap rates on commercial real estate compressed drastically from 2020 to early 2022. When investors pay more for a property’s net operating income, cap rates compress. This means investors accepted lower rates of return for the same streams of cash flow. This set the stage for a reversal when fundamentals shifted.

Stage 3: The Turning Point

While property prices were soaring, the stage was being set for substantial repricing. The turning point for commercial real estate came in 2022 with a rapid rise in interest rates.

Benchmark rates spike

As inflation persisted, the Fed was forced to aggressively raise interest rates. This resulted in a spike in the Secured Overnight Financing Rate (SOFR) which many floating rate loans are benchmarked on.SOFR went from 0.04% in March 2022 to 5.30% as of October 2023 (Federal Reserve).

Borrowing costs surge

On a variable loan priced at a spread over SOFR, monthly payments could have easily increased by more than 10 times between 2020 and 2023. This has drastically compressed debt service coverage ratios. Loans that initially made sense are now underwater.

Rents start declining

Making matters worse, inflation is impacting consumers’ budgets. Shelter inflation has driven rents higher over the past two years. But there are signs of a peak as demand deteriorates.

CBRE projects rent growth will decline from more than 10% in 2022 to around 4% on average across key cities in 2023 (CBRE).

With higher costs and weaker incomes, many commercial properties are seeing cash flow decline.

Stage 4: Distress and discount purchases

The combined impact of higher rates, lower rents, and inflated purchase prices has left many owners underwater. Unable to refinance or sell at a profit, defaults and distressed sales are on the rise.

Mortgage delinquencies are climbing

According to Trepp, the delinquency rate rose 14 basis points to 4.39%. This could just be the beginning of a wave of defaults.

Deals are starting to blow up

In Houston, over 7 multifamily properties have already been foreclosed on (see more in our video). These distressed properties often sell at substantial discounts compared to recent valuations.

Capital calls increase risk

Many property owners need additional equity infusions from their investors to stay afloat. However, most of these “capital call” requests were not anticipated at the time of investment. This increases risk.

Vulture investors circle

While uncertainty abounds in commercial real estate, well-capitalized investors are raising record amounts of dry powder. They aim to acquire discounted properties from stressed and distressed sellers.

What Should Investors Do?

For investors already committed to deals, transparency from operators is key. Understand the capital stack and risk exposures. Be ready for capital calls. Take comfort in the fact that generational buying opportunities often arise from times of dislocation.

Commercial real estate borrowers have limited options

With property values falling and loans underwater, commercial real estate borrowers have very few options to remedy the situation. Many borrowers are finding they are unable to refinance or sell without bringing substantial capital to close the shortfall.

Some may attempt to negotiate with lenders for modifications but most bridge lenders are not incentivized to give concessions. The only viable options for stressed borrowers may be to inject more equity, default, or try to sell at a loss.

Most likely, the wave of distressed transactions will need to run its course before stability returns. Until then, owners are stuck between a rock and a hard place.

Not all property types will be impacted equally

While all commercial real estate will face challenges in the period ahead, some sectors are better positioned than others. Multifamily housing, storage, and industrial warehouses have fared well during the onset of rising rates over the past year,  thanks to a still strong tenant demand and a booming economy. Hotels, Airbnb rental properties, and office space have lagged as business travel and remote work drag on performance.

Within property types, higher quality and well-located assets will hold up better. Their higher, more stable incomes can better sustain debt and value.

Understanding nuances across sectors, markets, and asset classes will be key to capitalizing on distress opportunities.

Questions investors should be asking their operators

For investors already committed to commercial real estate deals, frequent communication with operators is essential during this turbulent period.

Investors should be asking questions such as:

• What is the debt service coverage ratio and has it changed?
• What are you hearing from the lender?
• What is the outlook for property performance over the next 12 months?
• Do you anticipate any need for additional capital contributions?

Gaining transparency into the property’s financial health and capital structure will help investors assess risk and make informed decisions if capital calls arise.

Conclusion: A time for caution and opportunity

In summary, the stage is set for substantial correction in commercial real estate:

• Highly leveraged bridge loans are facing interest rate shocks.
• Property prices are declining as incomes fall and cap rates rise.
• Refinancing and sales will lead to substantial losses at current valuations.
• Distress and foreclosures will present buying opportunities.

While uncertainty and risk exist in the near term, the emerging downturn also represents a rare chance to buy discounted assets. Being prudent and selective will be key. We have weathered past cycles and there are always opportunities to capitalize on ahead.