The US commercial real estate market finished 2022 in a much different position from when it started, with limited clarity over pricing, substantially higher interest rates, and faster-than-expected obsolescence for some sectors. For many, it was two years packed into one. The biggest story was the rapid increase in interest rates and how this rise would pave the way for the next real estate cycle.
“The first half of 2022 was extremely strong,” Indraneel Karlekar, senior managing director and global head of research and portfolio strategies at Principal Asset Management, says. “Rates were very low, capital was widely available, and that was when private market values hit the peak. When the Federal Reserve started to change its policy aggressively, the cost of debt increased dramatically, and the cascading effects of debt on value started to be felt from the third quarter.”
The Federal Reserve began to raise interest rates in March 2022 to fight inflation, and executed a series of rises that left the Federal Funds rate at 4.25 to 4.5 percent by December, a steep increase from the 0.25 to 0.5 range seen at the start of the year. It was this change that first slowed, then halted, investment sales and financing activity, with the knock-on effect of making it difficult to determine pricing or valuations for most assets.
“[The rate hikes] took a pretty significant hit on investor appetite and started to slow down transaction volume,” Karlekar says.
Higher rates were not the only factor driving 2022. There were also significant headwinds from geopolitical tensions around the Russia-Ukraine conflict, US-China trade frictions and other macro events. “The turmoil in Ukraine and the impact it had on commodity prices fed its way into inflation in 2022,” says Karlekar.
Although the Russia-Ukraine conflict began in February, the impact on US real estate was delayed, says Danielle D’Ambrosio, head of real estate debt asset management and servicing at Charlotte-based manager Barings Real Estate. One group of sponsors immediately moved to refinance maturing debt as soon as possible, while another saw it as a blip and wanted to wait.
“We know who’s right, in hindsight,” says D’Ambrosio. “You saw turmoil in the markets in February, but we were still closing deals because deals had been negotiated months before and had to get closed.”
For global institutional investors, geopolitical risks led to a more cautious approach. “Inter-regional capital flows, [like] Asia to the US, [or] Asia and US to Europe, have definitely stepped back,” says Doug Weill, founder and co-managing partner of Hodes Weill & Associates. “Institutions are more regionally focused at the moment in this very cautious market.”
One notable withdrawal is China, which is not as large an investing force in US real estate as it was in the past. Karlekar says, however, the gap created by the diminishing investments from China could ultimately be filled by a diverse group of international investors.
“The US remains the deepest, most liquid, most sought-after real estate market in the world,” says Karlekar. “And I would argue that if there’s a reasonable correction in US real estate values, that will open the doors for a lot of investors who’ve been waiting on the sidelines.”
Setting the stage
Looking ahead, analysts mapped out several trends in the US commercial real estate market: as leverage levels lower and interest rates rise, cap rates will continue to move up.
“Where there is price discovery occurring, it does suggest that the fourth quarter trends of declining valuation have continued into the first quarter,” Karlekar says. Debt, he adds, plays a very important role in repricing the real estate market in a transitional period.
Weill has also observed a drop in asset values. “In the fourth quarter, core and core-plus funds took about a 5 percent average write-down in net asset value. Some of the very large fund managers have taken moderate write-downs, [with] some cases less than 5 percent, [and] at the high end close to 10 percent.”
Sadhvi Subramanian – senior vice-president for commercial real estate at Minneapolis-based lender US Bank – believes the impact from rising rates will continue to be felt. Higher rates mean buys will be less aggressive, resulting in rising cap rates. “I think the 3 percent cap rates on multifamily and industrial are gone because you can’t get the growth in net operating income to get the exit cap rate that you need, and still make a return on your investment,” Subramanian says.
Still, Subramanian notes the transaction market will start to resume as sponsors come up against near-term maturities. “There have to be sales. People have to [be willing] to sell and there has to be a meeting of the sale price between the seller and the borrower.”
Analysts say the “unlocking” process of the lending market will look like a cycle: once the markets reprice to where the lending market feels comfortable, lending activity will return in earnest. Once the lending market becomes active, greater flows of equity will happen.
As for maturing loans that face delinquencies and default risks, lending institutions and borrowers are working on maintaining or modifying their existing financing.
“What we’re finding is most of the borrowers that have [maturities] coming up are working directly with their lenders,” says D’Ambrosio. “Distressed assets, especially financed by banks, are getting a lot of accommodations.”
She says Barings is happy to take back properties still performing. For properties with issues, Barings’ strategy is to look for terms changes and convince borrowers to recommit to the building. With possible negotiations like resetting interest rates, extending loan terms and paydowns, “most borrowers show a willingness to protect their equity by meeting the lenders in the middle,” she adds.
Some lending momentum in 2022 also triggered a profound paradigm shift in sectors like office, while other, alternative property types further emerged as popular investment opportunities catering for today’s secular and demographic changes.
“The biggest trend really has been the emergence of alternative property types,” says Karlekar. “The non-traditional asset property types that have become so important are really going to become the new core. The structural drivers of the economy are what’s causing the huge surge in demand for some of these non-traditional property types.”
Data centers, self-storage, manufactured housing and student housing have continued to attract capital, for example, while strategies like industrial outdoor storage, and movie and TV studios are gaining more attention in the market as the growth of e-commerce or the content industry created demands for relevant properties.
The office sector, however, elicited particular concern as loan maturities loom. Financing costs are higher and fewer lenders are active. Additionally, many tenants are trying to reduce their space footprints given a shift toward hybrid work culture, Subramanian says.
More broadly, on the institutional investors’ side, 2023 will also be a transitional year where capital would be reallocated when investors try to rebalance their portfolios as a result of the denominator effect.
“There is a view among institutions that once the [real estate] market resets and transactions resume, and we’ve [had a] better sense as to where cap rates are, the next couple of years could be good vintage years for capital deployment,” says Weill.
Although interest rate hikes had a dampening effect on transaction volumes that made institutional investors move slower to deploy capital, according to Weill, there are some large institutional investors that remain active in the market. They will be instrumental in getting the next real estate cycle going.
“There have been a number of take-privates, including take-privates backed GIC out of Singapore, one of the largest sovereign’s wealth funds in the world,” says Weill. “There are signs that some of the largest institutions are starting to come back into the market and trying to take advantage of some of this [market] dislocation.”