FS Investments sees a long-term shift in commercial real estate returns amid market uncertainties

A new report from FS Investments believes that as historically low interest rates and liquidity are drying up, a higher percentage of total returns in commercial real estate will come from income and yield rather than capital appreciation. 

“Over the past five to 10 years, a significant portion of real estate returns has been driven by capital appreciation, and a big reason for that has been the really low cost of financing,” Andrew Korz, director of the investment research team at the Philadelphia-based manager, told Real Estate Capital USA.  

The federal funds rate has risen from 0.25-0.5 percent in March 2022 to 4.75-5.0 percent a year later, with an additional 25-basis-point increase expected this week. This increase, combined with wider loan spreads, has meant a substantially higher all-in cost of capital. 

“To deal with the higher debt service costs, property owners will have to raise rents, and try to cut costs, and it’s really come down a lot more to their ability to generate income on the asset than buying real estate as a financial asset, and hoping it appreciates over time,” he added. 

The rising rates have affected the transaction market. Commercial estate sales in the first quarter were subdued as broadly expected, marked by a decreasing transaction volume across all property types to around $85 billion, according to the MSCI capital trends for Q1 2023. Sales of CBD office fell 78 percent from a year ago, a level below the historical average. 

Furthermore, the report expects transaction volumes to remain muted in Q2, with more of the activity being geared toward refinancing as around $400 billion in commercial real estate loans will come due in 2023. 

Meanwhile, according to FS Investments’ research, values of all commercial real estate properties have fallen 9.3 percent from their July 2022 peak, which amounts to a reversal of 38 percent of the price gains in December 2019. The office sector noticeably lost more than 60 percent of the gains since pre-pandemic, while the apartment sector has lost around 40 percent of gains and seen values fall 13.1 percent from July 2022.  

Sponsor options 

Property owners now either must sell the assets into a buyer’s market or opt to pay higher debt costs at a time when valuations are dropping, Korz said. However, Korz also mentioned the majority of the maturing commercial real estate loans have benefited from price appreciation over the past five to 10 years, which will help property owners to refinance at a lower loan-to-value ratio, and without having to inject significant fresh equity. 

“Most of the loans that we’ll see come due will have a much lower LTV than they [were] originated at,” Korz said. “For maturing apartment loans that were originated 10 years ago, the average asset has appreciated by 135 percent, which, assuming an initial loan-to-value of 65 percent, puts the current LTV at around 28 percent.” 

Korz added net operating income growth of 54 percent across property sectors over the last 10 years should also give borrowers the ability to cover what will be a substantial uptick in debt service costs. 

Challenged returns 

A tighter lending market will also have an impact on LTVs. Banks have been tightening lending standards since the interest rates started to rise steeply last year and this is expected to continue, fueled by the recent volatility in the banking system. Small and mid-sized regional banks, which made up 27 percent of the commercial real estate market in 2022, could also scale back their positions, Korz added. 

Despite various headwinds for borrowers, Korz believes a combination of the growth in NOI and dropping property values will incentivize property owners to work with lenders rather than hand back the keys to assets. 

From the perspective of the lenders, however, Korz said: “This is a situation where you really want to be a debt holder, because not only is the underwritten return to equity lower, but the income you can generate on the debt is higher.” 

This is a favorable scenario for well-capitalized lenders to deploy capital at attractive spreads while retaining conservative underwriting standards, he added: “I think the relative attractiveness between equity and debt has fundamentally shifted, and that’s a multi-year phenomenon, not something that’s going away quickly.”