The commercial real estate market has been the subject of negative headlines for much of the past year, but market participants agree that the real story to watch is playing out at the Federal Reserve.
“The outlook on rates is probably the biggest variable before the transaction market starts to normalize,” says Indraneel Karlekar, a senior managing director at Des Moines, Iowa-based Principal Asset Management. “There are some concerns that the Federal Reserve is not done raising rates.”
The reason why the Federal Reserve’s actions – and not the pessimistic headlines – are the thing to watch is simple, market participants say.
“The markets are looking at the Federal Reserve to know when rates will peak and that knowledge will, in turn, give confidence. Values will stabilize and borrowers will be able to pencil in a more terminal cost of borrowing,” Karlekar says.
Negative headlines in the mainstream press about commercial real estate have tended to focus on three pressure points: the health of national and regional banks with strong exposure to real estate, the impact of the estimated $1.9 trillion of commercial mortgage debt expected to mature over the next three years and the potential for distress in the office sector.
“The overriding issue for everything, and probably part of the reason why people are tending to paint real estate with one brush, is because the Federal Reserve changed interest rates more than 500 basis points,” says Mike Acton, director of research for Boston-based manager AEW Capital Management.
Many of the headlines in the mainstream media are also conflating distress in the office sector with the broader commercial real estate market.
“When people hear about problems in office buildings, it’s natural to extrapolate that to real estate very broadly. But commercial property is far from monolithic. There are a million little stories going on,” Acton says.
Toby Cobb, co-founder and managing partner of national lender 3650 REIT, believes although real estate is a sector- and market-specific asset class, the doom-and-gloom headlines are well-warranted.
“I wish that I had a more constructive view about real estate writ large, and that it was different than the popular press,” Cobb says. “The sad news is, I actually think it’s going to be worse than the popular press says it’s going to be.”
This is because real estate is a highly levered asset class that has been deeply affected by the rate increases, Cobb says.
“With the rate increases we have seen, the pure math means values should be down across the board,” Cobb says.
“Frankly, I think some of the worst problems are going to be in multifamily, which everyone thinks is a protected asset class.”
That, however, is where the nuance once again comes in. “The macro demographics for multifamily will mean better outcomes over the longer term,” Cobb adds.
In addition to the Federal Reserve’s actions, public real estate companies are also offering real-time metrics that open a window into the performance of the market.
Iman Brivanlou, a managing director at Los Angeles-based TCW Investment Management Company, notes the most recent slate of earnings from real estate investment trusts have painted a brighter than expected picture.
“If you combine that with generally strong economic metrics; inflation, which tends to be dropping; and a data-dependent Federal Reserve, which is now on pause, the no- or soft-landing scenario is gaining credibility,” Brivanlou says.
Still, Brivanlou believes a recession is likely. “There is variability in the lags from the impact of monetary tightening. The extent and pace of tightening that occurred this year has not yet been fully felt and we don’t think will be fully felt until 2024,” he says.