Relative value in the commercial real estate market, after a decade of growth fueled by low interest rates, has pivoted to the credit side of the business, according to panelists at the PERE America Forum, held last week in New York.

The panel included John Murray, managing director, global private real estate at California-based PIMCO; Lee Levy, managing director at New York-based Goldman Sachs Asset Management; Prashant Raj, managing director and head of US real estate debt at Vancouver-based QuadReal; and Varuth Suwankosai, head of global credit at Toronto-based Oxford Properties Group.

There is a key reason behind this shift – the more than 500 basis point increase in interest rates over the past 18 months has changed the metrics of commercial real estate investing, Suwankosai said.

“Equity development and value-added projects made a lot of sense when rates were zero. It does not make a lot of sense when rates are 5 percent,” Suwankosai said. “I think relative value has swung toward the credit part of the capital structure.”

This shift does not mean, however, that lending or investing is without its challenges, Murray said. In a presentation preceding the panel, entitled “A Real Estate Reckoning,” he outlined the macroeconomic and geopolitical factors that have stalled deals and made it difficult for lenders and borrowers to determine valuations.

“In 2021, the 10-year Treasury was at around 1 percent and the rationale [around investing] was that we were in the new normal of low cap rates. And then we got to 2022 and had a big spike in the 10-year Treasury. What did real estate do? For the first six months, the market said, ‘We have this big historical spread between where cap rates are today and where the 10-year Treasury is – we can absorb this, and we will be fine.’”

But in the second half of the year, as rates continued to rise, there was a sense that growth would help the market out of short-term difficulties, Murray said.

“When we got into 2023, we experienced short-term rates being pushed out and the mindset became ‘Stay alive until 2025.’ Now the question is, ‘Do I want to stay alive? Will this ever end?’ Murray said. “That sentiment is dramatically changing the dynamic in the market.”

The changing dynamic in the market is in some ways centered around the question of valuations. While there has been widespread discussion of dislocation, Oxford’s Suwankosai believes “correction” is a more accurate term.

“The market benefited from a rate environment that was conducive to growth for the past decade. The fundamental truth is that real estate is correlated to interest rates and now we are dealing with a correction,” Suwankosai said.

Suwankosai continued: “I have the benefit of being a borrower and credit investor as well, so I see both sides of the house. As a borrower it will be challenging, and we need to think about how we are positioning our portfolios and our business lines to face an environment in which liquidity is paramount.”

Goldman Sachs’ Levy traces some of today’s problems back to the global financial crisis, when rates were extremely low.

“It was not that we were over-leveraged, it was that the assets that we all levered were overpriced,” he said. “Rates were near zero and cap rates were the tightest they have ever been. It was not that people were putting on a 70 or 75 percent debt structure, it was just that the assets were mispriced because rates were in a different world.”

Dealmaking difficulties

QuadReal’s Raj noted it continues to be difficult to get any deal done. “I don’t think we really know where values are today,” he said. “As a credit guy, I think the equity in a capital structure is basically a buffer and that is going to be under pressure. It will be hard unless banks and other senior lenders come back to the market. And it will be really hard to get credit transactions done without sponsors putting equity into a deal.”

Still, there are signs the current freeze is breaking. The market has been through covid, rising rates, multiple wars and uncertainty that has pushed investors to a risk-off mentality, but this will ultimately change once there is more certainty around rates, Levy added.

The imminent sale of the Signature Bank portfolio also is not expected to provide the clarity on values the market is seeking.

“I’ve heard people say the sale of the Signature Bank portfolio will be the catalyst for value, but that won’t really tell you anything,” Murray said. “If you’re on the outside, you don’t even know what the assets are. If Company X buys Portfolio Y from Signature Bank for 70 cents on the dollar, you don’t know the structure of their financing or the business plan. That won’t be a catalyst.”

Flexibility in investment will be key, with the panelists citing their ability to look at the entire capital structure of a deal before making an investment. Many of the questions lenders and investors are asking means a tilt toward the credit side of the capital structure, Murray added.

“What is the profile of this investment? How does it look with a wide range of cap rates and growth assumptions? This generally leads more toward debt in the capital structure,” Murray said.

At Goldman, the firm will be agnostic about doing an equity or a debt deal.

“I think in a market like we are sitting in today, there is a challenge to put out equity capital unless you have the kind of structure that requires you to,” Levy said. “The sweet spot is in the credit space, whether it is buying loans or making preferred equity investments. It is a nice way to look at real estate from a relative value perspective.”