Commercial real estate market trends and themes from 2023
The CRE debt fly-wheel remained stuck throughout 2023, and it’s apparent that the slow pace of originations is increasingly a very big problem for borrowers (and many legacy lenders). To put things into context, there’s roughly $5 trillion of outstanding U.S. CRE mortgages. Nearly half of those mortgages (~$2.3 trillion) are scheduled to mature during the next four years. However, the pace of new origination activity implies only $1.3 trillion of new originations over the next four years, leaving a $1 trillion potential funding gap.
While we believe liquidity will improve from 2023 levels, the market still faces an uphill climb to fully close that $1 trillion funding gap. One major issue is the severe curtailment of new lending from large and regional U.S. banks, who have historically been the largest lending channel with ~38% market share. Many of these banks continue to wrestle with office and multifamily loan exposure and write-offs, and that situation is expected to persist. As described by Wells Fargo’s CFO regarding these problem loans: “It’s a long movie… We’re past the opening credits but we’re still in the beginning of the movie, and so it’s going to take some time for this to play out.”
The office and multifamily sectors are currently sitting on estimated paper losses approaching $1.1 trillion, and that figure is likely to grow with persistent office demand issues, elevated multifamily supply, and higher interest rates and cap rates. At the end of 2022, Morgan Stanley estimated the total market value of the U.S. CRE market to be $12.7 trillion with office representing the largest sector at $3.1 trillion (~24%) and multifamily representing the second largest sector at $3.0 trillion (~24%). Green Street Advisors estimates that office and multifamily property values declined by -25% (~$780 billion) and -12% (~$370 billion), respectively, from the end of 2022 to the end of 2023, or $1.1 trillion on a combined basis. Much of the value destruction in multifamily is stemming from valuation, acquisition, and leverage decisions made only a couple of years ago during the euphoric 2021-2022 period.
Private capital will have to play a bigger role in the refinancing and equitization cycle that the U.S. CRE requires over the next few years. Record-high private equity dry powder targeting global CRE opportunities will help some, but that amount currently sits at just $384 billion in total – a far cry from the potential $1 trillion funding gap. And of the $384 billion, only $57 billion (15%) is earmarked for credit opportunities. $262 billion (68%) is earmarked for opportunistic and value-add opportunities, and the remaining $65 billion is targeting core and core plus opportunities.
Legacy portfolio issues and a lack of discipline from 2021-2022 are major factors slowing private capital’s ability to come to the rescue. Private equity firms seem to be struggling to figure out how to put their dry powder to work due to distractions or an overly bearish sentiment. The J-curve effect for that $384 billion in dry powder will certainly become more top of mind in 2024, but we remain pessimistic that these groups will see activity levels return to more normalized levels in 2024. Many private capital pools also seem to have become more pro-cyclical allocators to U.S. CRE rather than playing the role of counter-cyclical investors like in past downturns.
In addition to legacy portfolio issues, groups are also having to navigate several macro risks that have carried over from 2023 to 2024. Heightened geopolitical conflicts and risks, questions about the state of the U.S. political landscape and fiscal health, and lingering questions about the trajectory of interest rates will all continue to be top of mind for investors.
In terms of interest rates, the market seems to have recognized that the Fed will not immediately begin reducing rates in the first part of 2024. There’s still a lot of liquidity in the financial system with several trillion dollars having flowed into money market accounts and fixed income investments where yields finally seem attractive. Additionally, wealth effects are stirring animal spirits once again as a distorted housing market and rising stock market drive household net worth back towards peak levels. We believe these factors will diminish the likelihood the Fed lowers rates rapidly – doing so could risk a quick flow of capital back into the real economy and the stock market, and potentially risk another boost in inflation.
In addition to the factors above, there’s also the matter of the U.S. presidential election this year. With Donald Trump having all but locked up the Republican nomination, he seems to have a very viable path to winning a second term, further complicating the outlook for commercial real estate. It’s hard not to believe that a Trump presidency would have an inflationary bias – tax cuts, “stock market to the moon,” tariffs, and trade disputes. There’s also a possibility that an anti-interventionist approach to current geopolitical crises creates more issues and higher treasury issuance in the medium term, keeping upward pressure on treasury yields. These policy positions would further complicate the Fed’s ability to reduce interest rates (something Chairman Powell is probably already very focused on) and would likely maintain upward pressure on interest rates and cap rates for a period of time.
It’s not all doom and gloom (or nightmares), though. Prior to the pandemic, a major concern was that inflation in the U.S. had disappeared and the Fed would struggle to regain its most potent policy tool – rate-setting. Now, for better or worse, base rates of nearly 5.50% mean the Fed has significant capacity to cut rates to support the economy in response to a severe recession or macro-economic shock. Investors should take some comfort in this potential insurance buffer against unknown tail risks.
The markets also seem to be working through debt issues in a reasonably constructive manner, helped in part by much stronger discipline and prudence in lending prior to the pandemic (thanks to many of the post-GFC regulatory changes). Banks generally have better diversification and higher capital buffers, and regulators seem to be paying close attention to more material issues in the banking sector. Banks’ loan write-offs during the past couple of years have started to create more flexibility to lean on borrowers and flush out problem loans / assets through loan sales and short sales. In fact, we’re already hearing of a notable uptick in lender-mandated short sales of properties. With the wall of CRE loan maturities upon us, debt will continue to rule everything around us for the foreseeable future. A fortunate consequence so far is that we have seen a notable uptick in stressed and distressed investment opportunities since summer 2023, and we are extremely busy. The “bid-ask gap” on asset valuations has narrowed significantly as many sellers are motivated to do something (anything) after kicking the can for so long – equitize (if they have liquidity), refinance at market terms, or sell at a market-clearing price. They are just simply out of time and out of options. We expect this dynamic buying and lending environment to last for at least a couple of years as CRE debt issues persist. And we are entering this next phase being in the very fortunate and enviable position of having no legacy portfolio issues, thanks to good decision making, strong discipline, and certainly some luck along the way. As a result, we’re able to think calmly, constructively, and opportunistically about the opportunity set in front of us. And in these respects, at least, perhaps the current environment could actually prove to be a “dream” come true after all.