The Discussion: Real Estate Trust’s Signal; The Worst Behind in the US?
In a recent interview with Bloomberg Television, Rich Hill, Head of Real Estate Strategy & Research at Cohen & Steers, discussed the current state of commercial real estate and the future of office buildings nationally (observations can apply less in Miami). This conversation took place as the Dow Jones historically surpassed 40,000.
Current State of Office Spaces
Nationwide office vacancies are at a staggering 20%, with expectations of further increases. Hill noted a disparity in performance among different office categories. New, clean, and green office spaces, especially in prime locations like New York City, are doing exceptionally well. For instance, Hudson Yards and One Vanderbilt have seen high occupancy rates. In contrast, Class B and C properties, typically built in the 1970s and 1980s and lacking significant capital expenditure, are struggling. Hill emphasized that while office spaces are facing challenges, they only constitute 20% of the commercial real estate market and 3% of the US listed real estate market.
Lending Environment and Property Valuations
The lending environment for real estate investors is a critical issue. Commercial real estate is a heavily leveraged asset class, with most properties purchased with substantial debt. This leverage has led to significant pressure on property valuations. Hill pointed out that property valuations have generally declined by around 20%, with office valuations down by about 35%. This decline is driven not by poor fundamentals but by higher financing costs and reduced availability of debt.
The Role of Lenders and Borrowers
Hill explained the complex dynamics between lenders and borrowers, likening it to a “prisoner’s dilemma.” Banks are not keen on owning office spaces, as regulatory capital charges for owning property on balance sheets are higher than modifying loans at a high loan-to-value (LTV) ratio. This has led to modifications and extensions of loans, a practice some might see as “kicking the can down the road,” but Hill views it as a necessary adjustment in a challenging environment.
Private Credit in Real Estate
The growth of private credit in the real estate market has been notable. In 2015, private credit accounted for about 10% of total lending, peaking at around 20%. Although this market share has slightly decreased, private credit remains a significant player. Hill noted that private credit can fill gaps left by traditional banks, particularly in underwriting and working out loans.
Future Outlook
Despite the challenges, Hill suggested that the feared collapse in commercial real estate lending has not materialized. Instead, the market is experiencing a slow adjustment. While property valuations are expected to drop further, reaching a peak-to-trough decline of 25-30%, this might signal a bottoming out. Sellers capitulating and buyers stepping in could indicate a healthy contrarian signal for the market.
In conclusion, while the commercial real estate market, particularly office spaces, faces significant hurdles, there are signs of stabilization. The strategic modifications in lending practices and the role of private credit provide a framework for navigating these challenges. The market’s slow adjustment, rather than a sudden collapse, offers a cautiously optimistic outlook for the future.